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Apple's Supply Chain Creaks, Groans as iPhone 6 Production Ramps Up

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The company's seasonal product schedule and reliance on low-tech production lines will eventually, if they haven't already, put Cupertino at a disadvantage to integrated competitors like Samsung.

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It's that time of year again -- when countless Apple (NASDAQ:AAPL) suppliers hang their stockings, say their prayers, and go to bed dreaming of a successful iPhone launch. Foxconn (TPE:2317) and Pegatron (TPE:4938), who last year shared assembly duties for the iPhones 5S and 5C, are reportedly hiring up to 130,000 employees to work on the iPhone 6, expected for release this fall. Japanese equipment suppliers are enjoying brisk business, as Chinese orders for machine tools hit record levels; and yet there's a distinct lack of holiday cheer this time around.
 
The Nikkei Asian Review reports that "there is no buoyant mood... as sales of new Apple products have failed to live up to expectations in recent years." The large, annual swings in demand present a problem. One supplier complained that "steep fluctuations in production adversely affect earnings." This sentiment was echoed by a senior executive from Sharp (TYO:6753), who said in an interview last month that the company's Apple-dedicated display facility "presents a high level of volatility risk." The interviewer characterized this facility as "not very profitable," and wasn't contradicted.
 
These rumblings follow Foxconn's efforts to diversify away from the iPhone, and Pegatron's earnings miss last fall due to the cost of iPhone 5C production. To be sure, the iPhone continues to provide an enormous windfall to the companies that supply its parts, but this payout comes with risks. A failed launch would be a disaster, given the amount of capital and labor leveraged by suppliers; and the odds of such a failure have increased with the maturation of the smartphone market, intensifying competition, and as Apple complicates its product line with new models like last year's 5C and this year's rumored 5.5-inch phablet.
 
Given the fact that nearly half of Apple's suppliers reside in China, rising wages add even more uncertainty to the business model. The iPhone's seasonal demand makes it more practical for manufacturers like Foxconn to hire temporary labor than it does for them to invest in automated equipment that will sit idle for half of the year. This flexibility has proven to be one of the great advantages of Chinese sourcing, but wages in China have tripled over the last decade, and Bank of America (NYSE:BAC) expects them to rise an additional 10% this year

It's notable that Samsung (KRX:005930) doesn't have this problem; steady demand and year-round product launches (plus deep pockets) enable the electronics giant to assemble many of its phones in-house, at an advanced and heavily automated facility in Gumi, South Korea, and in increasingly automated factories in Vietnam.
 
An infographic from FinancesOnline.com tells us that Apple's manufacturing strategy is motivated by scalability and supply chain risk. But in both cases, the iPhone-maker is merely offloading those costs onto suppliers. Scalability means the sort of labor-intensive, low-margin assembly lines that Foxconn is trying to get away from; CEO Terry Gou told shareholders last month that "business transformation is crucial for Foxconn's sustainable growth in the next 10 years."

The risk of excess capacity and overproduction is something Apple's suppliers deal with every year -- not to mention other liabilities, like the increased scrutiny that comes from a relationship with Apple. Foxconn has spent the last several years cutting down on workers' hours and responding to criticism, and a death at Pegatron last winter thrust that manufacturer into the spotlight as well.
 
Apple's supply chain may be groaning, but at this point, there's little expectation of a blowout. Suppliers anticipate a healthy 20% growth in iPhone sales this year, and Jeffries analyst Peter Misek predicts that any increase in the iPhone's bill-of-materials will be attributable to the larger display. Indeed, there's a virtuous cycle at work. So long as suppliers see an opportunity for growth in the iPhone, they'll be more willing to accept the risks that come with it and to offer price concessions.
 
Things won't be so pretty should Apple suffer a bad launch or make a poor product decision, and regardless, the company's seasonal product schedule and reliance on low-tech production lines will eventually, if they haven't already, put Cupertino at a disadvantage to integrated competitors like Samsung.

This is going to be a problem for many consumer tech companies, who for years have relied on cheap labor as a surrogate for investment. They and their suppliers are now staring at a very large bill; and the fact that Foxconn can't afford to automate means that, one way or another, Foxconn's partners will pay the price. The iPhone machine may not be broken yet, but it's due for replacement.

Also see: Apple Has Big Plans for Siri After Falling Behind Google, Microsoft
No positions in stocks mentioned.
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