Foxconn Needs Something Sharper

Taking a knife to some of the Japanese company's units would make a lot of sense.
Updated on

As Foxconn closes in on its four-year battle to purchase Sharp, Chairman Terry Gou needs to buy one more item: a knife.

Under an agreement announced by Sharp on Thursday, Foxconn would control about 66 percent of the company after forking out 484 billion yen ($4.3 billion) to buy new shares at 118 yen apiece. Foxconn says it’s looking more closely before signing any definitive agreement. 

If a deal does happen, Gou would add five new Japanese divisions and a whole lot of debt to his huge, but lean, Taiwanese manufacturing empire. If Gou wants to cover those liabilities and recoup his costs, he'll need to do more than simply convert those businesses to the Foxconn Way.

Flagging Fortunes

Two of Sharp's divisions have been persistent laggards

Source: Company financials

While Gou has likely pledged not to break up the company as part of his pitch to Sharp's board, history has shown that what one says and what one does aren't always in sync.

After various incarnations, Sharp's five divisions are Consumer Electronics, Energy Solutions, Business Solutions, Electronics Components and Displays. Dividing Sharp into its constituent parts and then valuing those parts against their industry peers based on projected sales gives the Japanese firm an enterprise value of about 1.8 trillion yen. Subtract items like debt and minority interests, and Foxconn is sitting on a little over 1 trillion yen in unrealized equity value.

To help unlock that, Gou should jettison at least two divisions.

When Foxconn first made a play for Sharp back in 2012, it was the Displays unit that appeared most enticing. Fast forward a few years and that division is still trumpeting its IGZO technology, a chemical process that makes display screens brighter and reduces battery drain. It was a modern marvel but since then, the world's moved on. Apple is investing in exactly the same area, which potentially could cut Sharp out of the picture entirely, and even Foxconn is building its own large display-technology factory in southern Taiwan. Sharp also didn't invent IGZO and thus shares licensing rights with its competitors, including everyone's nemesis, Samsung.

Based on the average enterprise value-to-sales ratio of industry peers and Sharp's own revenue forecasts, the Displays division is worth about 435 billion yen. Not too shabby, but considering there's unlikely to be another buyer and that Gou could slash costs, he might as well hang onto it and see what value he can extract.

The Gravity of Panel Pricing

LCD panel prices continue to fall with no improvement in sight

Source: Bloomberg data, Witsview.

Using the same methodology puts Sharp's Business Solutions unit at 356 billion yen. That's the division that makes point-of-sales terminals, cash registers and printers. Although it's not very sexy and by sales is the second smallest, it actually brings in the most profit. That shouldn't be a reason for Foxconn to keep it. Indeed, it's an opportunity to spin it off to a strategic investor or private equity firm.

Energy Solutions is the group that makes solar cells and air conditioners. It's the smallest unit and hasn't turned a profit for the past three quarters. Sharp had forecast it would be in the black this fiscal year but realized earlier this month that wasn't going to happen. Gou, however, has something of an emotional attachment to renewable energy and environmental technologies, so while a sale would make sense, he'll probably hold on to it.

That leaves two key divisions -- Consumer Electronics and Electronics Components.

Hidden Gem

Sharp's Electronics Components division offers the most value

Source: Bloomberg calculations based on Sharp's forecast FY2015 sales and EV/Sales of industry peers

One of them should go.

For many, Sharp is synonymous with high-end consumer electronics. The company's decades of experience and marketing nous has built a reputable brand that spans televisions to white goods. That's precisely why this is the division Gou should offload.

Foxconn is already in the business of supplying to consumer electronics names such as Sharp and its rivals. To then turn around and compete with those same customers by owning a brand is a recipe for disaster. Acer tried it back in the 1990s before spinning off Wistron, and Asustek followed a few years later when it created Pegatron.

Gou has built Foxconn into a global behemoth by looking after his customers, and deliberately not competing with them. Now is not the time to alter that strategy. With an enterprise value of 331 billion yen, Consumer Electronics isn't the fattest pig in the pen but there are plenty of would-be buyers (read Chinese companies) that have both the money and desire to pay a premium for a famous global brand.

For all Gou's talk about LCDs and their ilk, it's hard not to suspect it's the Electronics Components division he's most excited about.

Contributing 19 percent of sales, it's neither the biggest nor smallest unit but it does make some of the most lucrative widgets in the whole tech industry, including camera modules, analog chips and air-quality sensors. With an operating margin around half that of its peers, this is a business that's clearly punching below its weight, most likely because it's been bogged down in a slow-moving Japanese company.

Furthermore, component makers are routinely valued much higher than other companies in the sector, so ascribing a calculated worth of 525 billion yen is hardly a stretch.

Gou knows that the Electronics Components division is a diamond in the rough. He can leverage its technology to boost sales and, unshackled from the other units, it should be worth a lot more. In the end, that value could rise to a point where it pays for Foxconn's acquisition of the entire company. That's a Sharp move.

(Updates to reflect subsequent Foxconn statement)
This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

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    Tim Culpan in Taipei at

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    Katrina Nicholas at

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