Apple May Have To Eat Its Ecosystem

  • Apple’s margins are based in part on its ability to keep suppliers competing.
  • Apple may have to invest in Sharp to keep its LCD supplier afloat.
  • Apple has to be careful with its distribution as well.

Apple’s enormous margins are based on the fact that, while it controls its production system, it doesn’t own it.

For instance Hon Hai Precision, also known as Foxconn, makes the company’s products in China but only brings 3% of its gross revenue to the net income line while doing so.  Apple (NASDAQ:AAPL), by contrast, brings nearly 20% of its gross sales to the net income line.

This is possible, in part, because while Hon Hai absolutely needs Apple, Apple doesn’t absolutely need Hon Hai. Apple has suppliers around the world and likes to pit them against one another in order to keep its profit advantage. Samsung Electronics (OTC:SSNLF) can’t be certain of getting Apple’s processing chip orders, for instance, because they might go to Taiwan Semiconductor (NYSE:TSM).

But Apple has become so enormous that its decisions are driving some of its suppliers under. GT Advanced (OTC:GTATQ), for instance, which was working on its TouchID technology using sapphire crystal, was forced to declare bankruptcy a year ago.

Now Apple is running into trouble with another supplier, Sharp Corporation (OTC:SHCAY). The reliability of flat panel displays has long been a big problem for TV makers like Sharp, which moved into other types of displays, like iPhone displays, in order to survive. But now the business is sinking anyway, and the only way to save it may be to have Foxconn buy it, with some help from Apple.

While this gives Apple greater control of its supply chain, it also adds to costs, not just in manufacturing but in research. Regardless of whether Foxconn’s name is on the door, through this deal Apple is taking responsibility for keeping Sharp afloat. The deal reveals that if Sharp goes under, Apple has a problem.

There is an old saying that when you borrow enough money from the bank, you own the bank, because their fate has become tied to yours. This is the position Apple is going to increasingly find itself in, and it’s hard to see how it won’t affect manufacturing margins.

Now it’s possible that Apple could maintain its profitability by integrating in the other direction, taking more control over its distribution and retail network. Its recent announcement that it will finance iPhone purchases directly, as a way to assure that people upgrade regularly, is going to take profits from carriers like Verizon (NYSE:VZ) and AT&T (NYSE:T), putting those profits into Apple’s pockets.

The plan, for now, is only available through Apple Stores, and while the number of such stores only numbers in the hundreds worldwide – against literally thousands of retail outlets for the carriers – even a simple expansion online could hit the carriers hard.

The point is that Apple, as the 800-pound gorilla in the consumer electronics space, is increasingly having to take responsibility for its production and distribution. At what point does that eat into its margins?

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