Inside Apple and Tim Cook's Operational Brilliance

It's life-cycle week at Industry Focus! In this week's tech episode, Dylan Lewis and Evan Niu go over the steps it takes to get an iPhone from the factory to your hand. Listen in as we explain where a few of the most important iPhone parts come from, why Apple (AAPL 0.24%) has shifted to the contract manufacturing model thanks to Tim Cook, and some of the pros and cons of that approach.

A full transcript follows the video.

This podcast was recorded on May 27, 2016. 

Dylan Lewis: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Friday, May 27, and we're talking tech, trying to explain just how an iPhone winds up in a customer's hand. I'm your host, Dylan Lewis, and I'm joined on Skype by Fool.com senior technology specialist and knower of all things Apple, Evan Niu. Evan, how is it going?

Evan Niu: Pretty good, good Friday.

Lewis: Yeah, yeah, right before a nice little three-day weekend. We will not be doing a show on Monday, listeners, just so you know. Enjoy your Memorial Day barbecues; unfortunately you're going to have a Spotify playlist going or something like, you won't be able to have a new episode of IF to enjoy the brats and beer and whatnot. We're wrapping up product life-cycle week here on Industry Focus, and we're going to do a little discussion of everyone's favorite consumer electronics device, or at least my personal favorite consumer electronics device -- I know you're also a big fan, Evan -- the iPhone. Namely, how it gets into consumers' hands.

A lot of people in the earlier episodes this week have followed a chronological approach of the background from start to finish. We're going to come and do the reverse. We're going to talk about the intermediary that assembles everything, and then get into some of the individual suppliers that provide those products and the components to the assemblies. Evan, I've seen estimates that roughly 90% of the iPhone comes from outside the U.S.; you think that's about right?

Niu: Yeah, it sounds about right. I know it's a lot; very little of it comes from inside the U.S. these days. They have other products that are made here like the Mac Pro, but as far as the iPhone goes it's mostly abroad, yeah.

Lewis: I don't know how much that really is different than the component breakdown in the past, maybe in the early '90s, mid-'90s for standard consumer tech stuff. But one of the major changes that Apple underwent, really, with Tim Cook, was this idea of changing from having their own in-house manufacturing, their own in-house warehouses, company-owned, to moving to this contract-manufacturing-type relationship.

Niu: Yeah, they did that, I think, in the late '90s or so. They used to make Macs in the U.S. in California; they just realized that it was way too expensive in-house. A lot of it is also the engineering and manufacturing quality you can get now. Because of course a lot of people criticize that they won't bring those jobs back in the U.S., but in Apple's defense nowadays it's not just about low-cost labor -- it's also about, you don't have as many mid-level manufacturing engineers available in the U.S. anymore, just because as an economy we don't have as many of those types of jobs. That's not the type of education that we focus on anymore, and there's a ton of that over there.

Including the lower-cost labor, they have more people that are within the specific skill sets that they need to ramp up the manufacturing. I think a long time ago they said you could fit every single manufacturing engineer within, they would need a baseball stadium; in the country, that's just how many there are now. Over in China, Foxconn can get hundreds of thousands of engineers within a couple hours if they need them to make some change, or tweak some processor. There's a lot of sides to the story why they do it like that.

Lewis: This pivot, this decision by the business to go to this contract manufacturing relationship: it was really something that Tim Cook pushed aggressively for, all the praise that Steve Jobs gets as this design, branding, user-experience mastermind. This is where Tim Cook's expertise really is, in operational efficiency and just running a business extremely well from a supply chain's point of view. He has really pushed the business to where they are now, where they rely heavily on Foxconn and Pegatron, to name two, as these contract manufacturers. Listeners, just so you have an idea if you don't know what this term means: Basically, Apple doesn't own any of the facilities where iPhones are being assembled. Instead --

Niu: Well they own, let me just add in that they own a bunch of the manufacturing tooling and the equipment. A lot of their capital expenditures these days are: they buy the actual infrastructure and the gear, and then they put that inside of the facilities that they don't own. They kind of own a lot of the stuff and Foxconn owns the factory and then they hire the people, and then they operate that stuff. I mean their capex is like 10 million yuan, which is insane. Majority of that goes to this product tooling that sits in Asia inside a factory facility.

Lewis: Yeah. I'm glad you hopped in and clarified there. But, largely they're paying these manufacturers to put together devices and then ship them over, right?

Niu: Right.

Lewis: Foxconn is the name that you will hear the most, and when you hear that name you often think of Foxconn City, which is the company's largest manufacturing plant, and that's in Shenzhen, China. So chances are if you're holding an iPhone or listening to this episode on an iPhone, it was put together in China. On that one campus alone, and when I say campus, I mean that that's kind of the vibe that you get looking around -- if you ever see pictures of this setup, it's incredible.

They have hundreds of thousands of employees working there. It's over a square mile, and they have dorms for employees, its own shopping center, I think they have their own cable network there. The executives there are likening it to this college experience, I think it's kind of a stretch. You have people working 12-hour days, six days a week, putting together iPhones. That one Foxconn City location is just one of the 12 that the company has in China. Actually, folks following tech might have heard earlier this week, Foxconn announced it automated 60,000 jobs in one of its factories. Going back to that idea of providing some of the tooling, I'm sure Apple had something to do with that.

Niu: Yeah, I wonder if they helped fund some of that affair. If they're going to be using those robots for primarily iPhone production, it would make sense that Apple helped them pay for some of that.

Lewis: Yeah. We don't have firm details on that, but it wouldn't be a stretch by any means.

Niu: Right.

Lewis: More recently, Apple added Pegatron, that's a name I mentioned earlier, as another contract manufacturer. I think this was maybe 2012 or so, 2013. I think there were two big reasons for this. One of them was diversification, to downplay the risk of relying solely on one contract manufacturer so heavily, like Foxconn. I think maybe another was in a response to the company's increasingly complex fragmented product offering. They wanted to have that split among a couple different suppliers, just because of some of the specialization required to produce the different sizes, models, and form factors. If you're listening to this show on an iPhone, chances are it started out in a Foxconn or Pegatron factory, most likely in China. I can think of a testament to the growth and diversification strategy among their contract manufacturers. Recently, they've added another Taiwan-based company to this list, Wistron. Just another thing to keep an eye out for. Evan, any thoughts on why they do this, beyond just the very conventional cost, because it's cheaper to outsource production to some of these countries where labor's a little bit cheaper?

Niu: I think part of it is that in addition to the engineering talent thing I was talking about earlier, Tim Cook absolutely hates inventory. Setting up this model and supply chain, I've read reports where other industry executives look at Apple's supply chain and they're just blown away. They're like, "Well, we can't compete with this." You can order a custom-built Apple device like a Mac, or an iPhone or something. You'll get the tracking information and it literally ships from the factory to your doorstep, in a matter of days. They build it and they ship it directly to you. That's the kind of scenario when the purchase transaction goes like that. I mean, Apple does very little hands-on. Apple's not physically handling the product too much if you're ordering like that, and that's kind of a testament, because they still get to book all the revenue and the sales.

It goes from a contract manufacturer, to a third-party shipping company, directly to a customer. With that happening all so quickly, their inventory turnover times are so insanely high, that it's comparable to fast-food restaurants and stuff like that. Instead of $600 smartphones, and I think that's been a huge boon to Apple, because that just makes the whole operation a lot more efficient.

It's this huge trick because again, other companies have seen this and they're like, "We can't do that. We can't set it up this seamlessly and streamline to this point where is incredibly efficient and direct." Of course, they have to have a lot of inventory for retail stores and things like that. They're very good in inventory management, they keep it really lean. Otherwise, having a lot of inventory is not really a good thing, because it just sits there and risks getting written down; if you can't sell it, and if you have too much, it's just kind of a big pain. That's why Tim Cook has really pursued this path so aggressively.

Lewis: To your point, while I was researching this show, I came across this stat that the flip to contract manufacturing took the amount of time that inventory sat on Apple's balance sheet from months to days. You talk about that inventory turnover and actually, this is something that Vincent Shen alluded to when he did the consumer goods episode of Industry Focus, talking about industry turnover, that Apple's got the best in the business. It's because inventory sits on their balance sheet for such a short amount of time.

Niu: Mm-hmm. Yep.

Lewis: I think beyond that, there's also a little bit more manufacturing flexibility abroad. I think some of these contract manufacturers are ready to go, and they can get things set up very quickly. They have the talent in place to within two weeks really be up and running.

Niu: That's another thing. If you had these really big demands and you need to be able to scale up and down depending on seasonality in these other factors. That's another big benefit of these contract manufacturing models, because you can just say, "I need X number of units, go build them." Whereas if you're doing the manufacturing yourself, you also have to worry about things like excess capacity, capacity utilization. Let's say you need to ramp down for whatever reason, which makes a lot of sense now with the iPhone just finally declining for the first time. Just in general, to have that ability to, this lever of being able to increase production as needed, without really worrying too much about the logistics of personnel. Like hiring, laying off, which is -- companies that have a lot of footprint have to constantly worry about how they're going to manage increasing and decreasing production. Particularly when it comes to hiring and laying off workers, which is a tough thing to do, and they're kind of outsourcing that responsibility in a way too.

Lewis: Yeah, of course. This approach is not without its own risks, right? For as much as we praise Apple's operational smarts here, there are some issues with the model. One of them namely, I think is control, right? We haven't seen a ton of this, but there is the possibility of quality control being a problem. I think more when you think about Foxconn and some of the contract manufacturers in Asia, there's always this worry about working conditions, and this is something that has gotten a lot of press in the last couple years. There's always this concern of working conditions being substandard, of being overly demanding, of overtime being required, things like that. That's definitely one of their risks here.

Niu: Yeah, I definitely agree there.

Lewis: One of the other ones that immediately comes to mind for me is just intellectual property risk, too. I think you can't go more than a couple weeks without seeing online leaked photos of some rumored iPhone design or configuration. I think that's a byproduct of these contract manufacturing systems. When you have all these intermediaries within the design and fulfillment, it's just bound to happen somewhere.

Niu: With as global as Apple's business has become, the supply chain is just too massive. You can't keep it secret. There's just too many moving parts, there's too many third parties involved. Everyone wants a piece of it and wants to know. You can easily sell a picture of a leaked iPhone and get paid a ton of money if you can smuggle it out. You'll risk losing your job, but I mean for some of these workers, there's actually a lot of upside to sneaking these things out. They know how much appetite the media has for it.

Lewis: I wonder how much the company really minds that that happens. You know? For them --

Niu: Well, I know that they've punished workers that have been caught doing this. It's pretty severe punishment, I don't remember exactly what it was. Obviously Apple is such a huge contract for them and they have all these confidentiality agreements, and all these things like that. I do think that Foxconn does care, they do try to do their best to stop it. Again, when you're talking at this scale, all it takes is one person to get a picture, prototype, or mold or something out. Then what?

Lewis: The life of an iPhone in some ways begins at a Foxconn or Pegatron factory. I think it really begins even earlier than that. Before they're assembled there, there are all these components that are made by individual suppliers, or provided by individual suppliers. I think some people have done very well investing in iPhone component manufacturers. I think it kind of makes sense to discuss a couple of them here that you're particularly interested in, that you think are worth talking about. One of the first ones that comes to mind for me is Corning (GLW 0.48%), and they are the manufacturers of Gorilla Glass, which is the glass that is on the front of the iPhone. It's the one that your finger touches all the time, and the one that Steve Jobs famously insisted on.

Niu: Yeah, I remember the story was he had the original prototype which had a plastic screen in his pocket, and it kept getting scratched up. Then six months or six weeks -- it was some ridiculous timeline before the unveiling -- he was like, "All right, we need to go make this happen." Which again, kind of ties back in to the whole engineering talent we were talking about earlier. They needed to make this change within such a short period of time that you needed to have an army of mid-level manufacturing engineers that could put this together, from a manufacturing perspective, to actually make this happen. It probably wouldn't have been possible in the U.S. with the kind of talent we have here.

Of course now Gorilla Glass is the standard feature in all high-end smartphones. Apple really kind of brought this thing back from the dead, because this technology had been like 60 years old and Corning had no idea what to do with it, because there was no market for it. Then all of a sudden, Apple's like, "hey," and they created a market for this product. Now I think they're on Gorilla Glass 4 or something. Of course they improved the glass every few generations or so, it's so common nowadays.

Lewis: I think, if I remember the story correctly, Steve Jobs said people are going to have this in their pocket with keys, and the keys are going to scratch plastic, we need to have something else. Enter Corning, right? I'm sure they're very happy to be an Apple provider. Although, there was a period where it looked like they weren't going to be an Apple provider, right? It seemed like Apple was going to be pivoting over to GTAT at one point.

Niu: Yeah, there was a lot of talk about the whole sapphire thing, which has its merits but also has its downsides. There were pros and cons to switching to it. It's more scratch-resistant, but it's also more brittle, so it actually shatters easier than Gorilla Glass --

Lewis: That was one of the problems in manufacturing it, right, and one of the reasons that GTAT did not pan out as an Apple supplier?

Niu: Right. One thing I'll mention about Corning, is that when it comes to being an Apple supplier -- because being an Apple supplier is such a legitimate investing strategy nowadays. I think Corning there, it's their specialty materials division that includes Gorilla Glass, which is only like 10% or 15% of sales. Corning's not really a good candidate if you're going in and saying, "Hey, I want to buy an Apple supplier that has a lot of exposure to Apple," because they don't have a ton of exposure. The rest of their business is making other glass products like beakers, or science things, and all these other things that have use for glass. Their exposure to Apple is actually pretty modest in the grand scheme of things.

Lewis: Yeah, they are not your conventional tech supplier. I mean, they've been around for over 100 years at this point, and have a lot of operations in the U.S. I know they used to produce the glass in the U.S., and have since moved a lot of those operations over to Asia. I think part of the idea there is to just be closer to the contract manufacturing that's happening.

Niu: Right, right. Especially for Gorilla Glass, it's just so popular in consumer tech these days.

Lewis: Yeah. We touched on it a little bit, but can you give some background on the cautionary tale of GTAT and some of the struggles of being an Apple supplier?

Niu: Yeah, so GTAT is a good, probably the best, example of why being an Apple supplier is really this double-edged sword, because GT announced this giant deal with Apple; I forget all the specific numbers since it's been a couple years. Basically, they announced this huge deal with Apple where they would sell Apple the sapphire material. Whereas GT had historically always been, they always made the furnace for the sapphire. They didn't actually make the sapphire itself. What they did is they would make the furnace, and they would sell it to other companies, and the companies would actually operate the furnaces, make the sapphire, and sell the materials. GT had never actually had experience making the material in large volume. They only made the equipment to make the material.

This deal with Apple was basically asking them to switch their entire business model to create and sell a ton of the actual material. Apple would basically be buying a ton of sapphire at the low market rates, but it was such a massive deal that GT kind of, I think they got caught up in the storyline, and they knew it's sexy to be an Apple supplier, so they kind of signed on board. But even without having much experience in this kind of model of operation that Apple's asking for, Apple recently said we were going to buy furnaces, but then they kind of swapped in there that we just want the material. They set this whole agreement up where they're going to build this plant, in I think Mesa, Arizona, and they were going to operate it. But Apple inserted themselves in this process at so many points, and plus the deal was so asymmetrical. GT basically took on all the risks associated with this, Apple took on very little risk --

Lewis: They did provide some financing though, it really was like $500 billion to build that facility.

Niu: Right, they basically offered to have these prepayments. They had these four installments of prepayments of the total, I forget, I think it was $800 million or something like that. Basically, there was these different milestones that GT has to hit to get these prepayments. The prepayments are used because someone needs to help fund the capex of building this facility and making all these furnaces. GT was still going to be the owner of the furnaces. It's a ton of money that they don't really have at the time to just go and do this, so Apple is prepaying them and they're getting to all these milestones. What those prepayments did is, Apple gets to prepay and that's basically a credit that they were planning to use as payment for sapphire later on. It's like, we'll prepay you now, and they can use the money to build this thing up. Once they start outputting sapphire, then they start delivering some sapphire to Apple, it's like bar tabs, and then they owe all the sapphire.

It just became such a mess because Apple executives are overseeing GT engineers and trying to tell them what to do, but Apple has no idea how to do that stuff either. I remember reading through some of the bankruptcy filings and GT's like, "Hey, we need spare backup generators because if the power goes out we can lose hundreds of thousands of dollars of these boules in a batch." Apple was like, "Nope, we don't want to do that." Then the power went out two or three times, so you have this whole mess. They were basically betting the entire company on this deal. It's really not a far stretch to say that.

Particularly in light of the fact that they felt trapped by Apple. They felt that they were completely trapped in this deal, and the only way to get themselves out was to declare bankruptcy, which they did. Of course, if you look at the timing of the GT executives, they were cashing out some of their stock when the stock was high, right after the deals announced. It's like everyone's excited Apple brought up a deal. So the stock goes up and you see GT insiders start to cash out, and then six to 12 months later they declare bankruptcy.

Lewis: It didn't look good.

Niu: It was a little shady.

Lewis: Yeah.

Niu: I think they bit off way more than they could chew, and GT shareholders got burned pretty bad. They ended up bankrupt.

Lewis: If you're looking for a visual representation of how things went for GT, I would just search for the boules themselves online in Google Images. Because they have these hundred-pound boules of sapphire that are cracked and unusable for manufacturing purposes, because it was something that was out of their competency. It wasn't in their --

Niu: When you have Apple saying, "Hey, we want a ton of it." It was just such a huge change, like why would you think you could do this? I mean, of course at the time that's what was leading all the speculation that they were going to use sapphire as a cover glass for the iPhone, despite it being more brittle, and all these, some trade-off. They still use sapphire on the touch ID home button, and as the camera cover glass thing. Those are two pretty small pieces compared to the front panel.

Lewis: Yeah, the risk of that cracking is much lower.

Niu: I mean, people drop their phones all the time, and sapphire's more expensive too. There's that too, that's another downside.

Lewis: Yeah.

Niu: It's kind of a trade-off. What's more important, scratch resistance or cracking resistance? You know what I mean? No one likes scratching their phones, but if you drop your phone you don't want it to crack instantly. At the same time, it's kind of debatable, which one is more important. Gorilla Glass is better at one, and sapphire is better at the other.

Lewis: I think the lesson with investors with GTAT is if you're looking to play companies that are acting as Apple suppliers, see how reliant they are on Apple as a business and see that they are operating within a competency they are used to being in, right?

Niu: Right. It was just such a bad deal.

Lewis: Two other companies that you wanted to talk about: Qualcomm (QCOM 0.99%) and ARM Holdings (ARMH). Qualcomm, provider of modem chips, and it's the component that connects the iPhone to cell networks, provides the connectivity, that access to the Internet. What do you have to say about them?

Niu: Qualcomm, they have a few things in there. They have some modules, but I think the baseband processor is by far the most important. Qualcomm has had this spot locked down on the iPhone for five or six years. I can't remember exactly when they switched. I think they switched in 2010, or 2011, right after Intel (INTC -9.31%) bought Infineon, is when they switched to Qualcomm exclusively. It's such an important piece, because obviously you need a cell modem to connect your phone to the cell network.

I think for Apple specifically, one reason why Qualcomm was really able to lock it down is because they have the absolute best technology and they can support the widest range of LTE bands. Apple likes to streamline their manufacturing, so they only have a couple of models of the iPhone. They can put this one modem in and it'll basically work with any network in the world. Compared to something like Samsung, where they might have 12 or 15 different variants of the same phone, with different modems, that are set for different geographical regions, with different LTE bands. It's needlessly complex, and Apple just prefers the simpler approach like "we're just going to have one," and maybe have two or three variants for different geographical regions, but it's a lot simpler than 12.

Lewis: Yeah, it's a lot easier to hit scale with something that is a little bit more universal.

Niu: Yeah, exactly. I think they've done a really good job of being able to keep that spot, and staying ahead of the competition. Although, there is now talk that Intel might get into the iPhone 7. Which, that rumor's been around for years, so who knows if that happens this year or not. They might slowly be starting to lose their grip on it, but they've had a pretty good run with really maintaining that relationship. Apple and Samsung, I think a couple years ago, were half of Qualcomm's revenue. I mean, it's a big relationship.

Lewis: Yeah. What about ARM Holdings? They're a semiconductor company providing processors for the iPhone, basically the chip that carries out operations set by the computer program.

Niu: Right. The actual Apple processors are, I think, really interesting because you have ARM, which is a British company, and they design the chip architecture. They also design how to make the chips. They license this out to other companies to actually build and implement to use. They have a couple of different types of licenses, they have these kind of stock licenses for very specific processors. What they also have is an instruction-set license, so you basically get access to the underlying architecture. You can actually really build on top of what they've done and really cater a chip's performance to your needs in terms of power, consumption power, efficiency, just actual computing power. That's what the high-level companies do, like Qualcomm, Apple, Samsung. They all have an instruction-set license that allow them to really differentiate their chips. Before that, Apple was using pretty standard off-the-shelf parts that were made by other companies. With the A4, starting 2010, they put their own brand name on it and they're really differentiating. Now, all of a sudden they have 64 good processors, which are like desktop-class. They've done so much on their chips in the past five years that it's just insane. They've caught everyone off guard with how advanced they are. They barely even talked about it, too. In a classy, kind of Apple way, they don't talk too much about the tech specs of it. They just say, it's so much faster. You don't need to know the clock speed or --

Lewis: Eyes start to glaze over a little bit.

Niu: Yeah, exactly. Which a lot of people do, and it's a big branding strike that they can just be like, "Hey, it's done faster and it's desktop-class." It's comparable to low-end desktops, but we're talking about a phone processor, so it's still pretty impressive in my opinion. From a supply chain perspective, it's also pretty intricate because you have this British company that licenses out to Apple, who's in California. Then Apple goes and they do all their design work on top of that, and then they go and have contract manufacturing on the chip side. Samsung makes the chips for them; they recently had to hire Taiwan Semiconductor (TSM 0.71%), the chip maker. Those are based in Korea and Taiwan Semiconductor's in Taiwan. Samsung makes some of the chips in Austin, Texas. You have, just for this one chip, which is obviously a very important component, it comes from all over the world in terms of its own value chain. Then they also license the GPU technology from another British company, Imagination. You have this wide collection of companies in geographical areas, where they have to come together just for this one processor to come together, which is an incredibly important part of the device.

Lewis: Yeah, the sheer number of moving parts that go into Apple's supply chain is kind of baffling. If you want more of a taste of this, listeners, if you Google "Apple Supplier List 2015," the company makes available their top 200 suppliers. Some of them are within the same company but different addresses, but they estimate that their top 200 suppliers comprised about 97% of the procurement expenditures from materials, manufacturing, and assembly of products. You know that is across all their product lines, but that gives you a pretty good sense of all of the different suppliers that wind up going into these Asian contract manufacturers.

Niu: Mm-hmm.

Lewis: Evan, anything else to throw in before I let you go?

Niu: No, I think we covered most of it.

Lewis: Awesome! Well, thank you for your time, man.

Niu: All right, thanks.

Lewis: Listeners, that does it for this episode of Industry Focus. If you have any questions or just want to reach out and say "hey," shoot us an email at [email protected], or you can just tweet us @mfindustryfocus. If you're looking for more of our stuff, subscribe on iTunes, or check out the Fool's family of shows at fool.com/podcasts. As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear here. Thanks for listening, and Fool on!