By Jonathan Standing and Clare Jim
TAIPEI (Reuters) - Shares in Hon Hai Precision Industry Co Ltd <2317.TW> took a beating on Monday after lackluster quarterly profits, in sharp contrast with the booming fortunes of its main client, Apple Inc
The chasm between the two companies' margins illustrates the challenges facing contract makers that specialize in quick and reliable turnaround but have no brand cachet of their own, because of increasing competition and pressure from electronics companies to decrease manufacturing costs.
Hon Hai's operating margins slid to 0.9 percent in the January-March quarter while Apple's was 39.3 percent.
The margin squeeze for Hon Hai could worsen in coming months because of a 16 to 25 percent wage increase for workers, via a deal worked out between Foxconn Technology Group, of which Hon Hai is the flagship listed unit, and Apple.
At an event on Saturday unrelated to its earnings announcement, Chairman and founder Terry Gou acknowledged the difficulties of the company's business model.
"Labor cost is a problem everyone faces. Every Chinese city has a regulation on minimum wages ... we're paying more than other companies, it's hurting our profit," he said.
Rising labor costs in China, where millions of devices are assembled, could increase the pressure on Apple and other electronics manufacturers to help pay for it.
While neither Apple nor Foxconn has said what the cost-sharing arrangement, if any, is between the two companies, Wall Street is assuming that Apple will have to cover at least part of the increase in wages.
"It remains unclear whether Hon Hai will be able to successfully pass on increased costs to Apple, but if it does, then Apple's gross margins could be negatively impacted by 30 - 50 basis points," Bernstein Research analyst Toni Sacconaghi said in a recent research note.
Higher labor costs could be passed on to Apple via a price hike from Hon Hai, but would only take effect from April, a report by HSBC estimated.
Hon Hai's first-quarter net profit - up 3.6 percent to T$14.92 billion - was well below the previous quarter and missed analysts' forecasts by more than a third.
By sharp contrast, Apple's nearly doubled its quarterly profit, propelled by strong sales of the gadgets Hon Hai makes: iPhones and iPads.
"Competition for contract makers is very heavy. They have to make concessions on margins and cut prices in order to win orders," said Jamie Wang, Taipei-based analyst for technology research firm Gartner. "This is the case especially for Apple's contract makers because everyone wants to squeeze into its supply chain."
Hon Hai's operating costs rose 28.6 percent from a year earlier and its cost of sales increased 43.3 percent. Gross margin at Apple of 47 percent was almost 12 times Hon Hai's.
Hon Hai shares opened down the maximum 7 percent allowed in a session and remained at that level - a 3-month low - until the close. It was the stock's biggest one-day drop since November 2008.
In the past two years, Hon Hai's net profits have surprised the market on the downside in five quarters, compared with Apple's once, Starmine data shows. The Taiwanese maker has reported four quarterly profit declines in the same period, while California-based Apple has posted rises in all. Hon Hai gets about 45 percent of its business from Apple.
COST OF LABOR
Analysts attributed the big miss in the first quarter mostly to Hon Hai's rising salary costs.
The company has been spending heavily in the last year as it fights perceptions its sprawling plants in China are sweatshops with poor conditions for its million-strong labor force. It regards the criticism as unfair.
The Foxconn Technology Group, of which Hon Hai is the flagship listed unit, announced in mid-February it had raised wages for workers by 16 to 25 percent. In late March, it reached an agreement with Apple to hire tens of thousands of new workers to reduce overtime work.
Hon Hai has been trying to cut rising Chinese labor costs in the past two or three years, and has been relocating plants to areas of China where wages are lower.
"Hon Hai is a manufacturer; its margins have not been doing well in the past few years because of the relocation costs in China, even though its revenue has been good," said an analyst from a European brokerage, who declined to be named. "But we should see more correlation between Hon Hai and Apple's results from this year as Hon Hai's relocation is coming to an end."
Other reasons for the weak first quarter included a worse than expected loss from affiliate Foxconn International Holdings <2038.HK> and low yield rates on the new iPad in January and February, analysts said.
Hong Kong-listed Foxconn International, the world's top contract handset maker, has warned of a substantial increase in its net loss for the first half of 2012 on lower demand from some of its main customers.
In the second quarter, analysts expected margin improvement would be mild as the company spends more in preparation for the iPhone 5 launch in the following quarter, while a pick-up in operating profit margin would be seen from the third quarter, driven by a ramp-up of the new iPhone.
(Additional reporting by Poornima Gupta in San Francisco; Editing by Jonathan Hopfner, Ian Geoghegan, Gary Hill)