Saturday, November 26, 2011

Apple's Cash Creates Opportunity

How often have we seen calls for Apple to turn its massive cash hoard into a big dividend? Big mistake. The Jaded Consumer regards ready access to massive capital as an asset to Apple as much as it is to Berkshire Hathaway.

The latest example is Apple's billion-dollar (that's billion, with a "b") investment in a cutting-edge Sharp LCD plant. Many years ago, when CRTs dominated the computer landscape, Apple ensured its supply of quality LCDs by making a $100 million investment in Samsung, to avoid parts and quality issues in its not-yet-shipping iBook portable. The payoff? When Apple wanted to make sure it didn't lose sales of MacBooks or iBook G3 units (remember those?) to production-related fulfillment delays, it guaranteed supply by funding the production in advance. The hundred million looked like a lot of money. Structured as a 3-year unsecured convertible note with a 2% yield, the investment was eventually sold back to Samsung in 2001 for $117 million. What did Apple get for tying up $100m from 4Q1999 to 2Q2001? For starters, Apple avoided LCD shortages that threatened the industry just as monitors were transitioning from desktop CRTs to LCDs. Apple's migration to an all-LCD lineup created significant exposure to LCD availability problems, which Apple cured with its Samsung deal. The $100m investment was a hedge against the risks of bidding in an open market for key parts.

A conservative strategy, perhaps – and effective at protecting high-margin production. What's different now? Apple isn't struggling toward averaging a million total devices sold a quarter while netting just over a half-billion in profit, it is selling tens of millions of LCD-based products per quarter at over $100 billion per year to earn over $25 billion a year. Apple's desire for premium displays isn't a matter of building LCD notebooks in a world of CRT desktops, it's a matter of filling an LCD lineup from iPod Touch, three different iPhone models (3GS, 4, 4S), two classes of notebook computers, the all-LCD iMac desktop line, and the stand-alone displays sold for users of every type of computer Apple sells – while maintaining a quality edge intended to support Apple's traditionally high-margin hardware.

In other words, the order-of-magnitude increase in Apple's LCD infrastructure investment reflects Apple's greater-than-an-order-of-magnitude increase in LCD consumption. A billion bucks – to buy entry into Apple's next-generation supply contract with Sharp – is just the increase in ticket price Apple faces as it seeks to maintain its supply-chain strategy in a world that can hardly supply its needs. And Apple gains a significant benefit from its supply chain management. By making capital investments in key suppliers, Apple ensures that it is supplied first rather than last as manufacturers line up for parts when supplies tighten. Being able to ship products is a necessary prerequisite to closing sales – and Apple doesn't want to risk being the one waiting for parts.

But let's think about Apple's strategy. Steve Jobs made it clear that Apple preferred to own the intellectual property behind all its products, yet it depends on third parties for absolutely critical elements such as LCD panels, wear-resistant glass, and so on. Apple is the planet's single largest buyer of Flash memory. To secure Flash supplies in a market subject to pricing variation and shortages, Apple has done things like pre-pay 10-figure sums for its expected Flash supplies. Supply risk isn't merely theoretical. Apple's consumption has been blamed for causing Flash memory shortages on a worldwide basis for years. In 2005, Creative blamed Apple's supply-chain management for Creative's inability to build MP3 players. Gartner predicted iPod-related Flash shortages in 2006. The supply/demand ratio for Flash parts remained unfavorable to buyers through 2009, with Apple's consumption for mobile devices expressly named as the culprit. In 2010, the shortage was being blamed on the iPhone rather than the iPod, but Apple was still being seen as the responsible party. Apple needs to deploy substantial capital to ensure its own supplies are met.

Yet, Apple doesn't want to create a free-rider opportunity for competitors. If Apple simply coughed up money to competitors by investing in their common suppliers as it did over a decade ago with Samsung, Apple would enable these suppliers to develop techniques and machinery they could deploy in their effort to supply any customer, not just Apple. Apple would, in effect, be funding the R&D of its competitors by enabling their suppliers to produce more products better for less money, on exactly the same terms available to Apple. Ick! What could Apple do to ensure that machinery it funded didn't lower the cost of production to competitors?

For that insight, let's look at Jobs' comments at the D5 interview in which he and Bill fielded questions.
Q: What did you learn about running your own business that you wished you had thought of sooner or thought of first by watching the other guy?

Jobs: You know, because Woz and I started the company based on doing the whole banana, we weren’t so good at partnering with people. . . . And we weren’t so good at that, where Bill and Microsoft . . . learned how to partner with people really well.

And I think if Apple could have had a little more of that in its DNA, it would have served it extremely well. And I don’t think Apple learned that until, you know, a few decades later.

Now let's think about what "partnering" has meant in connection with Microsoft. After Microsoft "partnered" with Apple to write applications for Apple's hardware, Microsoft earned more profit on MS-Office for Macs than Apple earned selling Macs themselves. PC vendors who facilitate Microsoft's OEM operating system licensing program have been reduced to mere commodity vendors, while Microsoft enjoys monopoly pricing (and profits) on its operating system. Vendors seeking to supply Microsoft with technology have been crushed. "Partnering" in this context is a sophisticated form of competitive positioning in which vertical integration is achieved not by owning the entire production column, but by arranging that non-owned portions of the column lack profit, differentiation, or competitive positioning.

This kind of "partnering" is what Apple learned from Microsoft. However, Apple has gone a step further: rather than license software under conditions that eliminate hardware differentiation (either by eliminating the profit motive for investing in it, or by making it impractical due to the limitations of the software ecosystem), Apple has used its supply-chain expertise to enhance its hardware differentiation. As described above and elsewhere, Apple contracted by using large advance payments to guarantee its components supply under conditions that leave competitors scrambling to find parts with which to build competing devices. But Apple has apparently gone far beyond that. When Apple bought all the production of key manufacturing tool maker, it didn't just deprive competitors of the ability to buy the same drills as quickly. As described at asymco in the article "How much do Apple's factories cost?", Apple isn't just ordering manufacturing equipment for use by its contractors. Apple is buying the manufacturing equipment and owning it itself. Apple has to own scads of capital-intensive manufacturing equipment, because it's got so much of it on its own balance sheets.

Think about this. Apple doesn't have to enter anticompetitive contracts with its own vendors, it only has to make clear that Apple's production equipment is for making products for Apple. In one swoop, Apple takes whole plants out of availability for competitors. Why? They're full of Apple property available only for use in Apple products. This sort of production partnering – Apple takes the capital investment risk because it can afford the capital and is willing to bet on its own products, but doesn't want to have to duplicate high-volume manufacturing expertise that can be provided more efficiently by production partners – allows Apple to negotiate for pricing much closer to the marginal cost of production than its competitors, who don't take the capital risk and have to pay for amortization of production facilities that the manufacturers and assemblers have had to take the risk to build. Apple-risk facilities are just for Apple-benefiting production, boys. If an Apple joint-venture factility were used to produce something for a competitor, of course, Apple would (as a joint venturer) share in the profit: competitors would in effect pay Apple to have their parts built.

Apple can do this with LCDs, NAND storage, microchip fabrication tools (it's designed its own mobile CPUs, which now include both the A4 and the A5, and has someone building these for it), hardware cases (this page offers some video of Apple-developed manufacturing tech, including a technique for machining the unibody Mac notebook chassis from a solid block of aluminum – no doubt in use by a contractor), batteries – everything that might possibly differentiate an Apple product from a competitor vending Wintel boxes or MP3 players or ARM-powered phones. Every time Apple gets a pricing advantage with its capacity to fund the manufacturing investment required to fulfill its orders, Apple puts competitors in a position of fighting just that much further uphill just to stay even.

Billion-dollar parts prepayments aren't normal except for Apple. Next-gen LCD development investments in the ten-figure range aren't normal except for Apple. The only thing that makes capital risk of this magnitude a safe activity for apple is that with so many tens of billions of dollars available, a mistake won't impact Apple's ability to execute on the rest of its operational requirements. The $80B is not some kind of retirement nest egg, it's a license to invest in the future and a ticket to the front of the line for parts and an AARP discount all rolled into one.

A day may come when Apple can't imagine anything it might want to do with all its cash, but that day isn't here yet. Let's not hear demands for dividends when we could be hearing demands for more insanely great products at prices competitors can't profitably match.

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