For an iPhone to be assembled in a Chinese Foxconn or Pegatron factory, hundreds of suppliers spread all over the globe need to manufacture the parts.
That's a challenging proposition that the iPhone company has managed very well. It's also one that's been very good for certain partners, while it hasn't worked out for others.
In this segment from the Industry Focus: Tech podcast, Dylan Lewis and Evan Niu talk about two companies, Corning (NYSE:GLW) and GT Advanced Technologies (GTAT), that ran the race to be the provider of Apple's (NASDAQ:AAPL) scratch-resistant screen. Find out why Apple chose to use a glass screen over plastic or sapphire, why Corning might not be the best bet for investors who want to buy in for exposure to Apple, and why GTAT's failed contract with Apple is a cautionary tale for those looking to invest in Apple through its parts suppliers.
A transcript follows the video.
This podcast was recorded on May 27, 2016.
Dylan 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, 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.
Evan 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 -- 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 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're 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 of Apple. I forget all the specific numbers, since it's been a couple years. Basically, they announced this huge deal to 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, 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, Ariz., and they were going to operate it. 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 pre-payments. They had these four installments of pre-payments of the total, I forget, I think it was $800 million or something like that. Basically, there were these different milestones that GT has to hit to get these pre-payments. The pre-payments 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 pre-paying them and they're getting to all these milestones. What those pre-payments did is, Apple gets to pre-pay and that's basically a credit that they were planning to use as payment for sapphire later on. It's like, "We'll pre-pay 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 doesn't know 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 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 deal's 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.
Niu: I think they bit off way more than they could chew, and GT shareholders got burnt 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 to cover glass for the iPhone. Despite it being more brittle, and all these -- some trade-off. They still use sapphire on the touch and 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.
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.
Dylan Lewis owns shares of Apple. Evan Niu, CFA owns shares of Apple. The Motley Fool owns shares of and recommends Apple. The Motley Fool has the following options: long January 2018 $90 calls on Apple and short January 2018 $95 calls on Apple. The Motley Fool recommends Corning. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.