Foxconn: Seeking Diversification Beyond Contract Manufacturing?

PATRICIA TSE AMY YIP

FOXCONN: SEEKING DIVERSIFICATION BEYOND CONTRACT MANUFACTURING?

Business transformation is crucial for Foxconn’s sustainable growth in the next 10 years.

- Terry Gou, Chairman and CEO, Hon Hai Precision Industry Company Ltd. 1

From its humble beginnings as a maker of plastic components for television sets in Shenzhen, China, Foxconn had grown into the largest contract manufacturer of consumer electronics devices in the world.2 Best known for the assembly work it did for Apple, Foxconn in many ways reflected the rise of the light-manufacturing industry in China since the 1980s. With a plentiful supply of cheap labor, it was able to gain a competitive advantage in labor-intensive, low-margin assembly work for global brands. The combination of a highly organized, military-style management, low pay and long hours gave Foxconn factories a “sweatshop” image, which came under intense scrutiny following a series of worker suicides in 2009.

As the largest consumer electronics exporter in China, Foxconn also experienced the challenges now facing the country’s manufacturing sector. Following three decades of economic development, wages had been increasing and labor was no longer cheap. Competition for workers became intense as job opportunities in the manufacturing and service sectors increased. Foxconn also faced slowing growth in the global consumer electronics industry and cutbacks in orders by Apple, its largest customer.

Realizing the limits to further growth of its contract manufacturing business, Foxconn looked for opportunities to diversify into other business areas. The initiatives reported in the press were wide in scope, indicating that Foxconn was looking for ways to transform and differentiate itself. What attempts did Foxconn make to diversify itself beyond contract manufacturing? What were the prospects, given Foxconn’s strengths and weaknesses?

1 Luk, L. (30 June 2014) “Taiwan’s Foxconn Recrafts its Future”, Asian Wall Street Journal. 2 Foxconn was the trade name for Hon Hai Precision Industry Company Ltd.

To order this case, please contact Centennial College, c/o Case Research Centre, Centennial College, Wah Lam Path, Pokfulam, Hong Kong; website: http://cases.centennialcollege.hku.hk. This case was fully supported by a grant from the Research Grants Council of the Hong Kong Special Administrative Region, China (UGC/IDS12/14). © 2016 by Centennial College, an Independent College Established by HKU. No part of this copyrighted publication may be reproduced or transmitted, in whole or part, in any form or by any means, whether electronic, mechanical, photocopying, recording, web-based or otherwise, without the prior permission of Centennial College. This case was prepared for class discussion purposes and is not intended to demonstrate how business decisions or other processes are to be handled. Ref. 16/003C Published: 11 August 2016

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Foxconn: Seeking Diversification beyond Contract Manufacturing? (Ref.: 16/003C)

Company Background

Foxconn was founded by Taiwanese businessman Terry Gou in 1974. From manufacturing plastic channel-changing knobs for black-and-white TV sets, it expanded into the PC industry in the early 1980s with the production of connectors, and began its collaboration with Apple in the 1990s.3 At a time when China was opening its economy up to foreign investment in export-oriented industries, Foxconn set up large-scale factories, which eventually became the global production base for iPhones, iPads and other branded consumer electronic devices. Foxconn’s clients were believed to include Dell and Hewlett-Packard (PCs), Amazon (Kindle), Nintendo (game consoles) and Sony (TVs), among others.4 Foxconn became the world’s largest contract manufacturer of consumer electronics in terms of revenue, at US$133 billion in 2014 (see Exhibit 1), employing more than one million workers5 in its production bases in China.

Consumer Electronics Industry

The consumer electronics industry included products such as smartphones, computers, televisions, video-game consoles and emerging categories such as wearables and 3D printers. Analysts expected slower growth in the global consumer electronics industry. IDC predicted that the growth in smart-phone sales – the driver of overall industry revenue – would decline by half, from 27.6% in 2014 to 11.3% in 2015, while PC sales would fall by 3%. 6 Competition in the industry was intense. New and successful products were quickly copied, resulting in short product life cycles, rapid commoditization and falling prices.7

One of the most important developments in the industry since the 1980s was its increasingly global supply-chain network.8 Brand-name firms in the US and Japan focused on product development, design and marketing, and outsourced manufacturing to firms in cheaper locations.9 The first wave of off-shoring saw the movement of labor-intensive production activities to East Asian countries such as Taiwan, Korea and Singapore. As these electronics producers grew in expertise and labor costs increased, they moved on to more advanced component manufacturing, with labor-intensive assembly services shifting to lower-wage countries in the region – especially China – in the 1990s. The trend gave rise to the growth of large “contract manufacturers” in East Asia, capable of serving multiple brand-name firms in different electronics-industry product categories.

3 Ibid. 4 Yang, L. (6 May 2013) “Foxconn Tries to Move Past the iPhone”, The New York Times. 5 Gold, M. and Lee, Y. (28 January 2015) “Apple Supplier Foxconn Seeks to Slim Workforce over Time, Eyes Robotics”, Reuters, http://uk.reuters.com/article/uk-hon-hai-labor-exclusive-idUKKBN0L00YZ20150128 (accessed 30 November 2015). 6 Ibid. 7 Soo, D. (December 2014) “Industry Outlook: Consumer Electronics”, Euler Hermes, http://www.eulerhermes.com/mediacenter/Lists/mediacenter-documents/Industry-Report-Consumer-Electronics-Dec14.pdf (accessed 30 November 2015). 8 Trends that enabled the fragmentation of the production process included the development of modular product architecture for the IBM PC, and improvements in transportation and communications technologies. Stages of production became separable from one another, and could be sited at the most economically advantageous locations. [Gangnes B. and Van Assche A. (2007) “Global Production Networks in Electronics and Intra-Asian Trade”, prepared for the SCAPE-EABER workshop, “Intra-Asia Trade and Factor Flows: Trends, Determination and Implications,” held in Singapore., 8-9 October 2007.] 9 Chan, J., Pun, N. and Selden, M. (July 2013) “The Politics of Global Production: Apple, Foxconn and China’s New Working Class”, New Technology, Work and Employment, 28(2), http://onlinelibrary.wiley.com/doi/10.1111/ntwe.12008/pdf (accessed 30 November 2015).

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Foxconn and the Consumer Electronics Supply Chain

Foxconn was one of the most successful contract manufacturers in the industry, best known for its role as the assembler of Apple’s products. As was typical with many brand-name firms, Apple focused on its core strengths in R&D, software development and marketing, and outsourced its manufacturing. Components, especially high-end ones such as LCD displays and memory chips, were sourced from a variety of suppliers, including Korean and Japanese firms. Foxconn was in charge of assembly operation. It was a labor-intensive process and margins were low, estimated at under 4%.10 Foxconn’s high revenues therefore came from handling large volumes of low-margin work for the world’s consumer electronics brands. [See Exhibit 2 for an analysis of the iPhone value chain.]

Foxconn’s ability to deliver high volumes of contract manufacturing work at competitive costs, speed and quality, was related to two external factors: (1) Foxconn’s Chinese production bases benefited from a plentiful supply of cheap labor in the 1980s and 1990s. Thousands of young workers in inland provinces, willing to work for low wages, travelled to southern China. These migrant workers, housed in large dormitories, enabled Foxconn to run huge assembly lines at low cost. 11 (2) Foxconn also benefited from the growth of large clusters of component makers and an excellent infrastructure in southern China. 12 This enabled Foxconn to respond to the changing demands of the global electronics industry with speed and flexibility.

Contract-Manufacturing Business Under Pressure

Riding on the trend of consumer-electronics outsourcing, Foxconn enjoyed a long period of double-digit revenue growth. In the period 2001 to 2010, revenue grew at an average of 42.6% a year, notwithstanding the drop in revenue during the global financial crisis of 2008 and 2009. Revenue growth however, began to record an obvious slowdown beginning in 2011, and fell to 1.2% in 2013, before partially recovering to 6.6% in 2014.13 [See Exhibit 1 for Foxconn’s financial information.] A few factors accounted for the slowdown in its contract manufacturing business:

Over-reliance on Apple

Although Foxconn did not disclose details of its revenue breakdown by client, analysts estimated that Apple’s business accounted for 40-50% of its revenue. 14 Foxconn began supplying computer components to Apple in the 1990s, and eventually became its main manufacturing partner for the iPod (launched in 2001), iPhone (launched in 2007), and iPad (launched in 2010). 15 Foxconn’s revenues grew with the success of Apple’s products. However, Apple began to diversify its supplier base in 2011 and shifted part of its orders to Pegatron, a smaller Taiwanese manufacturer reportedly willing to accept thinner profits.16 The cutback in Apple’s orders, plus the slowing rise in iPhone and iPad sales, resulted in dismal growth for Foxconn in 2013, which partially recovered in 2014 due to the boost from the

10 The Economist (5 September 2015) “Kicking the Apple Addiction”, http://www.economist.com/news/business/21663248-taiwanese-firm-strives-avoid-over-dependence-its-main-client-kicking- apple (accessed 30 November 2015). 11 Duhigg, C. and Bradsher, K., (21 January 2012) “How the U.S. Lost Out on iPhone Work”, The New York Times. 12 Pilling, D. (7 February 2013) “Foxconn’s Union is a Sign that Cheap China is No More”, Financial Times. 13 Hon Hai Precision Industry Co., Ltd. (various years) “Annual Report”; Bloomberg database. 14 Clover, C. (15 August 2014) “Lenovo Gains Smartphone and PC Sales”, Financial Times. 15 Luk, L. (30 June 2014) “Taiwan’s Foxconn Recrafts its Future”, Asian Wall Street Journal. 16 Dou, E. (12 November 2013) “Pegatron’s Apple Deal a Mixed Blessing – Becoming Primary Supplier for iPhone Leads to Record Revenue, Squeezed Margins, Labour-Group Scrutiny”, Asian Wall Street Journal.

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Foxconn: Seeking Diversification beyond Contract Manufacturing? (Ref.: 16/003C) launch of iPhone 6 and 6S. Analysts believed that while Foxconn once made 90% of Apple’s handheld devices, by 2015 its share had dropped to two-thirds.17 Analysts believed that Apple might place orders with yet other Taiwanese manufacturers to diversify and secure its supplier base further.18

Rising labor costs and worker shortages

Rising labor costs also harmed Foxconn’s ability to handle high-volume manufacturing at low cost. Foxconn’s management reported that its labor costs had more than doubled since 2009.19 As China’s economy developed, wages had been on the rise, as evidenced by the more than 10% increase in minimum wages in China’s major municipalities in recent years. 20 [See Exhibit 3 for the increase in China’s minimum wage.] Foxconn, in particular, faced strong pressure to increase wages after a spate of high-profile suicides at its factories beginning in 2009.21 Factory conditions, including low pay, long hours and military-style discipline, came under intense media scrutiny. This became a major public relations issue for Foxconn as well as Apple. Foxconn had since sought to improve labor conditions by increasing wages and opening itself to audits by international labor organizations.22 This put pressure on the margins generated by Foxconn’s assembly operations.

A related issue was a worker shortage. Analysts reported that Foxconn had to battle with chronic shortages of workers in manning its huge Chinese production lines. 23 China’s demographic trends pointed to an aging population: after three decades of its one-child policy, the number of young workers had peaked and started to decline in 2012.24 The issue was a particular headache for manufacturers, as young workers now had more choices and increasingly preferred service-industry jobs.25 Some electronics makers reportedly faced a 20% turnover rate monthly.26

In other words, Foxconn faced the prospect of declining orders from Apple and increasing costs of running its Chinese contract manufacturing business. Gou acknowledged that contract manufacturing alone was no longer enough to keep growth up, and actively sought opportunities to diversify into other product and service areas.

Diversification Strategy

Gou’s vision was that Foxconn would become an “information processing technology company,” 27 and he floated wide-ranging investment ideas and launched numerous projects generated by that vision. Foxconn’s diversification efforts will be described below. In all cases, the goal was to move into higher-value-added, higher-margin business areas.

17 The Economist (5 September 2015) “Kicking the Apple Addiction”, http://www.economist.com/news/business/21663248-taiwanese-firm-strives-avoid-over-dependence-its-main-client-kicking- apple (accessed 30 November 2015). 18 Luk, L. and Wakabayashi, D. (9 July 2015) “Apple Plans Record Number of iPhones”, Asian Wall Street Journal. 19 Luk, L. (30 June 2014) “Taiwan’s Foxconn Recrafts its Future”, Asian Wall Street Journal. 20 Dou, E. (25 August 2014) “Electronics: Outmanned in Robots”, Asian Wall Street Journal. 21 For a detailed discussion of Foxconn’s labor practices, see Lucas K., Kang D. and Li, Z. (2013) “Workplace Dignity in a Total Institution: Examining the Experiences of Foxconn’s Migrant Workforce”, Journal of Business Ethics, April 2013, Volume 114, Issue 1, pp. 91-106. 22 Mozur, P. (21 February 2013) “Foxconn Suspends Hiring at China Plants”, Asian Wall Street Journal. 23 Hille, K. (8 October 2012) “Foxconn Hit by Fresh Outbreak of Unrest at iPhone 5 Factory”, Financial Times. 24 Bloomberg News (20 January 2015) “China’s One-Child Policy Backfires as Labor Pool Shrinks Again”, http://www.bloomberg.com/news/articles/2015-01-20/china-s-one-child-policy-backfire-deepens-as-labor-pool-shrinks (accessed 30 November 2015). 25 Bland, B. and Mishkin, S. (8 October 2013) “Foxconn Feels Strain of Staff Shortages”, Financial Times. 26 Aeppel, T. and Magnier, M. (6 July 2015) “China’s Hunger for Robots Marks a Shift”, Asian Wall Street Journal. 27 Clover, C. (18 July 2014) “Foxconn seeks to escape the factory line”, Financial Times.

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Diversification within the consumer electronics industry

Component manufacturing: One of the earlier attempts at diversification was to acquire parts manufacturers and build capabilities in making simple components, such as casings, connectors and cables.28 These components often carried higher margins than final assembly services did. 29 Including the components made by its subsidiaries into the final product assembled helped Foxconn lift margins at the group level.

Gou also displayed an ambition to move into the manufacturing of high-end components, such as flat-panel displays. In 2009, Foxconn invested in Chi Mei Innolux, Taiwan’s biggest flat-panel maker by revenue. To gain access to advanced LCD technology, Foxconn acquired a 50% stake in Sharp Corporation’s display factory in Sakai, Japan, and also discussed taking a 10% stake in Sharp in 2012,30 though the deal was not completed.31 In 2014, Foxconn announced that it would partner with Innolux to invest NT$86.6 billion (US$2.8 billion) in a panel-producing plant in Taiwan,32 which was expected to make displays for smart phones “exclusively for a client.”

Software capability: Gou believed that “smartphone makers were not just competing on price and functionality,” they would “increasingly compete on software.” 33 In 2013, Foxconn announced a partnership with Mozilla, the developer of a new operating system called Firefox OS.34 Firefox OS was based on HTML and open-web technology, and was developed as an alternative to Apple’s iOS and Google’s Android, particularly for lower-cost smart phones in emerging markets. Foxconn would help design new devices, such as phones and tablets, using Firefox OS, and announced that it would hire 3,000 software engineers to support this initiative.35 By having the capability to supply software along with hardware for any company, such as ZTE or LG, which might want to launch Firefox OS devices, Foxconn could position itself as the manufacturer of choice, and capture a larger share of the profits in the supply chain. Foxconn however, indicated that it had no plans to build its own branded products based on Firefox OS.36

Own-brand business: In 2013, Foxconn launched its own brand of mobile accessories, such as iPhone casings, under the Coverbank brand name, in Taiwan.37 The accessories were sold under partnership agreements with major Taiwanese carriers such as Taiwan Mobile. The plan was to expand to China and Hong Kong, and later to other Asian markets through local retail distributors. Foxconn, however, indicated that it had no plans to launch its own brand of mobile phones.38

28 Mishkin, S. (15 May 2013) “Pegatron Takes a Bite out of Hon Hai’s Apple”, Financial Times. 29 Ibid. 30 Kwong, R. (11 April 2012) “Japan Loses Tech Edge to Neighbours”, Financial Times. 31 Sharp’s LCD business had good technology, but it invested heavily in display-production capacity when competition caused prices to fall. Sharp’s financial situation worsened, its share price fell sharply and Foxconn pulled out of the deal. [Luk, L. (24 October 2014) “Foxconn Aims to Make Screens for iPhones’, Asian Wall Street Journal.] 32 Bloomberg (20 November 2014) “Foxconn Unit to Build Dedicated Taiwan Display Plant”, http://www.bloomberg.com/news/articles (accessed 9 October 2015). 33 Hon Hai Precision Industry Co. Ltd. (2014) “Annual Report”. 34 Mozilla (3 June 2013) “Foxconn Adopts Firefox OS”, http://www.blog.mozilla.org/press, (accessed 10 October 2015). 35 Wang, L. (21 June 2013) “Hon Hai to hire 3,000 in Kaohsiung”, Taipei Times, http://www.taipeitimes.com/News/biz/archives/2013/06/21/2003565268 (accessed 9 October 2015). 36 Shankland, S. (3 June 2013) “Foxconn Taking Firefox OS to Tablets, not just Phones”, http://www.cnet.com/news/foxconn-taking-firefox-os-to-tablets-not-just-phones/ (accessed 9 October 2015). 37 Luk, L. (25 October 2013) “Hon Hai Branches out into Mobile Accessories for iPhones”, Wall Street Journal, http:/blogs.wsj.com/digits/2013 (accessed 10 October 2015). 38 Ibid.

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Diversification into more technology-intensive industries

Foxconn also moved away from a traditional focus on consumer electronics, and ventured into more technology-intensive manufacturing, such as servers, automotive components, and medical equipment.

Joint venture (server manufacturer): Foxconn launched a joint venture with HP in May 2014 to make servers aimed at service providers.39 The goal was to capture the increasing demand for servers following the rise of big data and cloud computing.

Automotive components: Foxconn had plans to invest in a facility in Harrisburg, Pennsylvania, to manufacture automotive components,40 and had “big projects” planned with BMW AG and Volkswagen AG.

Medical equipment: Foxconn acquired an undisclosed stake in San Diego-based medical devices start-up Sotera Wireless Inc. in 2014.41 Backed by Qualcomm Ventures and Intel Capital, Sotera made wearable wireless devices for monitoring vital signs like blood pressure. Foxconn would make sensors and batteries used in Sotera’s medical devices, and became the company’s exclusive sales agent in China. Sotera’s chief executive said Foxconn might eventually take over production of its devices.

Analysts believed that Foxconn’s entry into the medical equipment market might be motivated by the following factors: the global contract-manufacturing market for medical equipment was predicted to grow faster than that for consumer electronics; the product life cycle of medical devices was longer; and margins for these technology-intensive products were higher. Analysts believed that Foxconn would need to “implement cultural change at all levels to ensure quality improvement,” as only four out of Foxconn’s more than 90 production facilities worldwide were certified for medical devices or components.42

Moving away from manufacturing into services

Gou believed that an “information processing technology company” should be “more than just hardware”43 and had an ambition to expand into the more profitable service industry.

Retail: Foxconn formed joint ventures in China with foreign electronics store operators such as German consumer electronics retailer Media Markt (part of Metro AG Group). The business failed to generate much revenue due to intense competition.44 Foxconn, with its roots in manufacturing, also faced “cultural difference” with its partner, according to its executives.45 The joint-venture electronics stores in China were closed in 2013. More recently, Foxconn opened Syntrend Creative Park, an 18-story IT mall in its home market of Taiwan, to sell smartphones and other information-technology products.46

In the area of online retailing, Foxconn launched flnet.com, which competed head-to-head in China with e-commerce giants Alibaba and JD.com.47 In August 2015, Foxconn and Alibaba

39 Dou, E. (1 May 2014) “HP, Foxconn Starts Server Joint Venture”, Asian Wall Street Journal. 40 Luk, L. (18 February 2014) “Hon Hai to List Unit in Taiwan – IPO of Cable and Connector Business Next Year Would Come Amid Group’s Growth Abroad”, Asian Wall Street Journal. 41 Luk, L. (15 April 2015) “Foxconn Makes Push into Health Care”, Asian Wall Street Journal. 42 Ibid 43 Clover, C. (18 July 2014) “Foxconn Seeks to Escape the Factory Line”, Financial Times. 44 Luk, L. (5 March 2015) “Foxconn Takes On E-Commerce Giants”, Asian Wall Street Journal. 45 Ibid. 46 Yamashita, K. (14 May, 2015) “Foxconn to open IT mall in Taipei”, Nikkei Asian Review, http://asia.nikkei.com/Business/Companies/Foxconn-to-open-IT-mall-in-Taipei (accessed 10 November 2015). 47 Luk, L. (5 March 2015) “Foxconn Takes On E-Commerce Giants”, Asian Wall Street Journal.

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Foxconn: Seeking Diversification beyond Contract Manufacturing? (Ref.: 16/003C) finalized a deal to jointly invest US$500 million in a 10% stake in Snapdeal, an e-commerce company in India backed by e-Bay and Soft Bank.48 Analysts believed that by investing in India’s major sales platform for handsets, Foxconn could help its customers, such as Xiaomi Corp, secure a sales channel in India’s electronics market.

Telecommunications: Foxconn’s subsidiary Ambit Microsystems Corp. won two of the newly issued NT$9.2 billion (US$313 mil) licenses to build a 4G telecommunications network in Taiwan. 49 Four of the other five winners of the licences were Taiwan’s existing telecommunications companies. Analysts commented that entering the telecommunications business was a highly unusual move for an electronics manufacturing company. 50 The industry was capital-intensive and Foxconn had little experience in building such networks. Some analysts questioned the logic that it would help Foxconn sell equipment to telecommunications providers. Others believed that Foxconn could be looking at 4G service as an avenue to design its own branded equipment, such as base stations and smartphones.

The Way Ahead

Foxconn, one of the most successful consumer electronics contract manufacturers, faced the prospect of declining growth in its core business. Its share of Apple’s business had peaked, and rising labor costs and worker shortages put pressure on its Chinese production base’s competitiveness. In response, Foxconn made clear its vision of moving away from labor- intensive, low-margin manufacturing, and diversifying into high-margin activities, to drive future growth. Its vision of an “information processing technology company,” however, appeared broad, and analysts found it difficult to gauge progress-to-date, given the lack of disclosure by the company.51 As the company had over US$130 billion in revenues, it would also take time for any new business to grow to a scale sufficient to make a meaningful impact on revenue.52 Analysts had expressed concerns regarding diversification. By seeking a wider role in the consumer electronics supply chain, Foxconn ran the risk of potential conflicts of interest with some of its clients. Analysts questioned whether initiatives further removed from its core business were connected with the company’s core capabilities. 53 How Foxconn implemented its vision of business diversification would be keenly watched.

48 Bhattacharjee, N. and Wu, J. (19 August 2015) “Alibaba, Foxconn and Softbank Invest in Snapdeal”, Reuters, http://in.reuters.com/article/ebay-foxconn-snapdeal-idINKCN0QN18H20150819 (accessed 10 November 2015). 49 Mishkin, S. (30 October 2013) “Foxconn wins licence to build 4G network in Taiwan”, Financial Times. 50 Ibid. 51 Wu, J. (8 July 2015) “In Gou We Trust: Foxconn Founder Keeps Investors in Dark, Happy for Now”, Reuters, http://www.reuters.com/article/us-taiwan-hon-hai-idUSKCN0PI2LG20150708#QFLjsAKoZdoC4h17.97 (accessed 30 November 2015). 52 Harbet, T. (19 September 2013) “Hon Hai Cornered by its Own Success”, IHS Electronics360, http://electronics360.globalspec.com/article/3066/hon-hai-cornered-by-own-success (accessed 30 November 2015). 53 The Economist (5 September 2015) “Kicking the Apple Addiction”, http://www.economist.com/news/business/21663248-taiwanese-firm-strives-avoid-over-dependence-its-main-client-kicking- apple (accessed 30 November 2015).

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