Tech giants and VC: When the chips are down

Taiwan is still a formidable force when it comes to producing technology. Over the last three decades the small island state has transformed itself from a supplier of plastic toys and bicycles into one of the world's foremost manufacturers of high-tech consumer products and components. As of 2012, Taiwan-based companies were responsible for 89% of all notebooks produced globally and 46% of desktop PCs.

Computers and electronics are vital to the overall economy. According to Thomson Reuters, they account for just below 10% of all exports and around 6% of GDP. But the industry has also seen better days; a decade ago the share was 18.27% of exports and 8.27% of GDP.

The bottom line is that Taiwan's electronics giants need to innovate. This is where some industry participants see VC playing a role, seeking out new technologies that will shepherd the industry into a new phase of evolution.

"Hardware will continue to dominate the Taiwan's tech industry but the internet and software related industries are booming," says Joseph Chan, a partner with incubator appWorks. "Most big electronic companies are reviewing their computing strategy - some are going into infrastructure while others are looking at services. Meanwhile venture companies looking for opportunities in both these areas."

The primary cause of the electronics industry's problems is plunging demand for PCs. Shipments fell 13.9% year-on-year in the first quarter of 2013 as consumers switched to smart phones and tablets. The trend is a double-edged sword for Taiwan. The likes of Taiwan Semiconductor Manufacturing Company (TSMC), which makes chips for smart phone processor supplier Qualcomm, and MediaTek, which sold 110 million smart phone chipsets in 2012, are still healthy; but companies that have built their success on PC manufacturing are suffering.

PC exposure extends deep into corporate Taiwan, but the recent performance of Asus and Acer are a bellwether for broader trends.

Acer, which holds around 8% of the global PC market, reported a net loss of $11.4 million in the second quarter of this year. While some of this can be attributed it to the company's growing investment in product design, revenue for the quarter also declined 19% year-on-year as shipments fell by 32%. Asus saw PC shipments decline by 41.7% year-on-year in the second quarter to 850,000 units.

Taiwan's hardware industry includes a number of original equipment manufacturers (OEMs) and original design manufacturers (ODMs) making components and machines for Dell, Lenovo and Hewlett Packard. These companies' revenues have also fallen - and they operate on far thinner margins than Acer and Asus.

Start-up nation

Even a contracting electronics industry still towers over venture capital, but many see potential for growth in the space. According to AVCJ Research, VC investors so far this year have deployed $28 million across 12 deals in Taiwan's electronics, IT and computer-related sector, already more than in each of 2011 and 2012. The industry could be on course for its best year for investment since the global financial crisis.

If venture capital can offer guidance to hardware manufacturers, it would not be the first time. VC investment was a key component of Taiwan's first manufacturing wave.

H&Q Asia Pacific was among the first to invest in Taiwan's burgeoning tech industry. Back in 1982, the government was keen to create a version of Silicon Valley in Asia and approached investment bank Hambrecht & Quist for support.

In 1986 H&Q Taiwan was set up and duly launched the H&Q Han Tech Fund. The $20 million vehicle set about making minority investments in companies producing components ranging from graphics cards to keyboards - mostly Series A and B rounds. One of its first portfolio companies was a PC integrator and manufacturer called Acer.

Since then Taiwan has become one of the biggest OEM manufacturers in the world. This immense productivity has largely resulted from companies migrating manufacturing across the strait to mainland China.

"These strategic moves took advantage of the cheap labor in China where engineering costs are one third that of the US and assembly line wages averaged around $120 per month," says Julian Chu, head of international business at Market intelligence & Consulting Institute (MIC) in Taipei. "Facilitated by close proximity and the absence of a language barrier, the move not only reduced costs but allowed Taiwanese companies to focus on R&D, management and marketing."

But now China has emerged as a formidable market in its own right, with domestic companies capable of producing quality components at low cost for export or domestic consumption, and drawing on a large pool of local engineers. The country offers relative skill, scale and logistics networks to send shipments on their way.

For Taiwan's electronic industry, there have been several consequences. First, China is a competitive threat. Spreadtrum, for example, has come from obscurity to establish itself as the second-largest supplier of chips for mass-market phones. It sells components for as little as two thirds of the price charged by Taiwan's market leader MediaTek.

Second, labor costs in China are rising. The Chinese government wants the average minimum wage to rise by 13% between 2011 and 2015, and it has become clear the country is no longer the source of cheap labor it once was. Workers now get $300-500 a week, well above the $90 and $40 paid in Cambodia and Bangladesh. T-shirt manufacturers began to relocate several years ago.

In addition, greater pressure has been placed on suppliers to the PC and notebook market by the likes of Apple and Samsung, which are positioning themselves as low-cost alternatives to PCs. "Apple's iPad, released in 2010, demolished the sales of low-end notebook computer from Taiwan," says MIC's Chu. "The post-PC era began and Taiwan got blindsided."

Due for an upgrade

Partly as a result of the migration of manufacturing, salaries in Taiwan have stagnated. Despite GDP expanding 1.26% in 2012, wage-adjusted inflation fell 1.98%. There is plenty of anecdotal evidence indicating a brain drain from Taiwan to China as educated locals look for work elsewhere.

On the flipside, the situation presents an opportunity to shore up Taiwanese business. A number of incentives are being offered to manufacturers that relocate high-value production back to Taiwan under the "Strengthening the Promotion of Investment in Taiwan overseas Taiwanese Enterprises" program, which was set up in November.

The government - via its National Development Fund (NDF) - is offering NT$10 billion in special loans to support returning companies. Financing and assistance in acquiring land and establishing plants is also available. So far some companies have seized repatriation opportunity. They include Largan Precision, the world's largest mobile phone lens manufacturer, and metal casing maker Catcher Technology that between them will create 3,800 new jobs in Taiwan by 2016.

A free economic zone program has also been launched with a view to increasing private sector investment by NT$20 billion and contributing NT$30 billion to GDP by 2014. Within the pilot zones, Chinese firms are granted the same investment terms available to foreign players, which means they can participate in Taiwan's key industries - including semiconductors -without any cap on their shareholding.

Still, several leading manufacturers have concluded that they must shift away from PCs. Notebook specialist Pegatron, for example, now relies on PC-related business for 40% of its sales, down from 60%. The firm - which recently won contracts from Apple at the expense of Hon Hai Precision Industry, also known as Foxconn - saw its revenues jump 40% last year.

The mobile market, however, remains fiercely competitive with South Korean giant Samsung at one end and a host of cheap Chinese manufacturers at the other. Taiwan's share of the global tablet market has seen a spectacular decline from 94% in 2010 to an expected 53% this year, according to MIC data. As a result, many firms have moving in to entirely new areas.

Both Asus and notebook manufacturer Quanta Computers recently entered the cloud computing services space. Asus has launched Asus Web Storage while Quanta is expanding its server division, which now accounts for up 10% of revenue. The company sells 85% of its servers directly to its clients, including Facebook, that have to process huge amounts of data.

Diversification doesn't stop there. Hon Hai is looking to develop its own technology, extending its business to provide devices and applications that build on Mozilla's Firefox operating system such as smart phones, tablets, TVs, electronic whiteboards and outdoor displays.

The big question

Are these areas in which start-ups can lead the way? "What is clear is the future Taiwan economy cannot depend on hardware," says Joseph Tai, CEO at Integral Group. "What we are seeing now is that venture industry is increasingly being driven by the rise of the mobile internet and 4G. This will be the next trend."

While deal flow appears to have increased, many industry participants say there are still hurdles to overcome before innovative start-ups can flourish. Perhaps chief among its challenges is Taiwan's size. With a population of just 23 million, it lacks a large-scale domestic market in which new technologies can be nurtured.

Furthermore, while Taiwan may have a wealth of talented entrepreneurs, its strengths have always been in manufacturing; there are no household names like Facebook or Baidu.

The government, which had until recently a much more hands-off attitude to VC compared to its Asian neighbors, has been trying to remedy this. Last November the Ministry of Economic Affairs, together with the industrial Technology Research Institute, launched its Start-Up Taiwan project intended to develop the industry by matching new business enterprises with VC firms.

Most recent VC deals have been early-stage investment in the mobile internet space. Cloud gaming solutions firm Ubitus received over $15 million from investors Samsung Ventures; mobile app developer Cardinal Blue raised $2.3 million from a consortium of US investors; and online game provider Pubgame received $4.5 million from local investors appWorks and CID Group.

"I believe Taiwan has a good environment for innovation and early stage investment," says Vincent Wang, chairman at Sunsino Venture Capital. "Though small, the Taiwan consumer base is also very advanced, so this is a good place to test business models before expanding into other geographies."

However, it has not yet been demonstrated in a meaningful way that technological innovation at the start-up stage can filter through to Taiwan's electronic giants - especially with a lot of investment coming from overseas VC rather than domestic strategic investors.

Integral's Tai believes corporate Taiwan has the capacity to identify, support and then absorb new technologies that complement existing business. But it will be a natural evolution.

"We are going to see a change of management control over the next 4-5 years," he says. "The older generation of entrepreneurs heading up the likes of Acer will give way to a new generation talent and I think there will be an opportunity there."

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• Topics
• Technology
• Venture
• Greater China
• Early-stage
• M&A
• TMT
• Taiwan (China)
• manufacturing
• Venture
• The CID Group