The Apple You Don't See Is Just as Important as the One You Do

The Apple (NASDAQ: AAPL  ) you see in commercials and in Apple Stores is just a fraction of the company from Cupertino, Calif. A vast majority of CEO Tim Cook's time is spent making decisions on design and manufacturing of the products that eventually make it into stores.

It's this manufacturing and supply chain side of the business where Cook made his name and where Apple has been able to stay ahead of competitors without spending billions on its own manufacturing plants. Even Apple's IP is built around the supply chain, allowing Apple to sue companies like Google and Samsung over their designs rather than how they're making products.

Understanding how Apple has built its supply chain and why it makes sense can also give us a peek into why Apple may be a good investment long term.

The design of Apple's products is just as important as the way they're manufactured by suppliers around the world. Source: Apple. 

Apple's supply chain genius
While Steve Jobs was CEO, it was Cook's responsibility to operate Apple's supply chain in the most efficient manner possible. In a world where most electronics' manufacturing expertise was in Asia, that meant shutting down Apple's U.S. manufacturing and outsourcing production to suppliers like Foxconn.

This allowed Apple's executives the flexibility to focus on design rather than manufacturing, which could be performed more efficiently overseas. But it also meant that Apple would want to secure supply of key manufacturing inputs instead of putting that job on the outsource manufacturer. Over the years, that has meant a variety of different agreements but a couple of them give us a look into Apple's supply chain strategy.

A sapphire front face made by GT Advanced Technologies may be on the next iPhone. Source: Apple.

In 2005, Apple prepaid suppliers Hynix, Intel, Micron, Samsung, and Toshiba for NAND flash memory for iPods and paid another $500 million to Toshiba in 2009 to secure NAND flash memory for mobile devices. There have also been $1 billion and $500 million prepayments to Sharp and LG,  respectively, for LCD display supplies. Recently, Apple prepaid GT Advanced Technologies (NASDAQOTH: GTATQ  ) $578 million for sapphire supply that will likely become the front face of future iPhones.

Prepaying suppliers allows Apple to ensure supply without taking the same risk as building or buying manufacturing capacity to operate itself. But notice that Apple doesn't demand exclusive supply, so Apple just ensures a spot in line with suppliers.

How Apple gets to the head of the line
Think of Apple's supply chain strategy as a fast-food restaurant drive-thru. Apple pays up front for the food it wants, allowing its supplier to build out capacity, and as a reward, it gets the first spot in line. Apple gets to order the product it needs, and if there's demand and capacity left over that might speed up service or lower costs, all the better.

Apple has become a master of ensuring supply and protecting its designs. Source: Apple.

What's important to understand is that Apple isn't fighting to keep the manufacturing supply it buys proprietary -- that would be too costly. It just wants to ensure first dibs on any production. And the opportunity to get a prepayment from Apple is a big carrot technology developers are dying to get.

Getting a first glimpse at next-generation technology
What Apple's size has done is allow it to have a first gander at technology that may be years away from making it into an actual product. Whereas Jobs got inspiration for things like the mouse and graphical user interface by peering into Xerox's Palo Alto Research Center, today Apple is invited to look at the latest and greatest its suppliers and partners have to offer.  

When Sharp or LG comes up with a new display, Intel releases a new chip, GT Advanced Technologies makes a new sapphire material, or a new manufacturing method is developed, Apple can pick and choose what it wants to incorporate into design rather than develop the capability in-house. The process innovation can take place outside of Apple, leaving the design innovation for its engineers.

Protecting what Apple has
This process and design distinction is important from an intellectual standpoint as well. A process patent protects how something is made and to get around them a competitor just needs to modify the process. Apple leaves the process protection to suppliers, instead focusing on design patents.

The lawsuits between Apple, Samsung, Google, and others are primarily about design patents, not the process of making products. Apple doesn't care if Samsung has the same display (it's a supplier of chips and displays so it can make the same product) -- it cares about Samsung's phones looking like Apple's. The disputes over early-generation Galaxy phones were because they looked very similar to the iPhone and had similar design of the operating interface, which is what Apple was trying to protect.

This is an important distinction and differentiates it from most product development companies. Most companies are worried about competitors learning how to make the products they make whereas Apple knows anyone can physically make the same product, but thinks it can design a better product and interface using the same inputs.

Everything from Apple's intellectual property to supplier relationships are built around this fundamental view of products and design. For investors, it keeps Apple's capital expenditures low but requires large prepayments to suppliers to ensure Apple can be first in line. It's a model that's worked for years for Apple, but isn't one many companies could replicate.

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