Tech

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

It seems Foxconn shareholders aren't sure whether or not to forgive the company's terrible earnings.

Here's some help.

The company's Taipei-listed flagship Hon Hai Precision Industry fell 3.7 percent on Friday, recovered about a third of that Monday, before dipping again Tuesday. This loves-me, loves-me-not ride comes after Hon Hai reported second-quarter earnings that missed estimates by the most in four years, and investors aren't sure whether it's a one-off.

While a decline in sales at Hon Hai was already known,  hidden in a filing late Thursday was a set of figures nobody had expected and which spurred a flurry of trading that led to the biggest share-price drop in a year: Operating margins narrowed by one-third while net income margins also fell. And both were their lowest in three years.

Singular Charm
Shares in Sharp rose 36 percent over the past three trading days. Hon Hai's shareholders have not been as fortunate
Source: Bloomberg

At the same time, Hon Hai announced that its investment in Sharp had received approval from China's competition watchdog, clearing the last remaining hurdle to its takeover of the ailing Japanese electronics maker. Sharp's shares rallied.

The two are connected.

While Foxconn Technology Group and its founder Terry Gou collectively own around two-thirds of Sharp, Hon Hai itself holds just 44.6 percent. That lack of a majority has allowed Hon Hai to remain vague as to how it'll account for Sharp in its quarterly reports, an indication that company officials think they can choose whether or not to include the unprofitable firm in Hon Hai's consolidated financial statements.

But an Aug. 13 announcement removes any wiggle room. Hon Hai's formal takeover of Sharp led to the resignation of President Kozo Takahashi, replaced by 30-year Hon Hai veteran Tai Jeng Wu.

Under International Financial Reporting Standards, Hon Hai can't use its minority-holder status to avoid consolidating Sharp's numbers. In fact, the rules state that:

"IFRS 10 provides a single consolidation model that identifies control as the basis for consolidation for all types of entities,"

and further, that:

"an investor can control an investee with less than 50 per cent of the voting rights of the investee." 

In appointing its own president immediately upon finalizing the transaction -- and the fact Sharp itself said it couldn't issue a financial forecast until after the deal had closed -- Hon Hai would seem to fulfil the IFRS definition of control.

This means that instead of taking gains or losses from Sharp at the non-operating level, Hon Hai should include the entity from the revenue line down and remove the proportion of earnings (or losses) attributable to non-controlling interests.

What a Drag
Consolidating Sharp will damage Hon Hai's operating margins
Source: Company filings, Bloomberg
Note: Sept., Dec. 2016 quarters are estimates.

The difference isn't to be sniffed at.

Sharp, likely at the insistence of Foxconn, has cleaned up its financials with moves such as write-downs of inventory. That's spurred some bullish views on Sharp for the coming two quarters, predicated on the notion a spring clean can help turn things around.

This brighter view, however, doesn't mask the fact that Sharp's earnings and margins will probably remain weaker than Hon Hai's, resulting in a drag on the parent after all those years Gou spent working to turn things around.

A key tenet of the thesis for going long on Hon Hai has been that despite slowing, or even declining, sales, the company has been successful at widening margins and raising profits. Each time I've asked Gou about his revenue goals over the past few years, he's retorted with derivations of the company mantra: "Even if you can’t grow your revenue, you have to grow your margin."

But with this new subsidiary hanging like an albatross around its neck and the global hardware industry firmly in a funk, any slip up in Sharp's turnaround has the potential to reverse Gou's hard-fought marginal gains. That will be a sharp shock for investors.

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

  1. Taiwan companies are required to report monthly sales within the first 10 days of the following month.

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

To contact the editor responsible for this story:
Katrina Nicholas at knicholas2@bloomberg.net