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Personal computer manufacturers such as HP (HPQ), Dell (DELL) and Apple (AAPL) tend to outsource their hardware manufacturing to contract manufacturers in China. A recent New York Times article reported that cost of making consumer electronics devices like PCs, digital cameras and smartphones in China is likely to increase due to soaring labor costs, inflation and China’s strengthening currency, which makes Chinese exports more expensive.

In an earlier article, we concluded that rising input costs are unlikely to impact Apple’s stock price because the company sells premium products like the iPhone and enjoys very high profit margins. HP and Dell are different in that their PC businesses are characterized by high volumes and low margins. Both companies face significant downside risk if they are unable to pass increased input costs on to their customers. Our analysis follows below.

Rising Costs Squeeze Chinese Contract Manufacturers…

Foxconn (OTCPK:FXCNY), Flextronics (FLEX) and Jabil Circuit (JBL) are the leading players in the $250 billion Chinese contract manufacturing industry. These three companies manufacture and assemble most of the electronics products sold by Apple, Dell and HP. Because Chinese contract manufacturers have very slim profit margins, their business models depend on keeping operating costs contained.

This year, wages in this sector rose by 20% to 30%, driven by worker unrest and local government pressure. Raw material prices also rose sharply due to inflation. It will be difficult for Foxconn and its peers to stay in business without passing these cost increases on to their clients.

Who in Turn Squeeze HP and Dell

In the past, fierce competition in the PC market has driven steep price declines. We estimate that Dell’s average notebook price fell from around $1300 in 2005 to around $860 in 2009. We expect the decline to to continue, reaching $435 by the end of the Trefis forecast period.

Given these competitive pressures, HP and Dell may not have the option of passing cost increases on to their customers. Absorbing extra input costs will result in further pressure on their slim margins.

Dell’s notebook business currently has EBITDA profit margins of 4.5% and contributes around 18% of the company’s stock value. A 1% notebook margin decline would shave 6% off our $17 price estimate for Dell’s stock. Similarly, a 1% decline in HP’s margins would result in a downside of around 2% for the company’s stock price.

You can modify the charts below to see how changing EBITDA margins for notebook sales impact the stock prices of Dell and HP respectively.

Disclosure: No positions

Source: Chinese Manufacturing Cost Hikes Threaten HP and Dell