One of my first few articles on Seeking Alpha was about Foxconn (OTCPK:OTCPK:FXCNY), aka, Hon Hai Precision. This Taiwan based manufacturer, manufactures a number of products by Apple (AAPL), like the iPod, iPad and iPhone, but also other technology staples for Apple competitors. To name a few: the Amazon (AMZN) Kindle , Sony (SNE) Playstation 3 and Nintendo(OTCPK:NTDOY) Wii U. It owns plants all over the world, with a major part of their capacity located in China and Taiwan. However, Google (GOOG) Glass will be manufactured in the United States. Originally my article focused on Google Glass but I think that was a mistake.
I made quite a few intellectual mistakes in that article and I'd like to try and make up for that with this article on this under the radar company. The major mistake I made in the earlier article was in my overly rosy evaluation of Foxconn's core business.
Fundamentally the contract manufacturing business is a terrible business. Companies hang on by the mercy of their clients and have to fight off competitors left and right when margins get a little better because of a boom in demand.
Not a business you want to be invested in for the long haul.
However when the contract manufacturer can be acquired at a great price the bad business model shouldn't deter you. The company has outperformed the market by a few % since my earlier article. Yet I estimate it is again trading at a discount.
Per Yahoo Finance:
Foxconn International Holdings Limited, an investment holding company, provides integrated manufacturing services for the handset industry worldwide. The company engages in the design, manufacture, assembly, import, export, and distribution of handsets; and research and development, and project management activities. It also offers product development, after-sale, and repair services. The company was incorporated in 2000 and is headquartered in Lang Fang, the Peoples Republic of China. Foxconn International Holdings Limited is a subsidiary of Foxconn (Far East) Limited.
Revised Upsides of Google Glass for Foxconn
Earlier this year I examined possible upsides for Foxconn that I expected to come with the production of Google Glass:
- Foxconn will be less reliant on Apple, which currently accounts for 40%-60% of their revenue (estimates cover a wide range but it's always a number that does not look healthy).
- This prestige project puts Foxconn in a positive light. Although as a manufacturer of the high-end iPad, iPhone, iPod, Kindle, Playstation and Wii U devices, it's hard to question their ability to put quality products together. However, it could take some attention away from the bad press concerning their treatment of workers.
- If Google Glass becomes a huge success Foxconn will be well positioned to profit along with the American tech giant. When Google needs maximum capacity to meet great demand, margins will likely be excellent on a relatively expensive product.
Since then I've come to think different about a few things:
1. Relying less on Apple
The latest numbers floating around still point to signs that the company relies heavily (40%) on Apple. I still think a more diverse client profile could be a catalyst for stock price increase and it would be a real improvement of the company. But getting a portfolio of clients does not improve the fundamentals of the business of contract manufacturing. I'll still buy into a business like that if it's super cheap but I don't want to hold it for long.
2. Prestige project
In retrospect this is not a very strong argument. It is clear that Foxconn is a capable contract manufacturer. Sure they are getting some press because tech company's come up with fancy new toys but ultimately this isn't what drives intrinsic value.
3. Google Glass Success
A lot of if's in my argument and as a contract manufacturer I don't think Foxconn is in a great position to profit from anything. Partners will allow them to generate cost of capital but not a lot above and beyond that.
Additional Risks For Foxconn
There are many uncertainties surrounding Foxconn. They get a lot of bad press for their worker treatment. Clients do not want this reputation to rub off on their brands. Sources report they are addressing this issue. The company's financial results have been very good in the distant past. Over the last few years they have been less than desirable.
Foxconn has been declining again after having a terrific run this year. According to the Wall Street Journal, "Hon Hai is reluctant to expand its iPhone production site too much as it could lose orders to other smaller competitors such as Pegatron Corp and Wistron Corp next year. Apple is looking to add new contract manufacturing partners in Asia to boost its production of its smartphones and tablets, people familiar with the supply chain said earlier this month."
Why Foxconn is a buy again
Foxconn derives about 40% of its revenue from its major client Apple. The company tries to diversify its operations and client base as revenue from contract manufacturing slows. The company has branched out into the retail market by selling its own brand of mobile accessories. It is also making a push into software development and telecom services. These are higher margins businesses but the company has little to show for so far.
The main reason I consider Foxconn attractive again is because it is so cheap again. The market fears upcoming competitors and Apple's push for a diverse supplier profile. But when competitors come in what is essentially a no-moat industry they will discover its a very low margin business and that will put a quick stop to incumbents expansion plans. It's also possible Foxconn enjoys economies of scale because its a large supplier. I wouldn't rely too much on that advantage when investing though.
Discounted Cash Flow Analysis
When I wrote up Foxconn earlier this year I only occasionally put together discounted cash flow models but now I try to do them for most articles. Foxconn doesn't have a sustainable competitive advantage and because of that, I'll only project cash flow 3 years into the future. I'll assume a growth rate of 0% and discount against the S&P 500. Using the TTM cash flow number as a base, I've come to the conclusion that Foxconn has a net present value per share of $10.91.
Unfortunately that's only a 11% premium over today's share price. Not a discount that inspires me but if you have a strong thesis on a growth driver for the company, the pictures quickly becomes much more favorable.
There is some protection on the downside as the company trades close to tangible book value at today's price of $9.77.
I view this as a high risk opportunity to acquire stock of a company that has solid manufacturing capabilities and competitive execution. Certainly not a no-brainer, but in my view it's a bet with positive expected value. A conservative discounted cash flow calculation shows a discount of 11% to intrinsic value. If you have strong bullish views on the future of Foxconn, instead of my neutral perspective, the discount quickly widens to a very juicy double digits gap.