Internet & Tech, Talking Point

Too close for comfort?

Apple and Foxconn had the perfect corporate marriage. Is it now fraying?

Manufacturing machine: Foxconn workers assemble Apple products like the iPad and iPhone 5

Two of the firms that have featured most regularly in Week in China over the past four years aren’t even mainland Chinese: Apple, from the US, and Foxconn, which is headquartered in Taiwan.

That hasn’t stopped China from playing a pivotal role for both companies, both as the place where Foxconn makes products for Apple and as the market where the Californian firm now hopes to sell an ever-greater share of its goods.

It has been a lucrative partnership. Over the past decade they’ve enjoyed perhaps the most symbiotic relationship in the corporate world, coupling the benefits of cheap and efficient Chinese labour with cool Californian design.

But is the relationship now showing signs of fraying? After all, Apple has diverted increasing amounts of work to other contract manufacturers. While Foxconn – headed by the Taiwanese tycoon Terry Gou – is looking to develop brands of its own, as a means both to protect its margins and diversify its fortunes away from those of Apple.

Is Foxconn too reliant on Apple?

Contracts with Apple are said to account for a major share of Foxconn’s revenues (there is no publicly agreed figure but estimates of the share of business dependent on Apple vary from 40-70%). That means that any sign of slowing sales momentum for Apple or even rumours that Foxconn is starting to lose some of its Apple contracts can have an immediate impact on its share price.

Both seem to be happening. That became evident when Foxconn’s parent, Hon Hai Precision Industry announced quarterly revenues last week. It reported its biggest decline in sales in more than a decade (a 19% fall year-on-year to $27 billion) with analysts generally blaming slower growth for Apple products, particularly the iPhone 5.

A slowing Apple is bad news for Foxconn, which assembles the designed-in-California gadgets (such as the iPad) in its huge factories in China. And there are some worrying numbers coming from Apple. For example, iPhone shipments increased 7% in the last quarter, the smallest gain since the phone was introduced six years ago. That’s a contrast to the strong performance from Samsung, which now has almost a third of the smartphone market worldwide or close to double Apple’s 18%, according to research house Strategy Analytics.

Apple hasn’t released any new products for six months, which is also bad news for Foxconn – as these tend to drive spikes in sales and therefore orders at its factories. And while Apple chief executive Tim Cook has promised that “some really great stuff” will be released later this year and early next year, there is little visibility on what they might be.

All this has led Jenny Lai, HSBC’s Head of Research in Taiwan, to downgrade Hon Hai’s stock to ‘neutral’. She’s concerned that sluggish Apple orders will result in poor capacity utilisation at Foxconn’s factories (in the 60-70% range) and that this is likely to persist into the current quarter.

Is Foxconn losing contracts too?

Yes. If Apple’s slowing sales weren’t problem enough, there’s also the issue that the US tech giant is moving contracts elsewhere. For instance, news that Pegatron, a smaller Taiwanese rival, could be on the verge of adding a major new contract with Apple also had swift repercussions.

Currently Pegatron – which has revenues that are about a quarter those of Foxconn – makes the iPhone 4S and the iPad mini for Apple.

But what seems to have caught investor attention is Pegatron’s plan to hire 40,000 more staff in China, a 40% increase on its current workforce. The plan has prompted speculation that Pegatron will be doing more work for Apple as the Californian firm switches more of its business to alternatives to Foxconn. In particular it is fuelling rumours that Apple is on the verge of introducing a lower-price iPhone. Because Apple will be looking to drive down its supplier costs to defend its own margins on lower-priced handsets, the assumption is that Pegatron has won the contract to make the cut-price phone by offering to do it for a lot less than Foxconn.

But that doesn’t mean that Apple and Foxconn are heading for a fuller parting of the ways?

The contract for the lower-price iPhone is only a portion of Apple’s business. Yet any award to Pegatron comes at a time when media has been speculating about tension between Foxconn and Apple generally, following reports in China Business Journal in April that Apple returned as many as eight million defective iPhones to its Taiwanese supplier in March (the suggestion is that the fix would have cost it Rmb1.6 billion).

Spokesmen from Foxconn later rubbished the claim, saying that such a huge product failure was made impossible by factory protocols.

Despite this, it looks unlikely that either side would want to disengage too rapidly from what has proved to be such a successful pairing. After all, both firms reported record profits last year, with each benefitting from the other’s expertise. Such was the demand for Apple products – and such was the speed at which they were being produced – that Apple was turning over its inventory once every five days last year, says technology research firm Gartner. That was more than twice as fast as Samsung and at least 10 times as quick as a typical manufacturing firm. In fact, the only company shipping its products more rapidly in the Gartner rankings was McDonald’s.

But Foxconn is trying to do things differently too?

Some of the recent media coverage has been portraying Foxconn almost as a passive party, awaiting a decision from Apple before mapping out its own future. In fact, Foxconn has been active in adapting to changes in its operating environment. Accordingly it’s adopted two main approaches to safeguard its profits.

The first is to shore up its traditional business. And here, a reasonable argument can be made that Foxconn is ahead of its peers, especially in trying to respond to increases in labour costs. China’s 12th Five Year Plan (2011-15) aims to raise the national minimum wage by at least 13% a year, although local authorities can set their wages above the national level. Last year, the average increase in the minimum was about 20%. Foxconn has responded by moving a number of its factories further inland to places like Chengdu, Wuhan and Zhengzhou in search of wage levels a third lower than in the coastal provinces.

Another technique for dealing with rising labour costs is the switch to more automated production. Again Foxconn has been an industry leader, even if Century Weekly was reporting this month that the ‘Foxbot’ strategy has been slower to deliver results than expected. The company has built about 20,000 robots since it first introduced them to a factory in Shanxi three years ago, the magazine says, but at least half are mothballed because of the unanticipated complexity of integrating them into the production line. Apparently, the associated costs have led line managers to resist the introduction of more robots. “The transformation from manual labour to using the robots means the models of production will be changed and the changes are complicated,” Xu Fang, a director at SIASUN Robot & Automation, told Century Weekly.

The second prong in Foxconn’s strategy is to move into new business areas, something that Terry Gou spent nearly six hours talking about at last year’s annual general meeting. His vision for “eight screens, one cloud” is a strategy in which Foxconn will merge investments in e-commerce, online content and next-generation electronic gadgets. As part of the plan Foxconn spent $200 million in December on a stake in GoPro, the world’s fastest-growing digital imaging brand. Earlier this year internet TV content firm LeTV then announced that Foxconn will manufacture the company’s LeTV Super TV, an interactive ‘smart’ TV (these are internet-enabled devices that can be controlled using voice and hand gestures, as well as through the owner’s PC or smartphone).

On the podium for the LeTV announcement was Terry Gou’s son Gou Shou-cheng, prompting gossip that he will succeed his father at the helm of the company and lead Foxconn’s drive into the smart TV business. Gou junior has worked in the film and entertainment industry. “Foxconn’s strategic shift from original equipment manufacturer to the consumer market is what triggered Gou Shou-cheng’s return to Foxconn,” Beijing Youth Daily claimed.

The Foxconn-made TV went on sale on May 7.

Even so, Apple contracts are a key part of Foxconn’s future?

That seems a reasonable assumption, with Foxconn likely to feature as Apple’s main contract manufacturer in the majority of its products, including launches of some of the next-generation products. For instance, the United Daily News, a Taiwanese newspaper, has reported that Foxconn is currently working on a “small scale trial introduction” of the iWatch, another new gadget rumoured to be in preparation for launch.

Another product line where cooperation may be on the cards is iTV, Apple’s next-generation television. Quite what Foxconn’s involvement will be here mind you is unclear, not least because Gou is said to have signed an exclusive deal with LeTV that prevents him from manufacturing other internet-enabled TVs (then again, it’s possible that Foxconn still has wriggle room to provide screens to Apple, probably from a joint venture with Sharp).

In fact, Foxconn has moved into production of 60-inch televisions of its own too, made with LCD panels from a joint venture with Sharp, in an arrangement providing a further example of the very different ways in which the firm’s strategic choices are being parsed by industry analysts.

For some it is a sign of Foxconn looking to establish a new business line and reduce its dependence on the Apple relationship. According to the New York Times, Gou’s $800 million investment last year for a stake in a Sharp LCD panel factory in Sakai in western Japan (see WiC145) meets two commercial imperatives: it gets control of production of higher-value components in the supply chain (the LCD panel is supposed to account for more than half of the production cost of a television) and it supports the push for vertical integration (Foxconn’s TVs are said to have 90% of their components produced in-house).

Of course, the risk for Foxconn is that the focus on making more of its own products starts to upset some of its customers in its core supply and assembly business. Hence the new TVs are being sold under third-party labels – RadioShack in China and Vizio in the United States – rather than being branded as Foxconn products. “Hon Hai is the largest electronic manufacturing service company in the world,” Kay Chiu, vice president of the firm’s consumer electronics division, insisted to the New York Times. “We are the platform for all the brand-name customers and to have our own brand does not suit the company policy.”

Yet there is an alternative interpretation of Foxconn’s foray into television: that the investment in Sharp last year was made at Apple’s behest, after the Japanese firm failed to meet a supply contract on the expected terms. Apple’s rivalry with Samsung is also said to be a major factor. “Sharp slipped in its production of iPad screens and Apple had to rely on South Korea’s Samsung for the majority of screens,” Forbes magazine reported at the time.

Mutually assured destruction?

All in all, it looks to WiC like both Apple and Foxconn are hedging their respective bets on each other. Gou is a smart operator and being privy to Apple’s product pipeline he was probably more aware than anyone that the US firm’s relative dominance has likely peaked. In that sense simply piggy-backing on Apple’s growth no longer looks the surefire strategy it was when the Californian company successively rolled out hits like the iPod, the iPhone and the iPad. As for Tim Cook, he may have concluded that financially and operationally it no longer makes sense to rely on one key supplier.

The result? Apple and Foxconn will remain close – just not as close as they once were. Perhaps it’s to be expected. After all, it’s rare for two companies’ destinies to be as interlocked as this pair’s were in the last decade.

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