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Foxconn Is Failing -- and You're About to Pay More for Your iPhone

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But Foxconn is not alone; all of China's Original Design Manufacturers are facing the same financial challenges.

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They make almost every PC, tablet, and smartphone that comes to market. You won't find their names printed on the box, or their logos displayed in television advertisements, but this group of Taiwanese manufacturers is the pumping heart of the tech industry. They operate in China, and by leveraging that country's low costs in a way that few Western companies are able – or allowed – to do, they've made possible the great wave of inexpensive consumer devices that has revolutionized tech.

They're called Original Design Manufacturers, and they're in trouble.

These firms saw their margins tumble during the financial crisis, and then fall further as the global economy recovered. Since 2009, operating margins at the top five ODMs – who together produce three-quarters of the world's laptops, among other things – have dropped from 2.8% to 1.5%. Gross margins shrank from 6.5% to 5.1%, despite growing revenue and greater scale. Over this period cash positions have nearly tripled, as it's become more profitable to collect interest payments than to reinvest in the core business.

These companies are struggling, and their struggle gets overlooked in discussions about the future of PCs, the move toward the Cloud, and the fate of the great American tech companies. Little or no attention is given to the manufacturing model that makes it all possible, and few are watching as that model deteriorates. Foxconn (TWSE:2317) only makes the news when Apple (NASDAQ:AAPL) turns up some new labor violation. Quanta Computer (TWSE:2382) produced 24 million PCs for Hewlett-Packard (NYSE:HPQ) in 2010, but didn't get mentioned once in a recent New York Times story about HP's supply chain. As the saying goes, out of sight, out of mind – and the ODMs probably prefer it this way. The more you know about how sausage is made, the less likely you are to eat it.

That's part of the problem. Apple lifted the veil of secrecy two years ago when it began issuing "supplier responsibility" reports. Samsung (PINK:SSNLF) has since followed suit, and the industry is pushing forward with well-advertised efforts to improve suppliers' working conditions. The Times tells us that "companies like Hewlett-Packard and Intel (NASDAQ:INTC) say… they must overhaul how they interact with foreign plants and workers – often at a cost to their bottom lines". According to the article, Foxconn now offers its employees chairs with backs, and free courses in knitting. Happily, Apple's bottom line appears to have withstood the shock.

As the ODMs get pressured – perhaps trivially – by their American clients, the greater trouble comes from within China. Costs are rising. In 2000, the typical factory hand made $950 annually, measured in US dollars. Today, that same worker earns $5,800. The impact has been limited because, as labor costs have risen, capital costs have fallen. For 2000-2003, the real interest rate averaged 3.7%. In 2008-2011, it clocked at a mere 0.4%. Rising costs were passed on to Chinese banks and Chinese savers, and industry was largely spared. Companies that didn't take on debt nevertheless benefitted from lower prices in everything from raw materials to construction to new machinery.

This has changed in the last year. A property bubble and deteriorating bank balance sheets have forced China's central bank to rein in credit. Real rates have climbed to nearly 4% and "rebalancing" is the word on everyone's lips. (See: If China Rebalances in 2013, Will the Fed, Investors Be Ready?) The process is just beginning; Beijing has pledged more wage increases, further liberalization of interest rates, and higher taxes on the state-owned enterprises that supply power, materials, and infrastructure to the nation's factories. Chinese citizens are souring on factory jobs, environmental activism has become a cause célèbre, and as poor as the past few years have been for ODMs like Foxconn, Quanta and Wistron (TPE:3231), the future looks even worse.

It's a potentially destabilizing situation. When faced with higher costs, Nike (NYSE:NKE) moved shoe production from China to Vietnam. HP and Apple will have a more difficult time. High-tech assembly lines are not easily relocated, and skilled workers are required to run them. China is unique in its ability to concentrate manpower, resources, and logistics at low cost, and its great factory cities would be difficult to replicate anywhere else. The ODMs' great advantage is that, based in Taiwan, they speak Chinese and can operate fluidly in a country that presents barriers to Westerners. The fact that Quanta now has an assembly plant in Apple's backyard, and Foxconn is talking about expanding its North American operations as it curtails hiring in China, should be seen as a measure of their desperation.

Whether manufacturing remains in China, re-shores to the US, or moves closer to final markets around the world, the result will be higher costs. The age of cheap PCs might be coming to an end, and the era of smartphones and tablets are off to a rockier start than anyone imagined.

For more from the same series, see: The Post-PC Era: Why Apple Is Losing Market Share and The Future Will Have Intel Inside.
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