Hon Hai's Highs and Lows

It feels it has gotten justice over charges of iPod-related labor abuse and earnings are through the roof, but it has lingering PR problems

These should be happy times for Hon Hai Precision Industry, the world's largest electronics manufacturing services company. On Aug. 31, the Taiwanese manufacturing juggernaut announced spectacularly good quarterly results. Hon Hai, No. 2 in this year's BusinessWeek IT 100, counts as customers almost all of the world's top names in computers, cell phones, and consumer electronics, and it is enjoying a rising stock price at a time when Taiwanese rivals are struggling.

But just as it was announcing earnings, Hon Hai suffered embarrassing setbacks in China. First, the company is retreating from a lawsuit against two mainland reporters who had written critically about the labor practices of a China-based subsidiary. And according to a report in the official Xinhua news agency, the Chinese government has called on the company to allow the state-controlled labor union to organize its workers on the mainland.


  Although this is a lot more publicity than Hon Hai and Terry Gou, its press-shy chairman and president, are accustomed to getting, the Taiwanese company is well-positioned to cope with any fallout. When it comes to electronics outsourcing, Hon Hai, which uses the trade name of Foxconn, is more competitive than anybody.

Hon Hai makes PCs, cell phones, networking equipment, game consoles, and iPods, and just about every big name in the world of high tech is a customer. Dell (DELL), Hewlett Packard (HPQ), Nokia (NOK), Cisco (CSCO), Sony (SNE), Nintendo (NTDOF), Motorola (MOT), and Apple (AAPL) all depend on Hon Hai to manufacture many of their most popular products.

And while other Taiwanese electronics companies such as notebook PC maker Quanta Computer struggle with shrinking profit margins and floundering stock performance, Hon Hai just keeps getting stronger. Earnings for the second quarter jumped 43%, to $388 million. According to Daniel Chang, an analyst in Taipei with Macquarie Bank, the company is on track to record a full-year profit of $1.7 billion, up from last year's $1.2 billion, with revenue jumping 32%, to $36.5 billion.


  That kind of growth impresses investors: Hon Hai's stock is up 27% this year, compared to a measly 1.6% increase for the benchmark Taiwan stock index. And Hon Hai performs much better than its info tech peers. The stock price for Flextronics Intl. (FLEX), its closest rival, is up 13%, and Jabil Circuit (JBL) is down 28%.

While Hon Hai is already the world's biggest electronics manufacturing services (EMS) company, it continues growing as if it were an up-and-coming tiger. "None of the other EMS companies can do this," says Chang, noting that Gou has said Hon Hai will grow at an annual rate of 30% for the next five years.

How does Hon Hai manage it? One explanation is its unique business model. More than any of its rivals, Hon Hai is vertically integrated, producing cables, connectors, and other nitty gritty parts that make up the guts of computers, cell phones, game consoles, and iPods. The margins for making those components are much higher than for simply assembling the machine.


  In an industry where final assembly work is commoditized, Hon Hai's edge in components gives it a huge advantage. "We see a lot of companies trying to replicate the business model, but it's really tough," says Angela Lo, an analyst in Taipei with Daiwa Institute of Research.

Hon Hai also focuses on keeping costs down, which is one reason that it has found itself in the spotlight lately. Early this summer, a report in the British newspaper The Mail on Sunday alleged that Hon Hai mistreated workers producing iPods in China. The China Business News, a Chinese newspaper controlled by the government-backed Shanghai Media Group, published a similar article.

Last month, Hon Hai claimed vindication after a lengthy investigation by Apple, which accounts for about 20% of the Taiwanese company's revenue (see BusinessWeek.com, 8/21/06, "Hon Hai: Vindicated by Apple Report?").


  In an interview with BusinessWeek after the Apple report, company spokesman Edmund Ding said that the investigation had "returned justice" to the company, since it found that most of the alarming accusations were untrue. According to Ding, Hon Hai treats it workers better than many other companies operating in China. He also said that all of the attention was simply because Hon Hai had become too successful. "We are just so big," he said in an interview with BusinessWeek. "In Chinese, there's a saying: 'The big tree catches the wind.'" (Hon Hai did not respond to requests today from BusinessWeek for an additional interview.)

However, in the weeks since the Apple report, the wind hasn't let up. Following the story in the China Business News alleging mistreatment by a Hon Hai subsidiary of Chinese workers, the Taiwanese company sued the two reporters for defamation. Because of that lawsuit, the Chinese court froze the reporters' assets, prompting the two to appeal to public opinion by launching a blog on Sina.com (SINA), China's most popular Internet portal.


  After enduring furious criticism in the Chinese blogosphere, Hon Hai backed down by announcing that should it prevail in its lawsuit it would only seek a symbolic 1 yuan (or 13 cents) in damages. In a statement to the Taiwan stock exchange, the company noted that it "seeks legal remedy only to defend our name and to force out the truth," adding that Hon Hai wanted "simply the right to protect her reputation, to preserve the Chinese dignity."

Many analysts agree that Hon Hai is being unfairly singled out. "Our understanding is that the pressure of working at Hon Hai is relatively high," says Tony Tseng, an analyst in Taipei with Merrill Lynch (MER). "But the company is quite generous with employee bonuses." Tseng, who has visited one of Hon Hai's facilities in Shenzhen, says that the environment at Hon Hai "definitely meets the average standard."

But Hon Hai and others are likely to feel pressure from Apple and other customers sensitive about a consumer backlash. As a result, "every Taiwanese company is paying more attention," says Daiwa's Lo.


  As Hon Hai tries to control the damage from its Chinese lawsuit, the company will be looking for acquisitions in order to maintain Gou's ambitious growth targets. In June, Hon Hai took control of Premier Image Technology, Taiwan's leading producer of digital still cameras, in a deal worth $928 million. Many analysts expect Gou to keep on buying.

Some people are even saying that Hon Hai might acquire Quanta, the world's No. 1 producer of laptop computers. "There are a lot of rumors about a Quanta deal," says Macquarie's Chang. Daiwa's Lo agrees that a Quanta acquisition would make sense for Hon Hai. "The business model is vertical integration," she says. "Hon Hai has so many components in-house, so if they can increase the total pie, they can control the costs."

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