Apple (NASDAQ:AAPL) has built an empire on selling innovative new products to the masses. But what most people don't realize is that Apple has long focused on what it makes and not how it makes them. Under the leadership of CEO Tim Cook, the company has shut down its own manufacturing and expanded outsourcing to other electronics manufacturers.
This isn't a problem when your suppliers aren't also your competitors, but Apple has actually made competitors key suppliers. The biggest is Samsung, the rival that can compete with the iPhone. We now know that Samsung can manufacture products equal or better than the iPhone. After all, it's manufacturing a lot of Apple's components today.
Handing blueprints to the competition
Most investors knows that Apple outsources iPhone and iPad production to Foxconn, a standard practice for computer, tablet, and smartphone makers. This has more to do with cheap labor in China and less expensive business practices than anything. But Foxconn is essentially an assembly house for Apple and provides little in the way of competition.
The more troubling outsourcing is the manufacture of key components like touchscreens, batteries, and chips. Apple has made a big deal about its "advanced" Retina display, it always touts innovations in battery life, and it in-house line of chips that operates smartphones and tablets more efficiently. But guess who is making those products?
Yup, it's Samsung.
Samsung has made batteries for MacBooks and iPads, flash memory for iPhones, the chips that power iPhones and iPads, and even the displays for iPhones and iPads, just to name a few. This wasn't all that big of a deal when the iPhone first came our or even with the first-generation iPad. Samsung's products were far inferior to Apple's products and Google's (NASDAQ:GOOGL) Android operating system wasn't as refined, either. But in the process, Samsung learned how to build a quality smartphone and put what it learned to work.
A rival is born
I don't think Apple really knew it had a problem on its hands until the Galaxy X2 came out. It was comparable to the iPhone in many ways but came with a larger screen that clearly consumers gravitated toward (see larger screen on iPhone 5). The Galaxy S3 took Samsung's knowledge to another level and came out before Apple's iPhone 5. It had 4G before Apple, a larger screen, even near-field communication, a capability Apple has yet to add. The Galaxy Note 2 is another phone that fills out Samsung's portfolio and will make for a formidable competitor to Apple.
In the tablet market, Samsung has yet to make deep inroads like Amazon (NASDAQ: AMZN) has with the Kindle. But like the smartphone market, Samsung will continue to improve and we know it can make tablet products. Android tablets from Samsung are improving and a partnership with Microsoft (NASDAQ: MSFT) to make tablets may even help the competitor.
Apple thought that it could protect itself from this barrage of competition with a number of patents that protected the design and operation of the iPhone and iPad. Oh, how wrong it was.
IP not holding up against Samsung
Apple has held an all-out IP assault on Samsung over the past two years in hopes of getting Samsung's products off store shelves and sending the company back to the drawing board. The problem is that most rulings around the world have gone in favor of Samsung. Outside of a $1.1 billion ruling in a nearby California court, which will likely be overturned, Samsung has crushed Apple in court.
The damage is done
The only step left for Apple is to stop relying on Samsung for so many components. Recent reports suggest that Apple is trying to reduce its reliance on Samsung for a number of important parts. The company has shifted display orders from Samsung's 100% owned spinoff Samsung Display to other suppliers like LG Display (NYSE: LPL). Some memory chips will now come from suppliers like SK Hynix instead of Samsung. The company is also looking to Amperex Technology and Lianjin Lishen Battery to cut Samsung out of the battery equation. However, Samsung will supply some of these components and is the supplier of the A5, A5x, and A6 chips Apple designs.
The bottom line here is that the damage is done. Apple showed Samsung how to build a better smartphone and a tablet and paid for the company to expand its manufacturing capacity.
Secretive and trusting
For a company as secretive as Apple, I'm surprised it trusts so much of its manufacturing to outside companies. Earlier this year when I highlighted outsourcing as the biggest threat to Apple, I highlighted the fact that we've seen this before. In the computer industry, companies outsourced production to Asia, only to find that these suppliers eventually became full-fledged competitors.
Apple could have mitigated some of this risk by manufacturing key components in-house. It may be a more expensive plan but it can pay off in the long run. By worrying more about speed to market, the company relied on outsourcing manufacturing to key competitors like Samsung and inadvertently helped create its biggest competitor in the process.
Fool contributor Travis Hoium is short Amazon.com and manages an account that owns shares of Microsoft and Apple. You can follow Travis on Twitter at @FlushDrawFool, check out his personal stock holdings or follow his CAPS picks at TMFFlushDraw.
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