View From Asia, written by Conor O’Mara
On September 12th, Apple announced its 3 new iPhones to the world, with few surprises to investors in terms of the specifications. But yet again, the average selling price continues to trend up, with the cheapest iPhone now $749 for the 64GB LCD version and the most expensive $1149, as you can see in the table below. The market perception is that the LCD version in particular is too high relative to the OLED versions and also to competitor’s products.
Retail Prices of New IPhones
|Retail Price||iPhone XR||iPhone XS||iPhone XS Max|
Rising prices has been the key to Apple’s earnings power in the past year with the iPhone X significantly more expensive than the last version. Now Apple has taken this strategy one step further. Not only has it increased prices, by discontinuing the iPhone X SE, 6S and 6S Plus it can drive ASPs up even further by removing the choice of less expensive products. Apple has not seen any unit growth in iPhones in recent quarters, with Q2 units of 41.3m down 21% from a quarter ago and up 14% from a year ago. Yet sales continue to power ahead as its loyal consumer base have accepted higher prices, allowing Apple to post a 20% increase in iPhone sales from a year ago.
In the past week, many Asian tech suppliers into Apple have seen their share prices fall dramatically as the Trump administration has threatened to put tariffs on Apple products including the MacMini and Apple Watch, but not the iPhone. Apple has responded in a letter saying it would need to raise prices to cope with any tariffs. The share prices of suppliers such as Win Semi, Hon Hai, Pegatron and others have come under pressure as they depend on unit growth to grow sales; they do not benefit from Apple’s increasing prices.
In this article I will show why Apple is arguing for a value add approach to trade rather than way the US currently assesses trade balances based on the country of final assembly. Lets start out by examining what Apple said in its letter to the US Trade Representative about why tariffs would hurt the US more than China. The letter can be found here.
Apple Says The Burden of Tariffs Will Fall on the US More Than China
It its letter to the USTR, Apple says
“ The proposed tariff list covers a wide range of Apple products and the products used in our U.S. operations: Apple digital health and wireless connectivity products, including Apple Watch, Apple Pencil and Air Pods; Apple computing tools such as MacMini; Apple adapters, cables and chargers engineered for efficiency and safety; Apple-designed components and made-to-specification tooling for Apple’s U.S. manufacturing and product repair facilities; specialty testing equipment for Apple’s U.S. product development labs; and servers, hard drives and cables for Apple’s U.S. data centers that support our global services such as the App Store.
We have provided a list of the proposed tariff codes that cover Apple’s products in Annex A and a list of some of the hundreds of additional proposed tariff codes that cover Apple’s inputs for U.S. operations in Annex B. We urge the Administration not to apply tariffs on these HTS lines.
Our concern with these tariffs is that the U.S. will be hardest hit, and that will result in lower U.S. growth and competitiveness and higher prices for U.S. consumers. First, given the balance of Apple’s economic footprint, the burden of the proposed tariffs will fall much more heavily on the United States than on China. The traditional method of calculating the U.S. trade balance attributes the entire value of our products to the country where final assembly is located, in most cases China. That calculation, however, does not reflect the immense value that Apple generates in, and returns to, the United States. Every Apple product contains parts or materials from the United States and is made with equipment from U.S.- based suppliers. And every one of these products reflects the labor of 2 million U.S. workers across all 50 states, including our 80,000 direct employees, the 450,000 employees at our 9,000 U.S. suppliers, and 1.53 million U.S. app developers. We expect our total direct contribution to the U.S. economy over the next five years to exceed $350 billion. “……..
“ Apple sourced over $50 billion of inputs last year from its 9,000 U.S. suppliers across the country. These suppliers are key to our success, including:
- Texas-based Finisar, which makes advanced vertical-cavity surface-emitting lasers that power some of Apple’s most popular new features, including Face ID, Animoji, and Portrait mode selfies, and also received a $390 million investment from Apple’s Advanced Manufacturing Fund to increase its R&D spending and high-volume production;
- Kentucky-based Corning, which does advanced glass processing, and also received a $200 million investment from Apple’s Advanced Manufacturing fund to support R&D, capital equipment purchases, and state-of-the-art glass processing; and
- Massachusetts-based Analog Devices, which produces the semiconductors that enable iOS touch displays.
- Apple is the largest U.S. corporate taxpayer to the U.S. Treasury and pays billions more each year in local property, sales, and employee taxes.
Tariffs increase the cost of our U.S. operations, divert our resources, and disadvantage Apple compared to foreign competitors. More broadly, tariffs will lead to higher U.S. consumer prices, lower overall U.S. economic growth, and other unintended economic consequences. As a result, tariffs will ultimately reduce the economic benefit we generate for the United States. Second, because all tariffs ultimately show up as a tax on U.S. consumers, they will increase the cost of Apple products that our customers have come to rely on in their daily lives
Apple’s main profit generators are not on this list. iPhones and iMacs are not included, except for the MacMini. The Apple Watch is included, but that is a small product. So the core earnings base of Apple is unlikely to be impacted by tariffs. But , Apple is right to be concerned about the impact of tariffs on consumer demand for those products that are put on the list, as it is already asking its consumers to pay much higher prices then they did before. At some stage, price elasticity has to kick in leading to lower unit volumes.
Apple makes a very good point that the traditional method of calculating the trade balance on the entire value of the product where final assembly is located does not reflect the value created in the US and indeed in Japan, Korea, Taiwan and elsewhere. The MacMini, Apple Watch, accessories and other devices are assembled in China largely by Taiwanese companies like Hon Hai and Pegatron using components that come from Japan, Taiwan, Korea, Europe and the USA that in turn are manufactured using specialty chemicals and silicon wafers from Japan and foundry services in Taiwan. This results in a bill of materials that is significantly below the retail price. Slapping a tariff on the final assembly does not reflect the fact that assembly is the lowest margin and lowest cost per unit of any part of the production process, while the higher value is in semiconductors, displays and other devices.
Lets look at a teardown of Apple’s Watch to examine this
Apple Watch Teardown
Every year once Apple’s products launch, specialist teardown firms take them apart to see what components are inside and to estimate the total cost of the device. The total cost is called the bill of materials, or the BOM. Here is the BOM of the 2015 version of the Apple Watch from IHS which details the producers of each component and I have added in their country of origin.
|Apps Processor||$10.20||Apple, TSMC||USA, Taiwan|
|Power management||$5.50||Dialog, ST Micro||Germany, France|
|BT WLAN||$3.00||Broadcom||USA, Taiwan|
|User AI||$5.50||ADI, Maxim. Broadcom||USA|
|Other mechanical||$16.50||Taiwan & China||China?|
|Total BOM pre assembly||$81.20|
IHS does not say who the suppliers of the battery pack, box contents and other mechanical parts such as the PCB and wristbands are. I know Taiwanese companies make some of this. But even if we assume China makes all of this, then that comes to $26.30 in a total BOM of $81.20. As you will see below, that is a lot more than for Apples more advanced products like the iPhone. But you can see even with the Apple Watch, the vast majority of its costs come from components made in the USA, the rest of Asia and Europe. And with retail prices starting at $399, Apple is making an 80% or more gross margin on all of these devices.
So its claim that it would need to raise prices if a tariff is imposed seems a bit rich when its product mix is skewed towards more expensive products than this. It could easily bear the brunt of some of this, but it is right in its view that attributing the entire BOM to China as the US does does not reflect the economic reality of how much value add was created in China from the start of the manufacturing process of the iWatch to the end.
Apple iPhone X Teardown: Very Little Chinese Content
Even though the iPhone is not on the list of proposed tariffs, understanding the BOM of the iPhone will help you understand why Apple can sustain 30% margins when most consumer electronics brands struggle to achieve a single digit margin, with many like Xiaomi and Samsung for a period of time making losses. IHS estimated that the BOM of the $999 base model of the iPhone X was $370.25. So immediately you can see the gross margins on the device is 62%. Apple has created a strong brand image for innovation and is able to charge a premium price.
As outlined in the chart below, the most expensive part in the phone is the OLED display, which is made by Samsung in Korea. The least expensive is the $6 battery pack from Sunwoda and the box contents which are also probably sourced from China. Final assembly is not included in this BOM, but its typically 2-3% of the cost as that is the kind of margin that Hon Hai and Pegatron make. Like most of the companies mentioned in the table below, the final assemblers are not Chinese either, they are Taiwanese. And Hon Hai has already set up a plant in Wisconsin to hedge itself if the Trump administration does force a change in the global supply chain.
Apple iPhone X Bill of Materials
|Mechanical||$61.0||Catcher, Foxconn, Corning||Taiwan, USA|
|Cameras||$35.0||Largan, Sony||Taiwan, Japan|
|Apps Processor||$27.5||Apple, TSMC||USA, Taiwan|
|Power Management||$14.3||Dialog, ST Micro||Germany, France|
|Memory||$33.5||Toshiba, Hynix||Japan, Korea|
|RF PA||$16.6||Broadcom, Skyworks||USA|
|User AI||$10.1||Cirrus Logic||USA|
|Sensors||$2.4||Alps, ST Micro, Bosch||Japan, France, Germany|
|TrueDepth||$16.7||ST Micro, TI||France, USA|
|Box Contents||$12.0||Chinese providers?||China|
|Total BOM pre assembly||$370.3|
So looking at the BOM, we can see that only $17 (or 4%) of the phones costs stem from China, while 41% of the BOM comes from the display and memory suppliers of Korea and Japan. The USA accounts for over 19% of the BOM due to Apple developing their own apps processor and Qualcomm, Broadcom, Skyworks, Cirrus all supplying key chips. That is just the BOM, on top of that Apple itself makes a 60% margin on these products. So out of the final price of $999, the USA makes $701 per phone, or 70% of the total value of the phone.
It makes little economic sense for the Trump administration to chase after final assembly business that only garners 2-3% margins, but that what it is doing as its seen as a way to create some blue collar jobs for his voter base. Now lets take this one step further and identify a key earnings driver of Apple that few are aware of.
NAND Accounts for A Third of Apple’s Margin Alone
Apple typically offers 3 versions of each phone with higher flash memory capacity for storage. This flash is NAND and we are able to determine the price of these NAND modules by looking at the NAND contract prices from consultant InSpectrum.
NAND Module Contract Prices
We can then look at the incremental profit Apple makes from consumers choosing to have a higher memory phone rather than a lower memory. On average, well over half of purchasers go for the mid to high end option in any given year. Apple is charging $150 more to consumers for a 256GB version of the phone, but it only costs Apple $43 more in cost, so the incremental profit is $107 and the incremental margin is 9%. You can see this by the model in the table below.
Incremental Profit From Higher Memory Content Per Phone
|Increase in retail price XR||$50||$100||none|
|increase in NAND cost||$8.88||$34.48||none|
|% of total retail price||5%||7%||none|
|Increase in retail price XS||none||$150||$200|
|increase in NAND cost||none||$43.36||$67.84|
|% of total retail price||none||9%||10%|
|Increase in retail price XS Max||none||$150||$200|
|increase in NAND cost||none||$43.36||$67.84|
|% of total retail price||none||9%||9%|
So I can explain at least a third of Apple’s profits in iPhones from its price strategy in NAND alone. This NAND is manufactured by Samsung and Hynix in Korea and Toshiba in Japan. This is one of the key reasons Apple is able to sustain such high margins.
In conclusion, slapping a tariff on the final assembly in China does not reflect the complex supply chain of components that go into these devices from Asia, the US and Europe.