The CSRC fast-tracked Foxconn's A-share listing this Friday — and this company does more than assemble iPhones

Foxconn wants a higher-end manufacturing business, and the A-share market needs it to make a statement.

At 9:30 a.m. on June 8, the A-share market gets a big listing it has waited a long time for.

That is the day Foxconn Industrial Internet lists. It is raising 27.1 billion yuan — the largest IPO on the Shanghai Stock Exchange since 2015, and the largest ever by a non-state-owned company on the A-share market.

Over the past few years, almost none of China's best companies have listed at home. Alibaba and JD.com went to the U.S., Tencent to Hong Kong. Xiaomi and Haidilao, both in the pipeline, filed their prospectuses with the Hong Kong Stock Exchange.

To land Foxconn, the China Securities Regulatory Commission (CSRC) broke a string of its own records. The company met neither the written rule on how long an applicant must have been operating nor the one on having a controlling shareholder, and yet — Spring Festival holiday included — it was cleared to list in 36 days. An ordinary company queues for at least a year and a half.

Everyone knows the name Foxconn, which is not the same as a good reputation. Those three characters still bring sweatshops to mind first.

But the Foxconn listing on Friday is not that 1.3-million-worker iPhone plant. It is the parent company's attempt to move up and out of a consumer-electronics supply chain that Apple controls tightly.

Beyond a name that rides the fashionable "advanced manufacturing" policy, what exactly is Foxconn Industrial Internet?

Hon Hai's most successful new company is still a manufacturing business

Foxconn Industrial Internet's parent is Hon Hai Precision Industry. In 1974, a 24-year-old Terry Gou founded Hon Hai Plastics in Taiwan, making channel-tuning knobs for televisions. Three years later, Hon Hai built its first standard tooling line.

Most people know Gou's business today because it makes the iPhone. Its start, though, traces back to Apple's great early rival, IBM.

In 1981, IBM launched the personal computer, and Taiwan's electronics industry started up alongside it: TSMC and UMC in chip manufacturing, Acer and ASUS in PCs, VIA Technologies and MediaTek in chip design, AU Optronics and Innolux in display panels. The contract manufacturers that assembled Taiwanese and American parts into computers were Hon Hai and Pegatron.

Hon Hai Precision's first orders were for computer connectors, made for Acer and UMC.

The other great moment Gou caught was the mainland's reform and opening-up. At the end of 1987, the two sides of the strait agreed to allow home visits. That January, the first Taiwanese group returned to the mainland. Gou went back the same year and built a factory there, using mainland workers to cut production costs. "Foxconn" became the collective name for all of Hon Hai's mainland plants.

Hon Hai's businesses multiplied, and so did its listed companies. Hon Hai Precision, FIH Mobile, FIT Hon Teng, Yunzhihui Technology, and Xunzhihai are already listed in Taiwan and Hong Kong. They differ widely in size, business, and profitability.

The biggest is Hon Hai Precision — the one that assembles iPhones. Its 2017 revenue passed 1 trillion yuan, with profit of about 29.1 billion yuan. FIH Mobile, the subsidiary that assembles phones for Huawei, Xiaomi, OPPO, and Vivo, lost about 3.1 billion yuan that year.

Foxconn Industrial Internet, the company listing now, is Hon Hai's second-largest business. It makes high-precision parts for communications equipment, cloud server hardware (Amazon is a customer), and industrial robots (the kind used to build phones and cars). Its 2017 revenue was 354.5 billion yuan, with net profit of 16.2 billion yuan.

In a new generation of manufacturing built on data, Foxconn Industrial Internet's businesses touch nearly every stage, tracking raw materials and production from end to end:

• Generating data. Industrial robots, precision tools
• Moving data. Communications network equipment
• Storing data. Cloud computing equipment
• Industrial internet services. Analyzing and using production data

Covering every stage is not the same as selling every stage. What Foxconn Industrial Internet sells its customers today is not a whole-process industrial-internet solution.

For consumer-electronics customers it provides manufacturing management, processing equipment, and some R&D support. What cloud vendors such as Amazon AWS want from it is the hardware that fills a data center.

This is still a manufacturing business.

No longer a low-end assembly plant, but still a labor-intensive company of 270,000 people

The revenue is big and so is the payroll: nearly 270,000 employees. They work in dozens of factories across China — in Shanghai, Chongqing, Shenzhen and Dongguan in Guangdong, Hangzhou in Zhejiang, Nanning in Guangxi, Zhengzhou, Hebi, and Jiyuan in Henan, Taiyuan and Jincheng in Shanxi, Wuhan in Hubei, Langfang in Hebei, and Chengdu in Sichuan, among other places.

Measured by the old party question, "how many pigs does Foxconn eat in a day," the answer is about 270 (assuming each person eats 0.2 jin, or 100 grams, of pork a day, and each pig yields 200 jin, or 100 kilograms).

About 200,000 of those employees work in production, and more than 200,000 have less than a junior-college education. Each group is over 75% of the total.

Those 270,000 people produce about 1.3 million yuan of output apiece and contribute about 58,000 yuan of profit apiece.

Apple's 123,000 employees (including the staff of more than 500 retail stores worldwide) produce about 12 million yuan of output each and contribute 2.6 million yuan each. Foxconn Industrial Internet is nowhere near a technology business like Apple's, but it is no longer the assembly plant of old either.

The iPhone made Foxconn, but the two sides fight hard

Last year CICC took an iPhone X apart and priced it: about US$417 to build, of which assembly was US$4.2. That US$4.2 is where the money comes from for contract manufacturers like Foxconn.

The relationship is not that simple, though. Apple buys the key raw materials itself, down to things as unremarkable as aluminum.

The materials Foxconn uses to build Apple products do not come from material suppliers. Foxconn has to buy them from Apple. In 2015, 2016, and 2017 its cost of sales was 243.9 billion, 243.1 billion, and 317.7 billion yuan, and direct materials were 82.02%, 83.21%, and 86.51% of that.

The arrangement has a name: Buy and Sell.

Under Buy and Sell, Apple first buys the core components — chips, memory, touchscreens — and sells them to Foxconn. Foxconn assembles the phones and sells them back to Apple.

The point of the model is payment terms and cash.

When Apple pays material makers and contract manufacturers, it stretches the terms out. When it sells materials to those same contract manufacturers and collects, it squeezes the terms in. Once a company is big enough and powerful enough, adjusting payment terms alone lets it run its business on other people's money, and the cash flow is considerable.

Apple's products also sell: on average they are gone six to seven days after they are built. Gone does not mean in a consumer's hands — it means bought by carriers and retail channels.

Apple's supply chain runs at extreme efficiency. It collects from its contract manufacturers within 28 days but pays its material suppliers and assemblers on terms of more than 100 days. Its cash conversion cycle is negative, and it went from -68 days in 2016 to -80 days in 2017.

In other words, on every batch of products, Apple pays Foxconn the assembly fee 80 days after it has taken Foxconn's money.

On cash alone, working for Apple is punishing. Foxconn's answer is to push the same squeeze onto the suppliers that serve it.

Hence the striking feature of Foxconn's books: receivables and payables are both very large.

The phone supply chain is shifting, and the factories are moving upstream

On the surface Foxconn looks like the weaker party. But as its position in the chain keeps improving, its receivables should shrink year by year, its payables grow, and its cash conversion cycle shorten — which feeds through to revenue and profit and pushes both up.

In Foxconn's prospectus, receivables turnover ran around 67 days in both 2016 and 2017; inventory turnover fell, meaning products shipped faster; payables turnover rose. Overall the cash conversion cycle dropped from 51 days to 36.

Foxconn is shipping faster while owing its upstream brand customers for longer. Its bargaining power at both ends of the phone supply chain is growing.

Smart manufacturing of electronic equipment worldwide covers consumer electronics, computers, network equipment, telecom equipment, and cloud-service equipment. Foxconn Industrial Internet works mainly in smartphones, network equipment, telecom equipment, and cloud-service equipment.

By IDC's count, the world shipped about 1.98 billion phones in 2017, 1.52 billion of them smartphones — and that was the smartphone peak.

Once the fight over a growing market ends, the new goals become efficiency, taking share from rivals, and strengthening one's own position in the chain.

The phone supply chain has three links: components upstream, modules in the middle, assembly downstream.

Components fall into chips and parts. Chips include basebands, processors, and sensors; parts include memory, panels, lenses, and antennas. The main players are Qualcomm (chips), OmniVision (image sensors), BOE (panels), Sunny Optical (cameras), and Samsung (memory).

Modules include backlight modules, memory modules, and camera modules. One of Apple's camera-module makers is Foxconn (along with Sharp, which it bought). Other well-known module firms include OFILM and Sunny Optical.

Assembly means putting modules together into a finished device. The main players are Hon Hai/Foxconn, Pegatron, and Longcheer.

Assembly is the least technical link in the chain, with an average gross margin of just 6.92%.

As consumer electronics iterate faster, the demand for large-scale, flexible manufacturing keeps rising. Foxconn's hand has in fact grown stronger.

New consumer-electronics products need stable, large, efficient, automated factories to make the tooling and do the assembly. The trend is already visible. Beyond Apple, Foxconn's newer customers include Amazon AWS, for cloud servers.

This is the kind of business Foxconn Industrial Internet is taking on.

Foxconn's A-share listing is also the start of a financial-reform experiment

Late last year Fortune held its annual forum in Guangzhou. Onstage, Terry Gou listed the support Foxconn gets: he was due to meet several senior Guangdong officials that evening, and after an earlier meeting with Trump, governors from ten U.S. states had called him.

Whatever the public remembers about sweatshops and the run of worker suicides, local governments have always welcomed Foxconn for the jobs its huge payroll brings. Not only in China: Wisconsin put up US$4 billion in tax breaks for a Foxconn plant.

Policy is inseparable from this A-share listing too.

When it applied, Foxconn Industrial Internet was less than three years old and had no controlling shareholder. Under the CSRC's Administrative Measures for the Initial Public Offering and Listing of Stocks, which state plainly that a company must have operated continuously for more than three years, and given how often the issuance review committee rejects companies with no controlling shareholder, it should not have been approved early this year.

It passed anyway, and in a record 36 days from filing to approval, with a Spring Festival in the middle. Set against the year and a half an ordinary IPO applicant waits, the speed is startling. The 27.2 billion yuan it is raising is also the largest IPO since 2015.

Behind the fast track is competition: the mainland capital market and the Shanghai and Shenzhen exchanges have to answer Hong Kong.

The SSE 50 rose 25.08% in 2017, but banks, property, and baijiu did most of the work. ChiNext, the board meant to represent a new generation of companies, was a wreck.

Meanwhile Alibaba, JD.com, and NetEase kept setting highs in New York, and Hong Kong turned lively. Net capital inflow into Hong Kong stocks reached HK$339.9 billion for 2017, up 40% from 2016, and the Hang Seng Index gained 36% on the year. Several companies Tencent has backed listed there.

Then, in 2018, the Hong Kong exchange launched its biggest reform in more than 20 years, letting internet companies with dual-class shares list. Its edge over the A-share market keeps widening.

This year Xiaomi and Canaan have already filed prospectuses in Hong Kong, and even Haidilao, a restaurant chain, chose Hong Kong because of A-share industry and financial restrictions.

A-share regulators and investors alike have realized the market is at a dangerous point.

Money is finite, and it follows companies with potential. If the internet companies all list in Hong Kong and New York, the money that chases internet companies will go there too — however many new limits the foreign-exchange regulator puts on outflows.

The current push to bring overseas-listed companies back through CDRs exists to solve the same problem.

"New economy" and "unicorn" are now words regulators use. To make the point, they broke a set of rules they had written themselves, and brought in Foxconn Industrial Internet.

When will the A-share market become one that follows its own rules?

Charts by Feng Xiuxia and Gong Fangyi

Cover image: Sohu, Radovan on Unsplash, and Motherboard (Liam Young/Unknown Fields Division)