​Earlier this month w noted that five large Chinese companies would begin delisting procedures that would remove their shares from the New York Stock Exchange over a dispute with the Public Company Accounting Oversight Board, a 501© non-profit organization created by Congress under the Sarbanes-Oxley Act that required US public companies to face external audits, with broader powers than those held by the SEC.  Auditors themselves (if they have more than 100 public companies as clients) are audited yearly, and since its inception, the PCAOB has made public a database of additional financial material, usually held between company auditor boards and outside auditors, all a response to the constant flow of ‘restated earnings’ that were prevalent in the late 1990’s.
While such auditor inspections have become commonplace in the US, other countries do not have the same standards and there lies the problem with Chinese companies that are listed on US exchanges.  Many of such foreign auditing firms have not provided the necessary detail requested by the Board, and peppered with a bit of anti-China sentiment, a conflict has grown as to the undisclosed data and whether it might reveal conflicts of interest at the audit firm level or ties to what the US calls ‘adversarial organizations’ in China, which means the military, that were not revealed in the financial materials provided by the companies.
As we noted, a few have already made the decision to delist, although those procedures have not been completed, while the board is trying to work with other US listed Chinese companies to find a solution that satisfies both sides.  The US has selected Alibaba (BABA,9988.HK), JD.com (JD, 9618.HK), Yum China (YUM,9987.HK), and a number of other Chinese US listed companies for inspection in September as part of what seems to be the end of the dispute.  The audits will be done in Hong Kong (all have dual listing in the US an HK), whose exchanges have slightly more rigorous disclosure regulations.

Fun with Data – PC Shipments
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It is no great revelation that PC brands were overly optimistic about prospects for shipments earlier this year, so there is little need to reiterate all the things that were assumed or misconstrued earlier this year, or the issues that might have made them worse thus far, but it is interesting to see how far off some of the brand estimates were and how current targets equate to last year’s shipment levels.  Before we go further, Apple (AAPL) investors take hope in that the only PC vendor who has not changed its 2022 targets or seen them changed for them with weak 1H performance, is Apple, a nob to their more realistic optimism and the value of their brand.  We note the data in the table comes from Digitimes and can differ greatly from other estimates, including ours, as some include tablets, chrome-books, and monitors while others do not, with the point being more that PC brands set targets with blinders on earlier this year and now have taken them off.

​While the US government seems intent on expanding trade restrictions on semiconductor equipment for Chinese foundries, it seems that they will be making exceptions for those semiconductor fabs in China that are operated by South Korean firms, Samsung Electronics and SK Hynix (000660.KS), according to an anonymous diplomatic source in Korea.  As we have previously noted, US equipment vendors have received notification from the US Department of Commerce asking them to end the sale of tools and software used in the production of chips at or under 14nm, essentially making it more difficult for Chinese OEMs to design advanced node devices and similarly making it more difficult for Chinese foundries to produce same.
While the US has already been rejecting license applications for sales of such equipment from a number of US vendors, limiting the financial impact to a degree, with US ally South Korea having two fabs on the Mainland, getting equipment to those fabs would technically violate the US trade rules, which is the reason the US has recently spoken to the South Korean government, explaining that the fabs operated by Korean firms will not face the increased restrictions being placed on Chinese semiconductor companies.  Samsung and SK Hynix both produce NAND and DRAM at the Chinese facilities, which some would consider less than advanced technology, which would likely be the official basis for the exemption, but it seems that China has little recourse regardless of the reason, as punishing Samsung and Hynix for their relationship with the US would only serve to add to the possibility that neither company will look toward expanding its footprint in China.  The Chinese trade press is making considerable noise about how the country is expanding its efforts in EDA and production tools but the development of such an industry locally will be a long one and will leave China’s semiconductor industry years behind in the development of advanced processes until successful.

​Vietnam is the new kid in town, making a bid to replace China as the mecca for CE and technology manufacturing in Asia.  Samsung has invested over $17b in Vietnam over the last 10 years and Intel (INTC) opened a $1b semiconductor assembly and test facility, while Foxconn and Pegatron (4938.TT) have built out significant assembly facilities in the country, due to its low wages, young population, and numerous trade agreements, but there is a catch.
Vietnam is run by the Communist Party and earlier this week the Vietnamese government issued a decree stating that technology companies that operate in Vietnam must store their user data locally beginning October 1, which would force those without an office in the country to set up a local office.  That’s the easy part as the decree states that “Data of all internet users ranging from financial records and biometric data to information on peoples' ethnicity and political views, or any data created by users while surfing the internet must be to stored domestically”, and authorities have the right to request that data during any investigation.  Further, if any content is thought to be a violation of government guidelines, the government has the right to ask content providers to remove it.  Social media firms such as Meta (FB) and data collectors such as Google (GOOG) will have 12 months to set up local offices and data storage and will be required to keep all data locally for at least two years.
Taking a nod from China, Vietnam began working up to such a rule starting in 2019 when it implemented new cyber-security rules, which were followed by social media content rules last year, so the upside to Vietnam’s manufacturing infrastructure and lucrative trade agreements is government censorship and a free look into data if so asked.  These are the same issues that pushed companies out of China, and while their implementation might not be as rigorous as those on the Mainland, they are going to cause companies to think a bit more about the implications of adding production in Vietnam, especially if those rules are enforced or requests for data are actually made.  There is always a downside.
 
 

​Japan was one of the strongest proponents of ‘at-home’ learning during the early days of the COVID-19 pandemic, and the country's GIGA program, which was actually developed in 2018 (pre-pandemic) to move Japan’s 13m primary and secondary school students more quickly into the digital age, as tight educational budgets had limited the number of computers available in the country’s 35,000 schools, but as COVID became an issue, the plans were pulled forward.
The program’s mantra was “1 device for 1 student”, with 2/3 of the program’s budget going toward PCs, with the rest going toward programs to help teachers develop digital learning environments that will help them learn about the best ways to search for information, assemble presentations, and become familiar with digital testing, with the ‘added benefit’ of helping shy students express their ideas without having to raise their hands, although we find that more of a crutch than a panacea.
While the GIGA program, at least the hardware side, has ended, the Ministry of Education has decided to start testing the use of digital textbooks at elementary and high schools, providing free digital textbooks, primarily to learn English, to 5th and 6th grader and junior high school students.  Both digital and paper textbooks will be given so that the Ministry can study the effect of the digital implementation, although the program is expected to go fully digital by 2024.
90% of Japan’s municipalities have already completed the distribution of tablets to school children, but many schools are said to still be struggling to integrate them in daily teaching routines, but the digital textbooks will allow students who are learning English to hear how to pronounce words to see if that helps to improve language skills, and those schools that have an interest can pick one additional subject (math, science, music, arts & crafts, technical arts, homemaking, or health & physical education) to be supplied digitally.
While it is hard to gauge the impact of digital textbooks on such a narrow subject field, and while the Ministry is still trying to come up with a plan as to how to introduce digital textbooks effectively, it seems they have made up their minds about a full-scale introduction in 2024, which will mark the end to paper content in Japanese schools.  As to the program’s effect on tablet or notebook sales in Japan, with much of the student population already equip with a laptop or tablet, the effect should be minimal unless students find that those devices given out in 2020 and 2021 are a generation or so behind what is then necessary for digital textbook content in all subjects.  At that point however, we expect the burden and cost of upgrading to a more modern laptop or tablet will fall to families rather than the government, which we expect will limit the upgrade cycle a bit.

Over the last two years we have noted the somewhat unusual price volatility among raw materials used in consumer electronics and how they have affected component and device pricing.  During that period, many of the raw materials used in consumer electronics manufacturing and devices have increased in price, some to record levels, which in some cases has limited supply and in others just raised BOM costs.  While the effect has been pronounced up and down the CE supply chain, while some CE product categories able to keep pace with matching price increases while less price flexible product classes absorbing the increases, lowering margins and increasing inventory carrying costs.
Roughly 50% of a typical PC is made from various metals and in our 01/07/22 note we showed a table that noted the price increases of various metals used in consumer electronics during the 2021 year, and while the table does not represent a complete list of such metals, it does give some reference points as to how those same metals have performed so far this year.  The average increase in the prices of the metals in our list in 2021 was 79.67% while thus far in 2022 the same list has seen a decline of 3.6%, but what is more significant is that from the end of 2021 to the peak (March/April)) the list generated a gain of 31.3%, and since that peak the list has seen a 26.8% decline.
All in, things looked extremely bad in March/April, and while they are only modestly below last year’s closing prices, they are well below the peak.  We expect 3Q CE product production costs to have declined relative to 1Q, giving CE companies a small bit of breathing room as to holiday pricing, but there was considerable finished inventory in the channel for many products coming into the quarter, a portion of which carries some of the earlier high cost burden.  If brands are able to sell of a reasonable share of the excess inventory, some of the raw material price declines will begin to show toward the end of the year, especially if metal prices continue to decline.  While there are still many other pricing issues that remain, at least a number of raw material metal prices have begun to decline.  It’s a small point on which to hang a hat, but at least there is something to be optimistic about, which certainly was not the case earlier this year.   Selected charts are shown in Figure 1.

​Figure 1 - Metal pricing for Copper, Cobalt, Nickel, Gallium, Palladium, and Aluminum - Source: TradingEconomics

As skeletons are found as lake waters retreat across the US, things are just as bad in China where certain regions have been under high temperature alerts for over three weeks setting the tone for the most aggressive heat wave in 60 years.  With temperatures over 100⁰ conditions are taxing the Chinese electricity grid, the world’s largest (larger than the US, India, and Russia combined), and despite a 9.8% y/y increase in power production in 2021, consumption increased 10.6% over the same period and the grid has been faced with brown-outs and black-outs, especially during the most recent heat wave. With the heat wave causing drought conditions, tourists are faced with closures, such as the Chishui Waterfall in Guizhou, a 250 ft high and 260 ft wide attraction closed last weekend as the waterfall’s feeder river dried up 

​In order to conserve energy local governments have been issuing orders to shut down air conditioning systems in theaters and other businesses to funnel power to residential customers and given that this heat wave began earlier than the former record holder in 2013, meteorologists at the National Climate Center expect that this type of heat wave will become the ‘new normal’, starting earlier and lasting longer each year.  The current heat wave is expected to last another two weeks, making it the longest since record keeping began in 1961 
Power restrictions in some cities have gone further, limiting production or closing factories in a number of provinces, and while Foxconn (2354.TT) in Chengdu and Compal (2324.TT) in Chongqing say the restrictions have ‘limited impct’, an extended heat wave could pressure the supply chain for a number of CE companies, with concern that Apple’s (AAPL) expected October iPad update might be affected by the production restrictions, which were implemented yesterday and are initially expected to last until 8/20.  With South Korea is facing extreme flooding and China facing both power and drought issues, we have to consider the possibility that CE component and device pricing will remain higher than we might have expected, although trying to predict Mother Nature is a fool’s game.  Based on Figure 2 there is some hope toward the end of August…

​As of today the US Department of Commerce, Bureau of Industry & Security, has implemented additional export control rules concerning semiconductors based on Gallium Oxide and diamond, and CAD software specifically designed for developing GAA (Gate-All-Around) FETs, along with certain technology associated with the production of gas turbine systems.  As we have noted previously, the US government has been in discussions with various government’s whose companies might be affected by this new ruling, particularly the government of the Netherlands, where EUV tool vendor ASML (ASML) is located.
The substance of the new rules are as follows:
GaO and diamond based  semiconductors are able to operate at higher temperatures and voltages as opposed to those based on Gallium Nitride or Silicon Carbide and are therefore more applicable to military applications.  Exports to countries that have been singled out by the US government as having aspirations in conflict with the US would now be required to be licensed. 
While there are no current devices using PGC (Pressure Gain Combustion), a process that increases combustion pressure while consuming the same amount of fuel as conventional gas turbine engines, the BIS has cited the large amount of research being done in the area.  Citing the use of this technology in missiles, rockets, and military engines, the new rule will require licensing for any technology utilizing PGC, when they might occur in the future. 
ECAD systems used to design IC layout and lithography artwork necessary for the production of semiconductor devices has already been included in the EAR rules however the new additions are explicit in that ECAD tools that are for the design of GAA devices, which is a process that is used for complex chip production at nodes below 5nm and allows for the reduction of gate control issues that increase as device size decreases.  The application of GAA technology allows for faster, more power efficient, and smaller devices, again with applications for the military being cited in the rules and the BIS is asking for comments from the semiconductor industry as to the scope of the new rule, asking for details as to a variety of design functions in order to make sure all of the possible GAA related CAD design software modules are covered.  In order to receive these external suggestions, the implementation of the GAA rule is delayed for 60 days and items that have been previously licensed and are on loading docks or enroute are able to proceed as long as they are received before November 14.
At least on the surface the new rules would not add to the limitations already placed on ASML, given that the government of the Netherlands has not allowed the export of EUV tools to Chinese entities at the behest of the US government, while still allowing export of DUV tools that are able to produce at larger nodes.  EDA software vendors face a more complex challenge as the new rules are still broad enough that EDA companies might find that their internal thoughts on the application of certain modules might differ with those of the government, triggering a conflict as to whether they can be sold to those entities that fall under EAR guidelines, which is likely what much of the public commentary concerning the new rules will encompass.  Depending on the government’s ultimate decisions, the rule on EDA restrictions can be narrow or broad, with key EDA design firms such as Synopsys (SNPS) and Cadence (CDNS) generating 16.8% and 13.2% of revenue from sales to China in the most recent quarter, the most focused on the change, although the specifics as to GAA design revenue regional sales are not specified.

​Five large Chinese companies have indicated that they would begin delisting procedures to remove their shares from the New York Stock Exchange, tacitly over disputes with the SEC over audit information that has been ongoing.  While the China Securities Regulatory Commission has stated that the choice to delist was based on each company’s own business decisions, they have all complied with the rules and regulatory requirements in US capital markets, although the agency also indicated that it was keeping channels open with ‘relevant overseas regulatory agencies”, indicating that there is some ongoing dialog.  Given the increased tension between the US and China in recent weeks, the timing does seem a bit pointed.
The companies involved, Sinopec (600028.CH), China Life (601628.CH), Chalco (601600.CH), PetroChina (601857.CH), and Sinopec Shanghai Petrochemical (600688.CH) will begin the ADR delisting process this month with some maintaining Hong Kong and Chinese exchange listing.  As we have previously noted China Mobile (941.HK), China Unicom (762.HK), and China Telecom (728.HK) were delisted last year based on a previous administration’s administrative order “Addressing the Threat from Securities Investments That Finance Communist Chinese Military Companies” that was left intact by the Biden administration, which was separate from the audit conflict that is the root of the current delistings. 
Pundits are split on whether this would help or hurt the prospects for a deal that might satisfy the US audit rules, but it seems that the current environment is not one under which China is going to be making many concessions, especially if it means opening up books that might reveal connections that could spur further anti-China sentiment as we head into the November elections.  So far no Chinese CE companies have been forced to or voluntarily delist, but the HFCAA (The Holding Foreign Companies Accountable Act) , which contains the rules in contention has implications for a number of Chinese CE companies and the new delisting announcements only add to the tension.
 
 

There has been an unending stream of stories both in the press and media about how the excessive build-up of inventory levels in the CE space are the root cause of the ills that face the industry currently, along with a large helping of inflationary malaise.  While we look at many companies on a daily basis, most are either highly specific to a product category or technology and take on the characteristics of those products, not reflecting a broader sense of what is occurring in the CE space.  As we were updating our LG Electronics (066570.KS) model, we took a peek at LG’s inventory as the company has a broad line of CE products that span everything from ovens and refrigerators to TVs and projectors, a number of which are the leading brand in the category.
As seen in Figure 9 LGE’s inventory levels have been increasing since 2Q 2020, with the spread between initial cost and carrying cost relatively stable, and when inventory levels are compared to sales, that ratio has actually been declining, contrary to popular belief.  That said, when digging a bit deeper in Figure 11, it becomes apparent that the cost of raw material inventory is rising faster than sales, particularly since 2020, pushing the value of raw material inventory from 14.0% of sales in early 2018 to 16.7% in 1Q of this year, with some 18%+ peaks over the last two years.  Finished goods as a percentage of sales has also been rising, albeit not as much as raw materials, which puts LGE in the unenviable position of having to raise prices or live with lower margins.
What this seems to imply is that while there was certainly over-ordering in the CE space to protect brands from being unable to provide product to a demanding consumer base, the issue of raw material price increases seems to have had a bigger effect on inventory balances than a build-up of excess units.  That said, there are still many points in the CE supply chain where there is excess unit inventory, but we see the bigger issue as being the high cost of that inventory and how to market it to consumers, especially given the reduced buying power consumers are currently facing.  Do companies like LG dump the high-priced inventory at a big loss, figuring the year is going to be a write-off anyway and its good to clear the decks, or do they hold or even raise prices to maintain margins, likely extending the inventory glut and reduced production levels into 2023?
We expect that perspective has been changing over the last few weeks, with the idea that holding margins, even if it means carrying higher inventory levels, giving way to the idea of aggressive discounts to move high-cost units.  We still don’t believe CE companies are convinced that the current macro environment is ‘real’, with managers kneeling by their bedsides each night praying for a return to the ‘new normal’ demand they became used to in late 2020 and much of 2021, but we expect reality will catch up by the end of 3Q, especially if 3Q ends as poorly as it began.  If that mindset is translated into a heavily discounted holiday season will consumers respond?  We believe so, but not with the same vigor that was seen a few quarters back, as the need for a new smartphone, TV or laptop has been sated, leaving only a customer base of true bargain hunters, rather than a customer base that is willing to pay up for immediate gratification. 
This leaves CE brands betwixt and between, willing to take the quick hit to move inventory but unable to finish the job, dragging sales weakness into 1Q 2023, but that does give us hope that there is still potential for a better balance between CE supply/demand for much of next year, and we rarely take the optimistic view this far out, although to us, this is the least radical scenario we could expect.  Of course there is still plenty of time for deleterious world events or another outbreak of something to throw a monkey-wrench into the whole megillah, but it could happen.