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Apple Inc.'s Feud With Samsung Puts Future Innovation at Risk

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Why Apple's desire to distance itself from a competitor is self-defeating.

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On Monday, I discussed Apple Inc.'s (NASDAQ:AAPL) deteriorating relationship with a major Asian supplier, Foxconn (TPE:2317). For years, this contract manufacturer has assembled virtually all of Apple's IOS products, but now more of that work is going to a competitor -- Pegatron (TPE:4938).

This is unusual for Apple. The iPhone-maker has always shopped around for standard components like memory chips or displays, but when it comes to critical, designed-in-Cupertino parts -- like the A series of processors or the iPhone's final assembly -- Apple has typically opted for more exclusive partnerships. Cutting-edge products require capable assembly lines, and these require money. Partners are more likely to make the necessary investments if they feel assured of a long-term commitment. Like any marriage, the one between Apple and Foxconn removed some of the risk of having a baby.

Apple nurtured a similar relationship with Samsung (OTCMKTS:SSNLF). In 2006, it adopted the South Korean manufacturer's processors for the iPod, and subsequently the iPhone. Apple designed its own mobile chips beginning in 2010, but still gave the manufacturing work to its South Korean partner. In 2012, Apple accounted for 89% of Samsung's foundry output.

This relationship is also on the ropes. Last month, the Wall Street Journal reported that Apple has contracted with Taiwan Semiconductor (TPE:2330) to supply mobile processors, beginning next year. The two companies have courted each other for months, and the Journal hinted at a sticking point: "Apple asked to invest in TSMC, or to have TSMC set aside factory space dedicated to Apple chips…. TSMC Chairman Morris Chang rejected both requests because the company wanted to maintain its independence and manufacturing flexibility."

In other words, TSMC would prefer not to end up like Foxconn or Samsung -- two companies that are now trying to fill the void left by Apple. The Korea Times reports that Samsung is wooing Amazon (NASDAQ:AMZN), Sony (NYSE:SNE), and Nvidia (NASDAQ:NVDA) for potential foundry business. Foxconn derives two-thirds of its revenue from Apple, and is attempting to fill that hole with television sets and mobile devices of its own design. Both companies face retooling costs, plus the difficulty of transitioning from a single large client to an open marketplace.

Apple may have gained some concessions from TSMC, but the foundry's size insures that Apple will never be more than a minority customer. The size and duration of the Apple-TSMC contract is unclear, but Credit Suisse estimates that even 60% of Apple's business would translate to only 15% of TSMC's revenue, placing Apple on equal footing with other customers like Qualcomm (NASDAQ:QCOM) and Nvidia – both of which have complained of supply and yield issues. These complaints shouldn't be surprising: It's easy enough to satisfy a single client with a specific set of needs, but much harder to please a room full of them. And then, independent foundries generally earn lower margins, and have less capital to throw around than do integrated shops like Intel's (NASDAQ:INTC) and Samsung's.

It's revealing that Nvidia and Qualcomm, who share much of their supply chains, produce very similar products. Hewlett-Packard (NYSE:HPQ) and Dell (NASDAQ:DELL) utilize the same Chinese assembly lines, and their consumer hardware has become largely indistinguishable in terms quality, design, and desirability. Outsourcing is a great equalizer. The loss of design edge has presented Asian competitors -- closer to factories, and willing to tolerate low margins -- with a great opportunity. Lenovo (HKG:0992) has eaten up the PC market; Mediatek (TPE:2454) may one day gobble up the mobile chipset industry, if it can lever the same advantages.

On the other hand, Apple's A6 processor immediately stood out from the competition. From Anandtech:

Samsung was paying close attention to Apple's requirements and fed that experience into its own SoC and smartphone design…. Apple set its sights much higher. Steve Jobs hired some of the brightest minds in CPU and GPU design and kept them close by. They would influence silicon supplier roadmaps as well as help ensure Apple was on the forefront of performance.

There's no question that Apple influenced Samsung's foundry roadmap, accounting as it did for virtually all of Samsung's business. Together, they produced an outstanding product. Had Apple been forced to wait in line at TSMC, the result might have been mediocrity.

Apple's desire to distance itself from a competitor is understandable, and also self-defeating. In 2011, it brought Samsung to patent court -- the suit and counter-suit are still pending -- and this decision paid unpleasant dividends last fall when Samsung allegedly hit Apple with a price hike. Bernstein's Mark Newman suggested that Samsung had become "more assertive in price negotiations" in response to "Apple's hostile tactics." He went on to say that "Apple requires more capacity…. However, without a long-term commitment beyond the end of 2013, Samsung is refusing to spend literally billions of dollars."

To quote Steve Jobs, "we have to let go of a few notions here." The first: that you can't work with your competitors. Jobs argued that you can -- and subsequently proved it when in 1997, he announced that Microsoft (NASDAQ:MSFT) was investing in Apple. The second: that outsourcing should be approached like a one-night stand, with minimal commitment and maximum competition between suppliers. Many Western companies took this attitude, and diluted or destroyed their brands because of it. Apple thought differently. Investors should hope that it still does.

See also:

Apple Inc. Steps Over the Lowered Expectations Bar -- Now What?

Apple Inc. Fights Off Samsung's Quadruple Bypass Hummer of a Phone

The Two Types of Users That Apple and Google Have Abandoned
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