Tech

Tim Culpan is a technology columnist for Bloomberg Gadfly. He previously covered technology for Bloomberg News.

Terry Gou missed his goal last year of increasing Hon Hai's revenue by 10 percent. It's the third straight year that sales growth at the publicly traded flagship of Gou's Foxconn Technology Group failed to hit the mark.

Don't worry. Sales have become one of the least-important metrics for Hon Hai over the past few years, despite a continuous expansion driven by its reliance on Apple. As the chief manufacturer of iPhones, the Taiwanese company derives half its revenue from Cupertino. With Apple broadening its catalog of assemblers while iPhone demand has slowed, Hon Hai's top line is no longer growing at the same pace.

Gou boosted capital expenditure a decade ago as Foxconn prepared to assemble the first iPhone, a contract that helped boost sales but actually hurt margins. Prior to the iPhone, Hon Hai's bread-and-butter was PCs, servers, notebooks and most of the components that go inside them.

Following the iPhone's introduction in 2007, it was clear Gou had a winner and he went on another three-year spending spree, funded by the bump in revenue. Hon Hai expanded factories and equipment, decentralized away from its Shenzhen manufacturing base, and started investing in automation.

Expansion Wanes
Hon Hai's capex-depreciation ratio has fallen after a spending spurt
Source: Bloomberg data

That spurt of investment has run its course, as shown by the capex-depreciation ratio, which is now near its lowest on record on a five-year average basis (an increase in capex naturally leads to higher depreciation expenses over following years).

The result has been an improvement in the metric that best indicates Hon Hai's health: its operating margin . After being depressed by the years of high capital spending, this has started to trend back up. Hon Hai's operating margin climbed to 3.66 percent last year, the highest since 2009, the company reported Wednesday. It's improved every year since bottoming at 2.4 percent in 2011.

Mending Margins
Profitability fell after the iPhone but has improved amid automation and efficiency gains
Source: Bloomberg data

Being more experienced at building iPhones and automating more of the process has resulted in a slow but steady improvement in Hon Hai's operations. Net income climbed 12.5 percent in 2015, almost double the rate of sales growth.

The question now is whether the improvement can continue. Bulls would say that Foxconn's unparalleled speed and skill in making all manner of gadgets means more progress lies ahead. The bearish argument is that there's not much more to be squeezed out of using robots rather than humans, while competition for Apple contracts is increasing amid the iPhone slowdown.

Hon Hai's Rise
The shares have been lacklustre in recent years amid growth concerns
Source: Bloomberg data

Then there's Sharp, in which Foxconn agreed to buy a controlling stake for $3.5 billion on Wednesday. Because neither Hon Hai nor its affiliates will take a majority interest in the Japanese electronics maker, any earnings (or losses) will feed into the non-operating line of the income statement. That's good news for investors because they can separate the Foxconn wheat from the Sharp chaff.

It's not clear there will be any operational benefits from the Sharp investment. In theory, Foxconn could get more advantageous pricing by being bigger, and having access to better technology, which would flow through to its gross and operating margins. Yet these gains are far from certain, and Foxconn will devote a lot of its own resources to trying to turn Sharp around.

For sure, investors will keep watching Hon Hai's sales growth for clues to an entry or exit point. Operating margin remains a far better guide.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

  1. Net income is one of the toughest to model at Hon Hai because of the swings in non-operating items.

To contact the author of this story:
Tim Culpan in Taipei at tculpan1@bloomberg.net

To contact the editor responsible for this story:
Matthew Brooker at mbrooker1@bloomberg.net