Taiwan's Top 50: An S&P Scorecard
The third annual Standard & Poor's Ratings Services' survey of Taiwan's top 50 rated corporations is once again dominated by the high-tech industry. Our 2005 list comprises 28 high-tech companies, with the remainder belonging to "old-economy" sectors (see charts 1 and 2).
The aggregate net income of Taiwan's top 50 corporates slumped 17% year-on-year to New Taiwan dollar (NT$) 620.6 billion last year, mainly due to a weaker overall performance from Taiwan's high-tech sectors, especially thin-film-transistor liquid-crystal-display (TFT-LCD) and semiconductor companies, as a result of cyclical industry conditions and less favorable pricing.
Standard & Poor's projects the aggregate net income of the companies included in this report to fall a modest 3% year-on-year in 2006. In contrast to 2005, the weaker performance is likely to result from sharply lower earnings in old-economy sectors, including oil, chemicals, shipping, steel, and power, as a result of falling margins and rising costs, while high-tech sectors are expected to report higher profits, thanks to stronger industry growth and market demand.
In 2006, for the first time in six years, we project that high-tech companies will report higher aggregate net income (62% of total income) than old-economy companies (38%) (see table 1). Despite higher numbers of high-tech companies in Taiwan's top 50 list, the high-tech industry generated lower aggregate net income in 2001-2005 than old-economy sectors.
Whereas old-economy companies reaped the benefits of favorable industry conditions and windfall profits over the past few years, the high-tech industry experienced a moderate downturn in 2005. But the tables are likely to be turned in 2006, with high-tech looking set to trump old-economy.
Overall, the median financial ratios of Taiwan's top 50 corporates have been relatively strong. Although 28 companies posted lower year-on-year net income in 2005, explaining the fall in aggregate net income as well as the decline in median operating margin (see chart 3), median pretax interest coverage and median EBITDA (earnings before interest, taxes, depreciation and amortization) interest coverage remained quite robust at 18.6x and 19.6x, respectively (see chart 4). These strong ratios can be attributed to a combination of still good, albeit softening, profitability and Taiwan's very low interest-rate environment.
The median ratio of funds from operations (FFO) to total debt for the top 50 corporates remained very healthy at above 50%, while the median ratio of total debt to capital dropped to 26% in 2005 from 30% in 2004 because of a limited increase in total debt and a larger equity base boosted by earnings (see charts 5 and 6). From a net debt perspective, 20 corporates—mainly in high-tech sectors, as well as some telecom and auto companies—maintained a net cash position in 2005, up from 17 in 2004.
Here is Standard & Poor's roundup of the operating performance and credit metrics of individual sectors and notable companies in 2005, and our projections of anticipated performance in 2006:
Computer hardware/components/peripherals: Diverging credit quality
The operating performance of companies in this sector is polarized, reflecting their diverging credit quality. Delta Electronics' stellar operating margin of 12.4% in 2005 is a sharp contrast to BenQ's abysmal negative 3.9% over the same period.
Standard & Poor's considers Delta to have one of the stronger credit profiles in Taiwan's high-tech industry, as it has been able to maintain a relatively stable and high operating margin (above 12% in 2002-2005) and robust financial ratios, as well as an abundant net cash position over the past few years.
Acer's credit profile has also shown remarkable improvement following a strategy refocus that has resulted in stronger brand recognition and an increasing share of the global PC market. As a result, the company's sales and core earnings grew strongly in 2002-2005.
Furthermore, Acer has used its strengthened operating cash flow and proceeds from the disposal of long-term investments to reduce its total debt to a minimum level, while beefing up cash on hand. In stark contrast, BenQ's credit quality has rapidly deteriorated because of a sizable acquisition.
Tatung's credit quality remains very weak, as evidenced by its persistently poor core earnings and continuously negative ratio of FFO to total debt in 2001-2005. Nevertheless, given the company's plethora of valuable land assets, which provide substantial recovery prospects, and ample liquidity at domestic banks, Tatung has been able to maintain short-term credit facilities and refinance maturing long-term debt without facing any liquidity pressure.
Electronic contract manufacturers: Strong sales and earnings growth
Median sales and earnings of electronic contract manufacturers registered the highest growth rates of all the sectors represented in the top 50 corporates in 2005, boosted by strong competitiveness and increasing outsourcing by global original-equipment manufacturer (OEM) customers.
Although pricing pressure from OEM customers caused the median operating margin for the sector to fall to 5.7% in 2005 from 6.5% in 2004, strong sales growth helped keep the median return on capital at a solid 28% in 2005, even better than the 27% registered in 2004. Key financial ratios for the sector remained very strong in 2005.
Motherboards: Commoditization forces diversification
The motherboard sector has suffered from severe pricing pressure over the past few years because of product commoditization and intense market competition. The sector's median operating margin, which dropped to 4.9% in 2005 from 14.6% in 2001, has registered the sharpest decline among all sectors covered in this report. In a similar vein to other high-tech sectors, the largest operator in the motherboard sector is growing stronger at the expense of its smaller rivals.
In search of new growth opportunities and stable profitability, all of Taiwan's motherboard manufacturers have tried to diversify their product lines, but only ASUSTeK Computer, the largest company in this sector, has enjoyed a considerable measure of success. ASUSTeK's financial profile remains relatively strong, supported by the company's good profitability, conservative financial policy, and substantial net cash position.
Notebook PCs: Low margins but satisfactory credit metrics
Taiwan manufacturers account for more than 80% of the global supply of notebook PCs, yet their median operating margin of 3.9% is the second-lowest of all the industries represented in the top 50 corporates in 2005.
Weak operating margins reflect the strong bargaining power of large global customers like Dell (DELL) and Hewlett-Packard (HPQ), which has produced strong price competition among domestic notebook PC producers looking to boost sales. Nevertheless, strong demand has helped to maintain satisfactory profits and adequate returns on capital.
TFT-LCD: Consolidation is inevitable
Taiwan has overtaken Korea to become the largest supplier of large-area TFT-LCD panels, which are primarily used in computer monitors and notebook PCs, and increasingly in LCD TVs, which are expected to drive future TFT-LCD growth.
However, incredibly high capital-spending requirements, persistent negative free-cash flow, and highly volatile industry cycles are major credit concerns. The sector has registered the largest increase in total debt among the top 50 corporates and experienced highly cyclical ups and downs over the past three years. Standard & Poor's anticipates a recent industry downturn to persist through the third quarter of 2006, before the onset of a moderate recovery in the fourth quarter.
M&A activity is inevitable in Taiwan's overcrowded TFT-LCD sector. The gap between first-tier players (AUO and CMO) and second-tier players (CPT, QDI, and HannStar) has expanded, with the laggards struggling to compete due to their smaller size, less integrated operations, lower margins, and weaker product mixes. These weaknesses have led to very poor operating performance and very aggressive financial profiles.
Semiconductors: Upturn expected in 2006
Taiwan's semiconductor sector, which comprises fabless design, foundry, packaging and testing, and dynamic random access memory (DRAM) production, is another major sector contributing to the lower aggregate net income of the top 50 corporates in 2005.
With the exception of Taiwan Semiconductor Manufacturing (TSM) and MediaTek, most semiconductor-related companies reported sharply lower profits in 2005 due to a moderate down cycle. However, this sector is expected to post strong earnings growth in 2006 thanks to recovering industry growth and market demand.
The global semiconductor foundry industry continues to be dominated by Taiwan-based operators Taiwan Semiconductor and United Microelectronics (UMC). The two companies together account for about 70% of the global semiconductor foundry sector. TSMC has an above-average business profile, which is supported by its leading market position, advanced process technology, good operating efficiency, and solid customer relationships.
It also has a very strong financial profile, underpinned by very high EBITDA margins, strong positive free cash flow, and a substantial net cash position. UMC also has very conservative leverage and substantial cash on hand, but compared with Taiwan Semiconductor it has a smaller customer base, lower average selling prices, and lower output from advanced process technology.
The semiconductor sector's key financial ratios should improve further in 2006 and 2007, given the expectation of healthy growth in the global semiconductor industry over the next two years.
Autos: Low leverage to combat bumpy ride
Taiwan's auto sector, which enjoyed robust sales in the past two years, is experiencing a bumpy ride in 2006 due to dampened consumer demand caused by domestic banks' implementation of much more stringent credit approval policies to counter a rapid rise in credit- and cash-card delinquencies from the fourth quarter of 2005. Total new light-vehicles sales are estimated to fall by about 20% year-on-year in 2006, which will inevitably pressure the earnings performance of auto-related companies.
Still, the top three auto companies—Hotai Motor, China Motor, and Yulon Motor—are all in good shape to ride out this temporary choppiness because of their very conservative capitalization, with ratios of total debt to total capital below 10% in 2005. As a result, although earnings are expected to decline in 2006, the credit quality of the three auto makers is likely to remain stable.
Airlines: High fuel costs to dampen profits
Taiwan's airline sector continues to have the weakest financial ratios of all the sectors represented in the top 50 corporates as a result of low earnings and high leverage, characteristics common to the airline industry worldwide.
Taiwan's two international operators, China Airlines and Eva Airways, both reported good earnings in 2004. However, their earnings dipped substantially in 2005, and prospects for earnings and cash flow in 2006 are even grimmer, mainly because benefits brought by strong growth in passenger volume and cargo demand are being completely eroded by stubbornly high fuel costs.
Oil: Price caps weigh on profitability
Taiwan's oil sector is controlled by the duopoly of state-owned Chinese Petroleum and Formosa Petrochemical. CPC has a 70% share of the domestic petroleum market and conservative leverage, but a high cost structure. In contrast, Formosa Petrochemical has a 30% market share, moderate leverage, but a low cost structure.
In terms of profitability measures, Formosa Petrochemical has a clear advantage over CPC because of its capability to process heavy sour crude oil, which allows it to greatly benefit from the wide spreads between sweet and sour crudes. On the other hand, CPC's far lower leverage has enabled it to report stronger cash-flow protection ratios than those of Formosa Petrochemical.
However, the Taiwan government's reluctance, due to inflationary concerns, to fully reflect high-flying global energy prices in the domestic market in 2006 has underscored the disadvantage of CPC's cost structure. Current energy price caps mean that oil and natural gas imports are being sold at a loss to domestic consumers.
With its high share of the domestic petroleum market and a monopoly position in natural gas supply, CPC faces a far more challenging operating environment than Formosa Petrochemical and is expected to report substantial operating losses for the first time ever in 2006.
Chemicals: Subdued operating environment
Taiwan's chemical sector is dominated by the Formosa Plastics Group companies—Formosa Plastics, Nan Ya Plastics, and Formosa Chemicals & Fibre. After experiencing a banner year in 2004, the chemical sector cycle in the Asia-Pacific region dipped in the second half of 2005, causing moderately weaker financial ratios in full-year 2005.
These ratios are likely to fall further in 2006, as the operating environment remained subdued in the first half of 2006 and significant amelioration is not anticipated in the second half.
Steel: Price correction, rebound on the horizon
The steel sector, which enjoyed an extremely strong upturn and windfall profits in 2004, has seen steel prices fall by as much as 30% since the second half of 2005 in the Asia-Pacific region. However, after the price correction, a strong rebound is on the horizon.
The price of hot-rolled steel, a benchmark product, is expected to recover to above $500 per metric ton (from below $400 per metric ton) in the second half of 2006—a very profitable level that is likely to strongly boost steelmakers' earnings in the months ahead.
Power: Tariff cap continues to hurtThe power sector in Taiwan is still largely regulated. The state-owned Taiwan Power remains the only integrated utility on the island. Power generation has, however, been partly opened to market competition. Several independent power projects (IPPs) have been established to ensure stable electricity supply and adequate reserves. All IPPs are obligated to sell their output to Taipower, which maintains a monopoly over power transmission and distribution.
Taipower's financial profile has deteriorated in the last few years as a result of a rigid tariff-rate and dividend policy, consistently rising leverage due to heavy capital spending, and rising production costs stemming from high energy prices. The Taiwan government's approval of a tariff increase of about 6%, effective July 1, 2006 (the first increase in 23 years), will not be sufficient to offset the rising production costs.
Taipower is expected to report a net loss for the first time ever in 2006, at about NT$11 billion. In contrast, the credit profiles of the IPPs are likely to remain relatively stable, as their revenues, profit margins, and cash flows are underpinned by 25-year power purchase agreements with Taipower that obligate Taipower to make payments at guaranteed rates adjusted for inflation and energy price fluctuations.
Shipping: Navigating choppy waters
After enjoying exceptionally strong profits in 2003-2005, Taiwan-based container shipping companies, faced with rapidly expanding global container capacity over the next two to three years, are navigating choppy waters in 2006.
New vessel delivery will peak in late 2006 and 2007. As a result, buyers are gaining the upper hand when it comes to negotiating freight rates. The situation is exacerbated by rising bunker fuel costs, which cannot be fully passed on to customers. Consequently, despite still very high load factors, Taiwan's container liners are expected to report sharply lower operating profits in 2006.
Telecoms: Unwavering credit quality
Taiwan's telecom sector has demonstrated the most stable creditworthiness of all the sectors surveyed in the top 50 corporates in the past few years. Chunghwa Telecom continues to dominate the fixed-line sector due to its previous experience as the island's sole operator.
Consolidation in the wireless telecom sector in recent years has enabled the three remaining major operators—Chunghwa Telecom, Far EasTone Telecommunications, and Taiwan Mobile—to secure stable market positions, high operating margins, and strong cash flows.