Rating Research Service 信用評等資料庫 Media Release Outlook On Pegatron Corp. Revised To Negative On Weak Profitability; 'twAA-/twA-1+' Ratings Affirmed April 15, 2019 Rating Action Overview PRIMARY CREDIT ANALYST − Pegatron's profitability is likely to remain under pressure over the next one to two years amid David Hsu Taipei weakening smartphone demand, rising labor costs in China, additional cost linked to possible +886-2-8722-5828 capacity relocation, and weak profitability at Pegatron's subsidiaries. david.hsu − Pegatron's return on capital is likely to remain below 10% for an extended period if the company fails @spglobal.com to improve the cost efficiency of its EMS operations and the performance of its casing subsidiary. david.hsu − On April 15, 2019, Taiwan Ratings Corp. revised its outlook on the long-term issuer rating on Pegatron @taiwanratings.com.tw to negative from stable to reflect our view that the company faces significant challenges to restore its SECONDARY CREDIT ANALYST profitability over the next one to two years. − We are also affirming the 'twAA-' long-term and 'twA-1+' short-term issuer credit ratings on Raymond Hsu, CFA Pegatron. Taipei +886-2-8722-5827 raymond.hsu Rating Action Rationale @spglobal.com raymond.hsu The downward outlook revision reflects our view of the growing likelihood that Pegatron Corp.'s return @taiwanratings.com.tw on capital could remain below 10% for an extended period due to continuing significant pressure on the company's margins. We believe intense price competition, weak smartphone demand, rising costs associated with rising wages and likely capacity relocation, as well as the weak performance at its major subsidiary, Casetek Holdings Ltd., will continue to pressure Pegatron's profitability over the next one to two years. The company's profitability has deteriorated over the past few quarters as a result of several factors. These include intensified price competition in the global electronic manufacturing services (EMS) industry, weaker cost efficiency associated with weaker shipments of Apple smartphones, and elevated losses at Casetek, despite the subsidiary posting double-digit revenue growth in 2018. Price competition among Apple's EMS suppliers could become more intense, given that demand for iPhones could decline significantly year on year over the next few quarters. We now expect Pegatron's revenue from iPhone sales to fall 12%-13% with units sold declining 15%-20% in 2019, partly due to still-weak global smartphone demand. Under this scenario, we believe Pegatron could see more pricing pressure and experience weaker cost efficiency for its iPhone production based on weaker scale economy. This could impact Pegatron's margins, particularly as labor costs continue to rise in China where Pegatron maintains a large workforce across the east coast. These areas carry higher average wages than inland areas. Any wage hike will rrs.taiwanratings.com.tw erodes Pegatron's margin if the company cannot pass through the incremental cost to its customers, which appears unlikely amid intensifying competition. In addition, the increasing variety of iPhone models significantly increases the complexity of capacity and labor force management for Pegatron and further increases unit production costs because of lower production yields and high associated labor costs. Moreover, we expect EMS companies to gradually diversify their production bases away from China in order to manage business risks stemming from trade friction particularly between the U.S. and China, as well as rising production costs in China. We believe the inevitable production inefficiency caused by these transitions could raise EMS companies' costs. Pegatron has started to move part of its production back to Taiwan as well as Indonesia due to the impact of recent U.S. tariffs on China. However, the company is unlikely to move its major smartphone and PC productions out of China, because China will remain the most cost-efficient production base over the next two years with sufficient workforce for the world's EMS industry. Nevertheless, we believe Pegatron should be able to better plan its capacity for iPhone production and therefore better manage its cost structure in 2019 to cope with anticipated lower iPhone demand. Pegatron's and Casetek's efforts to diversify their product mix away from smartphone applications is also likely to alleviate the impact of weak smartphone demand, in our view. Indeed, Casetek has materially narrowed its losses in the fourth quarter of 2018, thanks to the launch of non-smartphone products by its customers that materially improved Casetek's capacity utilization. However, a meaningful improvement in Pegatron's profitability is likely to take time, given intense competition. The rating affirmation reflects our view that despite recently weak profitability, Pegatron has largely maintained its good competitive position in the global EMS market. In addition, the company's competitive technology and service offering could help Pegatron to weather current business headwinds. Moreover, Pegatron is likely to improve its cash flow and lower its debt in 2019-2020 after normalizing its receivables and inventory turnover by adjusting down its iPhone production. This effort should increase Pegatron's leverage buffer over the next one to two years, in our view. Outlook The negative outlook reflects material uncertainty about whether Pegatron can restore its profitability over the next one to two years. The negative impact from a labor cost hike in China, intense competition amid weaker smartphone demand, additional costs associated with possible capacity relocation, and uncertainty over its subsidiaries' performance could all prevent Pegatron from sustainably maintaining its return on capital above 10%. However, we do expect some meaningful working capital inflow over the one to two years, which should help the company to keep its debt to EBITDA below 1x over the period. Downward scenario We may lower the long-term rating if Pegatron's return on capital shows no sign of improvement over the next few quarters and we believe it will stay below 10%, likely due to the company's failure to improve efficiency to offset rising labor costs in China and withstand pricing pressures from its customers. We may also lower the rating if Pegatron's debt to EBITDA increases to more than 1.5x for an extended period. This could happen if Pegatron takes on more debt due to overly aggressive capital expenditure or acquisitions or significant working capital outflow coupled with weaker profitability. Upward scenario We could revise outlook back to stable if we believe Pegatron can recover its profitability in line with our base case scenario. This could be achieved if the company can recover its cost efficiency particularly in smartphone production along with meaningful improvement in the performance of its subsidiary. At the same time, Pegatron would have to maintain its debt to EBITDA ratio below 1.5x. rrs.taiwanratings.com.tw April 15, 2019 2 Our Base-Case Scenario Macro and industry assumptions: − S&P Global's projection for world GDP growth of 3.4% in 2019 and 3.6% in 2020. − S&P Global's expectation that global IT spending will decelerate amid the migration to cloud computing. 2019 global IT spending growth to track overall GDP growth. Amid continuing security and tariff concerns, Asian EMS companies such as Pegatron could also utilize their capacity in other regions, including Southeast Asia, to make U.S.-bound products without significant additional costs. Company specific: − Taiwan Ratings' base case scenario for Pegatron indicates 6%-8% sales decline in 2019 and recover by low-single-digit in the following year. o Smartphone sales to decline by 12%-13% in 2019 mostly driven by iPhone unit sales decline, although the decline should moderate in 2020. o Consumer electronics sales will continue to increase in 2019-2020 due to new business expansion into areas such as Internet of Things and auto electronics. o Low single digit growth for PC sales as well as other communication equipment. − Pegatron's margin is likely to remain low but improve slightly in 2019-2020 due to better capacity and labor force management based on a more conservative projection for iPhone shipments. Casetek's profitability should stabilize with higher capacity utilization through expansion in non-smartphone components. − Capital expenditure will fall to New Taiwan dollar (NT$) 13-NT$15 billion in 2019-2020, mainly because of lower investment at its casing and IC substrate subsidiaries. Capital expenditure for core EMS business will also decline, given the company's expectation of weaker demand. − We expect some improvement in receivable and inventory turnover days, which is likely to bring working capital inflow of about NT$25 billion in 2019. − Cash dividend payout ratio over the next two years to be the same as in 2018. Based on the assumptions, we arrive at the following credit measures: − Debt to EBITDA of below 0.5x in 2019 and 2020. − Return on capital of 7%-9% in 2019 and 9%-11% in 2020. Liquidity The short-term rating on Pegatron is 'twA-1+'. We have revised our assessment of Pegatron's liquidity to adequate from strong, which has no impact on the ratings. The lower assessment mainly reflects Pegatron's higher refinancing needs as a result of increased short-term borrowing. We expect the company's ratio of liquidity sources to liquidity uses will be 1.4x-1.5x over the 12 months ending 2019. We also believe liquidity sources will still exceed liquidity uses even if Pegatron's EBITDA drops by 15%. In addition, we assess the company to have strong banking relationships and a high credit standing domestically and abroad, evidenced by its good reputation in Taiwan's financial market. We also believe Pegatron can absorb high-impact, low-probability events with limited refinancing, due to its large cash on hand. In addition, we believe the company has sufficient headroom on its financial covenants over the next two years.