Costs and Crisis: Peeling Back the Layers in East Asia s Electronics Supply Chain

Transcription

1 Issue Brief Costs and Crisis: Peeling Back the Layers in East Asia s Over the past 20 years, cheap labor has been the driving force transforming East Asia into the global hub for electronics manufacturing. However, China which emerged as the favored outsourcing destinations for large foreign tech investors from the US, Japan, South Korea, and Taiwan is undergoing a fundamental shift from an economy with plentiful low-cost labor to one with higher-cost workers, driven by fast-rising wages, worker activism, and labor shortages. In this climate, electronic component makers, ODMs, and their branded clients face increasing pressure to adjust their production strategies, particularly their labor management strategies. Key Takeaways Without major improvements in labor management, the difficult labor dynamics of the coastal regions are following electronics manufacturers inland at an unexpectedly quick pace. There are already warning signs that the cost advantage to the electronics supply chain of moving manufacturing to inland China will be short-lived. Under pressure, manufacturers are most likely to either keep moving in pursuit of cheaper labor or shift more aggressively to a more automated production model. In the first case, current issues surrounding working conditions are unlikely to change. In the second case, companies may shed one set of problems only to face another as they lay off large numbers of workers. Even though high profile consumer electronics brands like Apple and HP have stepped up their supply chain labor strategies in response to increased media and NGO scrutiny, these companies will continue to face operational risks of product delivery delays due to work stoppages at supplier factories and reputational risks due to labor controversies in the supply chain. Electronic component manufacturing, especially the semiconductor fabrication, has not migrated to inland China as quickly as computer manufacturing. High costs to build new fabs, a lack of readily available highly-skilled workers in inland areas, and higher water stress risks in some areas, could all be contributing factors. The ODMs that have migrated inland may find themselves relatively more isolated from a complete manufacturing ecosystem and could be subject to higher transportation costs if semiconductor and component makers cannot afford to follow them inland. In its coverage of the MSCI All Country World Index (ACWI), analyzes 131 companies in the electronics supply chain, straddling two upstream industries (Semiconductor Equipment & Products and Electronic Equipment & Instruments) and two downstream industries (Computers & Peripherals and Communications Equipment). About three fifths of these companies are domiciled in Japan, South Korea, Taiwan, and mainland China, the four Asian leaders in electronics manufacturing, with the rest of the set concentrated in the US. While the US, Japan and South Korea have been the home to the majority of the branded companies in the set, including Apple, HP, Samsung and Canon, Taiwanese and Chinese companies are mostly positioned in the upstream of the supply chain, more Please refer to the disclaimer at the end of this document 1 of 9

2 Issue Brief specialized in providing design plus manufacturing services, producing components and subassemblies for branded companies. However, recent years have also witnessed the emergence of a few important branded companies from Taiwan and China, including Acer, HTC and Lenovo. Branded Consumer Electronics Many branded computer and communications equipment makers are highly dependent on outsourced manufacturing capacity in low-cost developing countries (see Figure 1), and in Asia and China in particular, where working conditions are typically poor and violations of labor norms at electronics factories are increasingly attracting media and NGO attention. The most prominent example is Apple, which outsources almost all of its production to Taiwanese contract manufacturers including Quanta Computer, Foxconn and Pegatron. Most of Apple s competitors in the PC industry (HP, Dell, Asustek) also heavily rely on a small number of Taiwanese original design manufacturers (ODMs)/ electronic manufacturing services (EMS) provider for manufacturing (including Quanta, Foxconn, Pegatron, Compal, Wistron, Inventec). The extensive reliance on China-based manufacturing capacity means branded hardware makers are very sensitive to shifts in China s labor demographics. FIGURE 1 Outsourcing Footprint in Developing Countries 135, % 108,000 80% 81,000 60% 54,000 40% 27,000 20% 0 0% 3-year sales average (USD million) Total estimated sales of product outsourced to developing countries (Est. USD million) Estimated percentage of sales outsourced to developing countries Source: Company disclosure, In recent years, the labor market in China is going through a critical turning point: from an unlimited to limited supply of labor and a transition from first to second generation of migrant workers. The second generation of migrant workers is more educated and tech-savvy, has higher demands on material and spiritual enjoyment and lower tolerance of poor working conditions than their predecessors. This has led to significant growth in labor unrest and demands for higher wages in China, which in turn has attracted media and NGO scrutiny. After a string of worker suicides at a Foxconn Apple factory in 2010, Please refer to the disclaimer at the end of this document 2 of 9

3 Issue Brief continuous media reports about labor rights violations at Foxconn s Chinese factories have put significant pressure on Apple and Foxconn to make changes. Apple is not the only target. Samsung, a rising star in the smart phone market, has been under the microscope and faced higher profile accusations of labor rights violations in suppliers factories. Under this spotlight, most high profile branded companies have stepped up their engagement with their supply chain. While Hewlett-Packard has long been a leader, Apple notably has demonstrated the most significant improvements under Tim Cook s leadership, quickly regaining ground in the reputational stakes with a series of sound improvements, such as publishing its supplier lists, substantially increasing the number of supplier audits, and disclosing and requiring corrective actions in the case of noncompliance. Samsung, with its brand recognition soaring in the smartphone market in the past few years, has been playing a rapid game of catch-up. FIGURE 2 Branded Consumer Electronics: Supply Chain Labor Strategies Total est. sales of product outsourced to developing countries (est. USD Million) Scope Supplier Code of Conduct Supplier training on Code of Conduct Other compliance efforts Scope Supplier Audits Reporting on aduit results Corrective action plan Assessment of Controversies Apple Inc. 101,253 Y Very Severe Hewlett-Packard Co. 74,657 Y Severe Samsung Electronics Co., Ltd. 66,474 Y Moderate Dell Inc. 45,420 Y Moderate CISCO SYSTEMS, INC. 34,485 Y Moderate Nokia Oyj 11,062 Y Severe ZTE Corp. 10,963 Y None Telefonaktiebolaget LM Ericsson 10,765 Y None ASUSTEK COMPUTER INC. 10,003 Y - None Lenovo Group Ltd 8,852 Y None Acer Inc. 8,678 Y Moderate HTC Corp. 4,910 Y... Moderate SanDisk Corp. 3,626 N None Motorola Solutions, Inc. 3,302 Y Moderate Western Digital Corp. 3,185 Y None BlackBerry Ltd 2,749 Y None Legend: Scope of Supply Chain Code of Conduct Covering all relevant ILO labor rights provisions Missing most of the important provisions Other compliance efforts Strong efforts (incl. supplier capacity building, workermanagement communication, etc.) Limited efforts Scope of supplier audits Cover all manufacturing and component suppliers No evidence of supplier audits or only general statement Corrective action plan Detailed plan... No reporting Source: Company disclosure, Reporting on audit results Reports detailed instances of non-compliance Reports some instances of non-compliance... No reporting Listed among Interbrand's 2013 top 100 brands Not listed among Interbrand's 2013 top 100 brands Despite the improvements made, branded companies have struggled to reconcile the tension between instructions to suppliers to limit excess overtime and pay higher wages, and simultaneous pressure on suppliers to produce quickly and at low cost. As a result, we anticipate that despite improvements in supply chain transparency and auditing, the branded companies will continue to face operational risks of product delivery delays due to work stoppages at supplier factories and reputational risks due to labor controversies in the supply chain. Please refer to the disclaimer at the end of this document 3 of 9

4 Issue Brief Suppliers Assembly & Manufacturing The world s computer manufacturing and assembly operations are concentrated in a few Taiwanese contract manufacturers, which are less visible to the investment world or the global public compared to their branded clients, and yet altogether account for 80% of global notebook PC production. While these Taiwanese contract manufacturers have concentrated their manufacturing facilities on China s eastern and southern coasts since the late 1990s, the soaring wages, labor shortages, and labor unrest in coastal areas in recent years has seen most of these companies shift production to the interior in pursuit of cheaper labor and a more docile workforce. Chongqing and Chengdu have emerged as the preferred destinations (see Figure 3). FIGURE 3 Computer Production Migrating to Inland China No. of collective labor disputes in ~99 100~ ~ ~ Major Taiwanese computer ODMs (no. of electronics factories owned) Foxconn (66) Quanta Computers (17) Compal Electronics (15) Pegatron (19) Wistron (12) Inventec(16) RMB Chengdu (85% ) Qinghai RMB Chongqing (54% ) 680 Chengdu Chongqing Shaanxi 1 Guangxi 2 Henan 4 Beijing 4 Shanxi Hebei 2 Shandong Hubei 1 Guangdong Jiangsu Shanghai 6 Zhejiang Nanjing, Kunshan, Suzhou (74% ) RMB Yangtze River Delta RMB # No. of plants owned by the six ODMs in Mainland China (coastal) # No. of plants owned by the six ODMs in Mainland China (inland) Pearl River Delta Guangzhou, Foshan, Dongguan (93% ) 1330 RMB Sources: China Labour Statistics Yearbook 2012, government websites, While the move to inland areas could help ease the pressure of increased labor costs in the short term, these benefits are likely to be short-lived. Without major changes to their labor management practices, we believe contract manufacturers will eventually face the same labor dynamics as in coastal areas, with evidence already mounting of rising workforce disputes and wage pressure in the interior. Minimum wages are rising as governments respond to workers demands and the soaring cost of living. For example, 2013 saw significant minimum wage increases in Chongqing (21%), Chengdu (41%), and Please refer to the disclaimer at the end of this document 4 of 9

5 Issue Brief Taiyuan (32%). The current five-year plan ending in 2015 calls for minimum wages to increase by an average 13% a year, which pictures a upward trend in labor costs in the near future. Low pay, overwork, and sweatshop-like conditions are common in Chinese electronics factories. Facing squeezed margins and increased pressure from their branded clients to produce high-quality but evercheaper products to extremely tight deadlines, contract manufacturers have little capacity to improve worker treatment. None of the major Taiwanese ODMs/EMS providers have demonstrated genuine best practices in labor management (see Figure 4). Although Foxconn appears to offer better employee benefits and have more comprehensive engagement programs than its peers, most likely in response to the negative attention it has seen over the last three years, it still has not been able to avoid labor unrest. FIGURE 4 Contract Manufacturers: Performance on Labor Management ODM/EMS Size of workforce % of production capacity in Inland (est.) Compensation and engagement programs for production workers in Inland plants Variable pay* Employee survey Employee comm. channels** Employee Welfare Committee Average working hrs (weekly)*** Assement of controversies IVA performance quartile on Labor Mgt. Foxconn 1,290,000 35% 60 Very Severe Bottom Pegatron 177,948 50% NA Moderate Bottom Quanta 121,917 40% 63 None Bottom Compal 67,156 50% 63 Minor Second Wistron 58,738 30% NA None Third Inventec 50,925 35% NA None Third Note: * typically include profit sharing plans, cash bonuses, stock-based incentives Evidence of specific benefits or programs **include employee assistance, consultation, suggestion box, compliant hotline ***from various media and NGO sources Source: company disclosure, No evidence The persistence of these labor dynamics, regardless of the move to China s inland, is already driving manufacturers to explore other solutions. Firms that are unwilling to invest in improved labor conditions may simply move again to cheaper destinations outside China in Southeast Asia. However, this option will be suboptimal for some, considering the huge moving costs, relatively lower labor productivity, and less-developed transportation infrastructure in these countries. A more promising long-term solution could be automation, which is now being enhanced or considered by a few leading manufacturers such as Foxconn, Quanta and Pegatron. While automation would significantly reduce direct operational risks due to labor challenges in the long-term, replacing workers with robots would inevitably cause short-term layoffs and restructuring, which in turn might lead to negative publicity. Suppliers Component Manufacturing Moving further upstream in the supply chain, we note that Asia also dominates the world s electronic component manufacturing. Within the MSCI ACWI coverage, about 50% of semiconductor manufacturers and 80% of electronic equipment manufacturers are domiciled in Japan, South Korea and Taiwan, and 73% of assets in these two industries are located in Asia (see Figure 5). While Japanese and Please refer to the disclaimer at the end of this document 5 of 9

6 Issue Brief Korean component makers historically have maintained most production capacity in their domestic markets, they are increasingly moving production lines to mainland China to capitalize on the fastgrowing consumer base and low labor costs, whereas Taiwanese companies have already had a significant presence in China. To maintain efficient operations and keep costs low, ODMs/EMS providers rely on components manufacturers forming a supply ecosystem around their main manufacturing sites. In their traditional coastal manufacturing hubs in China, ODMs/EMS providers enjoy this agile and efficient ecosystem where they can source a significant portion of materials and components from suppliers in the same region. However, so far this kind of supply ecosystem is not taking shape in inland locations with the upstream component suppliers lag in following ODMs/EMS inland. FIGURE 5 Distribution of Assets in Upstream Electronics Industries MSCI ACWI: Electronic Equipment & Instruments 6% 5% MSCI ACWI: Semiconductor Equipment & Products 11% 3% 16% 14% Asia Americas EMEA Rest of the world 73% 73% Source: company disclosure, The majority of upstream component and semiconductor suppliers that have operations in China have not followed ODMs to inland provinces. Semiconductor fabrication requires a more skilled workforce than basic electronics assembly, and semiconductor makers may be cautious about the availability of qualified workers in less-developed inland provinces. On top of the huge costs of building new manufacturing plants in new locations, this labor concern may be discouraging upstream component suppliers from moving inland. The aridity of China s north and west could be another deterrent, especially for semiconductor makers, which require substantial water inputs in the fabrication process. Moving production to some of the preferred inland destinations, such as Shanxi and Shaanxi, which suffer from acute water scarcity, could mean higher risk of operational disruptions for these companies (see Figure 6). Local water vulnerability also raises the bar for managing toxic releases from component and chip manufacturing, as water pollution is an increasingly pressing issue in China and companies are subject to growing scrutiny and compliance requirements. Please refer to the disclaimer at the end of this document 6 of 9

7 Issue Brief FIGURE 6 Electronics manufacturing in China & Water Stress Legend # # No. of computer assembly plants No. of component manufacturing plants Low water scarcity Low to moderate water scarcity Moderate water scarcity Significant water scarcity Severe water scarcity Water Scarcity Low Moderate Severe Northwest China 2 4 Sichuan 6 3 China North China 2 15 Yangtze River Delta 8 66 Taiwan 1 42 \ 8 31 Pearl River Delta *Note: Basin water stress is based on blue water scarcity indicators (total usage/blue water availability). The map only includes manufacturing plants owned by Asia-domiciled companies in the two upstream electronics industries in MSCI ACWI coverage Source: Hoekstra, A.Y. and Mekonnen, M.M. (2011) Global water scarcity: monthly blue water footprint compared to blue water availability for the world s major river basins; University of New Hampshire Water Systems Analysis Group; US Geological Survey; US Department of Agriculture; company disclosure; In the medium term, dragon head ODMs/EMS providers like Foxconn may be big enough to attract component manufacturers to their new locations, but smaller ODMs/EMS providers may struggle to do so. The ODMs that have migrated to inland locations may find themselves relatively more isolated from a complete ecosystem and could be subject to higher transportation costs if semiconductor and component makers cannot afford to follow them. Rising labor costs and disputes across China will continue to be one of the major challenges facing the electronics companies that rely on manufacturing capacity in China. While top-tier companies have been able to move significant portion of production to China s less-developed interior where wages are lower and disputes are less common, they face diminishing labor cost savings and risks of being isolated from a complete manufacturing ecosystem as component makers lag in making the same move. For investors seeking to understand the competitive position of electronics companies, it will be increasingly important to understand how labor dynamics in China are affecting different parts of the value chain and how companies are responding to competing demands to cut costs while keeping workers relatively happy. - Katherine Han, ESG Analyst (Beijing) Please refer to the disclaimer at the end of this document 7 of 9

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