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Apple, Qualcomm Cash Hoards Show the Perils of Outsourcing


Western tech giants revel in high margins, but where does that leave the cash-poor original design manufacturers?

Meet the starving children of the (tech) world: Hon Hai Precision, Pegatron Corporation, Compal Electronics, and Quanta Computer. These are the poor souls that make your laptops and your smartphones. Should you decide to buy a smartwatch, they'll no doubt have had a hand in that, too. When it comes to consumer electronics, Hewlett-Packard (NYSE:HPQ) and Apple Inc. (NASDAQ:AAPL) may talk the talk, but it's the original design manufacturers -- a group of Taiwanese and Chinese suppliers -- that do most of the walking.
And they're basically broke. Together, the four largest ODMs cranked out over $200 billion in sales last year, on which they earned a lousy 2%. Hewlett-Packard is only half their combined size but managed to pull more than twice the free cash flow. With $175 billion in sales, Apple made more profit in two months than the ODMs did all year. There may be good money in designing gadgets, but actually making them? Not so much.
American tech companies now face the first-world problem of trying to spend all of this cash. HP has bought back stock, retired debt, hiked dividends, and made ill-advised acquisitions. Strangely, these "investments" have done little to prevent Lenovo's (OTCMKTS:LNVGY) conquest of the PC market. In recent months, Apple has sparred publicly with activist investor Carl Icahn over its $150 billion nest egg. Should the iPhone maker continue to sit on it or pass hatching duties on to investors? Somehow, neither solution seems likely to reverse Apple's loss of market share to devices running Google's (NASDAQ:GOOG) Android operating system.
In a neat bit of irony, much of the industry's cash is sitting offshore, in close proximity to foreign partners who could desperately use it. For example, Hon Hai Precision -- better known as Foxconn -- has struggled to cope with rising labor costs in China. In 2010, the major Apple supplier announced that it would automate much of its workforce, installing 1 million robots over the following three years. These machines were estimated to cost $20,000 each, for a grand total of $20 billion -- or about 10 times Foxconn's operating cash flow that year.
No surprise, then, that as of 2013 Foxconn's automation plan was only 2% complete. According to Caixin, poor financial showings were a major roadblock: "Research and development of robots requires huge capital, and [this] forced Foxconn to seek ways to control expenses." From atop its mountain of lucre, Apple "urged Foxconn to buy automation equipment," but as they say: You can't squeeze blood from a turnip.
The agony of Hewlett-Packard supplier Quanta Computer can be attributed to a decline in computer demand, coupled with competition from integrated PC-maker Lenovo. HP has been hit by the same bullets, and one might reasonably think that both companies would be better off if HP's cash were to somehow end up in Quanta's hands, where it could be reinvested rather than used to placate shareholders.   
For that matter, Taiwan Semiconductor (NYSE:TSM) would be overjoyed to have just a piece of Qualcomm's (NASDAQ:QCOM) $30 billion bank account. The chipmaker is struggling to fund an arms race with Intel Corporation (NASDAQ:INTC) and has been forced to take on debt in each of the last three years. Taiwan Semi's partners obviously benefit from this investment, since they compete with Intel as well. I can only imagine TSM's indignation at hearing Qualcomm refer to its pile of cash as a competitive advantage, while TSM's own balance sheet runs dry.
At the same time, integrated manufacturers -- companies that design, make, and sell their own product -- are doing quite well. Samsung's success in televisions, cell phones, and PC components is a testament to its ability to produce quality products at a reasonable price. Lenovo is now the world's leading PC maker, and for a similar reason: The Chinese company regularly tops Rescuecom's computer reliability reports, while offering competitive prices.
Despite being caught off-guard by the mobile revolution, Intel has clawed its way back into contention, a feat that wouldn't have been possible without the leverage provided by its industry-leading facilities. This advantage comes at a hit to margins, as the profits earned by chip design are plowed into assembly lines, but it also provides staying power for Intel. Whereas IBM (NYSE:IBM), a company that long ago divested itself of most manufacturing assets, now runs for cover anytime a more agile competitor gets too close.
Outsourcing has long been blasted as a source of income inequality, but what often gets overlooked is that this is true at the corporate level as well. Low-wage labor pools are drying up around the world, and the ODMs are too cash-starved to modernize. By turning this into "someone else's problem," Western hardware firms have managed to preserve their high margins -- but at what cost? And to what end, when their earnings sit idle and attract vultures like Carl Icahn?
Cash hoards and starving manufacturers are, at the very least, signs of an industry out of balance. They also present an opportunity, for any CEO gutsy enough to defy conventional wisdom and build a factory.

Also see:

An Apple-Comcast Deal Probably Won't Fix Big Cable

Drop-Dead Date Looms for Microsoft's Windows XP

Google Just Upped the Ante in the Wearables Game

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