A 20-minute drive from the South Korean city of Daegu sits the Gumi Industrial Complex. Home to more than 2,600 companies and production plants, it looks like any manufacturing hub in a small quiet town. But over the past two decades its global importance has grown almost unnoticed as Apple and its rivals in Asia have concentrated production of vital components — for everything from smartphones to TVs, and the drivers of cloud computing — in the area.
Coronavirus is now exposing how risky that strategy was and how vulnerable the smartphone supply chain is: Daegu is at the centre of the South Korean outbreak of the pandemic, with 85 percent of the country’s 8,413 cases.
Samsung Electronics and LG Electronics, central to South Korea’s postwar economic miracle, are the world’s largest suppliers of memory chips, organic light emitting diode (OLED) displays and camera modules. Production of these essential components is concentrated in a handful of locations around Gumi and the Seoul suburbs.
For consumers, tightening supply of iPhone and iPads is already a problem, as the outbreak disrupted production in China. Retailers and mobile operators in the US and Europe are running low for some models. iPads are selling out as schools turn to e-learning. Apple has closed all its stores outside China and cut quarterly revenue forecasts. Backlogs in delivery of Samsung and Huawei smartphones have lengthened. Yet some in the industry are already predicting a parallel demand shock as the expected global downturn hits sales.
China, where the bulk of the world’s consumer electronics are assembled, has experienced a decline in infections since the first outbreak in the city of Wuhan in December and factories are slowly returning to work. Yet, even after those operations get back to normal, tech shortages may worsen. China is highly reliant for critical parts on South Korea and the outbreak there is more recent, which means disruption could drag on for longer.
“If supply chain outages persist, this could disrupt Samsung and LG Electronics’ overseas plants, including the ones in Vietnam,” says S&P Global’s Jun-Hong Park. A shortage of raw materials, tighter transport restrictions and production line closures could all add further delays for manufacturers.
Smartphones are especially vulnerable. Virtually all the screens in high-end versions are produced by Samsung and LG. Apple relies on the two companies to supply all its OLED smartphone panels used in the iPhone X and the iPhone 11 Pro models. The two Korean electronics groups use the same displays in their own smartphones. Huawei’s high-end models use Samsung panels. Google Pixel phones, iPhone camera modules and Apple Watch screens are made by LG.
Between them Samsung and LG produced over 94 per cent of the smartphone OLED display market last quarter, according to IHS Markit data. The companies’ presence in the living room is no less dominant, Sony, Bang & Olufsen, Panasonic and Philips’ OLED TVs incorporate LG panels. It is the only significant producer of these displays globally, producing almost 3m a year. And in the office, Dell and Amazon, the largest cloud services businesses in the world, rely on Samsung chips for their computers and servers.
Almost three-quarters of the world’s Dram memory chips — without which consumers would not have smartphones, computers or internet servers — are made by Samsung and local rival SK Hynix.
The impact from a shortage that ripples downstream from these companies and others would be extensive, including supply constraints and price increases for other products. Plants across the country had been running at full capacity at the start of this year. The combination of just-in-time supply chains and a complex chipmaking process that takes up to six months makes any swift ramp-up difficult. Analysts expect demand for the companies’ server chips, OLED screens and TV panels and wireless earphones to exceed supply by an average of 30 percent in March.
“Whether it is due to the supply or demand shocks, manufacturers will see the effects of the outbreak well through the rest of this year,” says Hyun Bae at Samsung Securities.
The world’s digital economy has become dependent on the Gumi Industrial Complex, a place few in the west have heard of, but it is critical to 21st century supply chains. The only time it made international headlines was in 1995, when Samsung chairman Lee Kun-Hee ordered 150,000 phones made in Gumi to be burnt and bulldozed when some were found to be faulty.
It is here that Samsung makes its premium line of phones, including the Galaxy S20 and Note 10 — that account for 47 percent, or $86.3bn, of total revenues. LG’s display factories are nearby. A concentrated production base offers the prospect of better quality control. The Samsung and LG factories have benefited from being close to their suppliers. Most employees live in corporate housing in the complex or nearby.
Unfortunately, workers also flock to Gumi from nearby Daegu — the southern city of 2.4m people which was the site of the country’s worst coronavirus outbreak as a result of cases related to a religious sect. Samsung’s smartphone plant shut down twice in February, following four cases of infection. LG subsidiaries LG Display and LG Innotek also temporarily closed plants making displays and camera modules. Samsung has been forced to temporarily move some production to Vietnam.
Display panel plants are designed to run 24 hours a day, seven days a week. If external pollutants enter the production cleanroom, continuous operations are halted for up to three days. Getting back up to full speed, including re-establishing all production settings, can take up to a week. Samsung typically makes more than 400,000 sheets of OLED display panels a month. Each sheet is cut to fit about 200 smartphones, enough for as many as 110m handsets. Cutting supply by just one week translates to a delay in more than 20m devices. That delay is passed down a supply chain which, in obedience to the principles of lean manufacturing, carries little surplus stock.
Other locations, such as Gyeonggi province — the area around the capital, Seoul — are not exempt. Chip production for Samsung and SK Hynix is concentrated in this area. Some 5.2m wafers, which are cut into hundreds of tiny chips, are made daily in this area, which saw a sharp rise in infections last week. Thousands of employees at the companies have been quarantined. Chips are at the centre of the global tech supply chain and 80 per cent of Korean memory chip exports were shipped to assembly plants in China last year. Taiwan, Japan and Vietnam also rely on Korea. Any break in production would stall work at thousands of plants across China and Vietnam.
Complicating the situation is a growth in the use of technology dependent on Korean components, even as it threatens to choke off supply. Across the world, coronavirus has meant more and more people are stuck at home, working, gaming, shopping or watching TV online. Data centres are struggling to cope with surging traffic. The price of server chips rose 10 per cent in February, the first double-digit increase in three years.
That leap in price reflects the market expectation of supply disruptions as cases of coronavirus increase in South Korea. Samsung and SK Hynix have started redeploying their mobile phone chip production capacity to churn out more server microprocessors. Orders have exceeded supply by more than a fifth since January. The timing could not be worse. A costly pile-up of inventory last year due in part to a diplomatic spat with Japan pushed chip prices down, but by December Korea’s semiconductors inventory-to-shipment ratio was at its lowest in more than a decade.
The situation left little room for any disruptions this year. Chip fabrication plants require 24-hour operations. Any disruption can cause errors for the day’s batch of silicon sheet wafers. After a shutdown caused by coronavirus it takes days for production to get back up to speed. A stoppage equivalent to a week’s output could reduce operating profits by more than $400m within three divisions of Samsung that produce the chips or depend on them, S&P Global data suggests.
Each day of lost production equates to delays passed along the global supply chain. Due to the high cost and time involved in set-up, chip facilities cannot be relocated like smartphone assembly plants. Each semiconductor fabrication line costs as much as $3bn to build. There are over 20 lines running in Gyeonggi province, with hundreds of suppliers located nearby.
These small and medium-sized companies pose yet another risk. They are especially vulnerable to a disruption in orders. In a prolonged shutdown, many suppliers would run out of cash within months. Their own plants are also at risk from the impact of coronavirus. Structural changes that separate production, testing and packaging mean the chips go through many more hands, adding to the risk of infection.
For the smartphone makers there is little respite. Demand for OLED smartphone screens grew sixfold in the second half of last year as the market shifted from traditional LCD screens to new smartphones. As for TVs, the years that Olympic Games are held have traditionally seen bumper sales. Notwithstanding doubts over whether the Tokyo games will go ahead, a shortage is still on the cards. Any capacity boost from a new plant in the southern Chinese city of Guangzhou — which has been delayed by more than half a year by technical problems — will not come in time.
Diversifying production geographically offers little relief. More than 120 countries have placed travel restrictions on passengers entering from South Korea. Following the temporary closure of its Gumi plant last month, Samsung moved half its smartphone production, or 150m phones, to Vietnam. But more than 700 Samsung engineers will be needed to re-programme plant specifications to produce its latest models in the country.
Even then they need parts made in South Korea such as the OLED panels to attach them to smartphone circuits, so quarantines are expected to cause production delays. Adding to the logistical nightmare, airlines have suspended more than 80 per cent of their flights in and out of South Korea, having an impact on deliveries to assembly plants and finished products to customers. Some are being shipped by sea to avoid additional controls on flights. Raw material imports to Korea are also subject to delays, further reducing output and meaning higher prices and longer delivery times.
For big tech companies, whether through a shortage in parts, a lack of finished products to meet demand or a rise in component prices, margins will be squeezed. Smaller companies, lacking volume, stand to lose out in the scramble for scarce capacity. The bigger challenge for both will be dealing with an impending demand shock at the same time.
As production and supply start to normalise, a pullback in consumption and closed businesses — the result of the global downturn the virus outbreak is threatening — will weigh on demand. The US has warned that the impact of the outbreak might last beyond August. That could translate into prolonged travel restrictions, lengthy quarantines and a plunge in consumption and demand for consumer tech. Those effects could last well into next year.
The depth and complexity of the global tech supply chain mean the full impact of disruptions will be far deeper than expected and highly unpredictable. For now, the best consumers can do is to be careful not to drop their smartphones. Financial Times