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The iPhone's China Problem, and Apple's American Opportunity

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The idea of tech companies making their own product has been heresy for at least a decade, but Apple recently tested the waters with its new Mac Pro.

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For the nation's most popular smartphone, the iPhone 5S is a surprisingly elusive creature. Supply problems dogged the handset when it was first released, and by early November -- two months after launch -- wait times still exceeded two weeks. Like Sasquatch, the 5S was often seen but rarely caught, and only in the last month has it been reliably spotted at Apple (NASDAQ:AAPL) stores around the country.

The iPhone 5C had no such problem. Apple's mid-range smartphone has been readily available since September in five vivacious colors. Of course, it's proven to be less popular than its big brother, which helps - but that's not the only difference between the two. The 5S is assembled by Foxconn (OTCMKTS:FXCOF), a manufacturer that, according to the Fair Labor Association, is "largely complying" with Chinese labor laws; whereas the 5C is mostly sourced with Pegatron (OTCMKTS:PGTRF), which last week received scrutiny over the death of an underage worker.

Long waits and bad press have become an either/or proposition for Apple, which relies on Chinese suppliers for the iPhone's final assembly. Foxconn's CEO recently told a conference that "the young generation doesn't want to work in factories -- they want to work in services or the Internet or another more easy and relaxed job. In the manufacturing sector, total demand [for workers] is now more than supply." The result has been rising wages and a loss of competitiveness. Citing costs, Samsung (OTCMKTS:SSNLF) announced this month that it will move production out of China, into neighboring Vietnam.

At the same time, criticism over working conditions has led Chinese manufacturers to reduce hours. Apple faces a particularly tough challenge: As the world's largest company, its suppliers have become the world's biggest targets. Foxconn spent 2012 reeling from negative media coverage, and promising to improve working conditions. It did. The result has been supply shortages for both the iPhones 5 and 5S, as well as difficulty attracting new employees, for whom less overtime means lower pay. Earlier this year, Apple decided to give more work to Pegatron, a manufacturer that had previously escaped the spotlight.

Celebrity came quickly. In July, US-based China Labor Watch labeled Pegatron "even worse than Foxconn." Criticism continued throughout the fall, reaching a climax after the death of several workers due to illness. Apple has defended its supplier, claiming that these deaths were unrelated to work conditions, but to no avail. Pegatron has been forced to promise that it, too, will do better; but as a China Labor Watch investigator told PCWorld, "there's no way they can achieve the working-hour limit. The factory must reach a certain quota in the production…. Apple is demanding the factory control the working hours, but the factory can't reach the goals."

Alas, the iPhone seems fated to create either first world problems, or developing world headaches. It has become the kiss of death for Chinese manufacturers: a harbinger of angry criticism and rising costs. Apple's customers could find themselves waiting even longer for next year's iPhone, or paying more out of pocket.

Cupertino may have no choice but to throw money at the problem. This would probably mean a higher payout for Foxconn and Pegatron, and a hit to the iPhone's industry-eating profit margins. There is another possibility, though: Apple could build a factory. The idea of tech companies making their own product has been heresy for at least a decade, but Apple recently tested the waters with its new 'made in the USA' Mac Pro. Last month, it announced plans to open a facility in Arizona, which rumors suggest will be used to supply one of the iPhone's components

It's conceivable that the "next big thing" from Apple won't be a gadget at all, but something more substantial. With a cash hoard of $150 billion, the tech giant has the potential to revolutionize manufacturing in much the same way that it reinvented the cell phone - and in the process, to carve out an advantage that few competitors could match. The attempt would be risky, but then, Apple has made its share of big bets. The iPhone's China problem may, in time, turn out to be its best opportunity yet.

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