Apple Plays Saudi Arabia’s Role in the Semiconductor Market

The retirement of Steve Jobs left most commentators wondering if Tim Cook could lead Apple marching ever onward and upward. In truth, Tim Cook’s contribution on the operations side has been just as instrumental in the destruction of Apple’s PC and consumer electronics competitors as Jobs’ product vision. Under Tim Cook’s guidance, Apple has increased their gross margins from 29% to 41% in the last five years and they look to increase this further. Cook is executing on what I will call the “Swing Consumer” strategy, which is a takeoff of Saudi Arabia’s “Swing Producer” position within the OPEC Cartel. What it means is that those companies competing with Apple will be operating off of high priced left overs.

Saudi Arabia, naturally took the role of “Swing Producer” within the cartel based on its vast oil reserves, its ability to easily lift over 12M barrels of oil a day at a cost of $2 per barrel in a country with a relatively small population. The net of it all is that Saudi Arabia for many years could financially support itself on less than half of its full capacity and therefore ensure a maximum oil price in the market per any given economic situation. Despite having a dozen members in the OPEC Cartel and gross margins of over 90%, in the case of Saudi Arabia, the oil market has not collapsed like the DRAM market does in perpetuity off a base of less than a handful of suppliers. Furthermore, Saudi Arabia recognizes that the kingdom itself is valued more on what’s still in the ground than what it produces in terms of the current cash flow. 200B+ barrels of oil at $80 is more than $1.6T of assets, which is why short term price fluctuations don’t matter as much as maintaining the long term oligarchy. They always adjust supply to get oil to an upper range.

Apple first moved into the “Swing Consumer” of semiconductors mode when it based all of its new, high growth products off of NAND Flash in combination with commodity ARM processors. By 2005, Apple was taking roughly 40-50% of Samsung’s NAND capacity and growing. To maximize their opportunity, Apple decided in July 2009 to write a $500M check to Toshiba as a prepayment for NAND Flash capacity at a discounted price. As the largest consumer of Flash coupled with commodity ARM processors that could be build anywhere, Apple found itself all alone, able to dictate the lowest worldwide pricing. The only exception would be if Samsung subsidized their smartphone and tablet groups. All of Apple’s competitors were left negotiating the 2nd best price within a sometimes spot shortage environment. There is no chance for them to overturn Apple’s component cost lead.

Apple’s premium brand combined with its “Swing Consumer” logistics has put it into a similar position to that of Saudi Arabia. At a moments notice it can not only shift NAND flash capacity but also DRAM suppliers, LCDs, wireless chips etc. Last week, an article appeared that confirmed Apple’s plan to source more NAND and DRAM from Toshiba and Elpida and away from Samsung (see Apple Looks to Japan for DRAM, NAND Flash Supply). The article speculated that it was in response to the legal issues it is embroiled with Samsung. It is that and more. It is a chance for Apple to lower Samsung’s prospects of being a serious competitor in the Smartphone and Tablet market and it is a leveling of the playing field. Apple needs both Toshiba and Samsung around as competitors always sharpening their pencils.

As a growth company with strong product margins, Apple is able to offer suppliers a guaranteed forecast that is always expanding, while its competitors like Dell, HP and others must remain tentative in their outlooks in the face of worldwide economic turmoil. As I discussed in an earlier article (Apple Will Nudge Prices Down in 2012: PC Market Will Collapse), margins for the PC OEMs and the retailers (i.e. Best Buy) are so thin that they are forced to under build and under forecast to suppliers because of the fear that they are left with too much inventory at the end of a selling season which will wipe out any gains they accrue in the first few months. Thus PC OEMs are in a death spiral losing more and more market share as time passes and thus losing cost leverage over suppliers.

Imagine the task at hand for new HP CEO Meg Whitman as she tries to salvage this quarter’s revenue by first having to reassure customers that they are staying in the PC business. At the time of the last earnings call, when Apotheker announced that the tablet was to be cancelled and the PC group spun out, HP lost immediate leverage with suppliers as they expected to receive order reductions and cancellations.

The near term bottom for tech stocks, and in particular Dell and Apple, came the following day: August 18[SUP]th[/SUP]. I would tend to speculate that Dell and Apple reached out to suppliers to take advantage of HP’s debacle. Now, as Whitman restarts the PC group’s engine, HP has to go back to suppliers to beg for parts at higher prices. And the worst part is that HP has to re-enter the 10% margin PC business in order to reassure customers who are looking at buying higher margin servers, networking and services. Apotheker’s critical mistake was that he believed dropping the PC group would not impact the other business units. The phones went quiet.

Apple’s complete domination of its supply chain through the “Swing Consumer” strategy will allow it to continue to squeeze suppliers and improve margins. They do, however, have one more threshold to cross and that is with its processor strategy. Apple will be a dual CPU House for a long time but it needs cost leverage over Intel. Both are playing a slow elephant dance before the ultimate partnership is signed that could be a benefit to both.

In the past year, both Intel and Apple have implemented communication and corporate strategies to try to gain an upper hand on each other. As everyone knows, Apple is good about keeping secrets for things that it truly doesn’t want the world to know. It goes to the extend of tracking down missing iphone prototypes mistakenly left at bars or cutting off suppliers who talk too much about upcoming and actual shipping products. In areas that it wants to frame public opinion, it communicates in ways that appear secretive: like the recent reports that TSMC is signed on to fab the A6 and future A7 processors at 28nm and 20nm respectively. It’s anybody’s guess if and what an A7 is but it magically appears in print. One wonders where Intel fits in the scheme of things.

Perhaps we have been offered a hint at what is coming.

Midway through Intel’s IDF conclave, where their upcoming 22nm chips were on full display, there was a simple press release announcing that Intel was issuing debt for the first time in over 20 years (see Intel Announces Senior Notes Offering). The initial press release made no mention of the amount but did say the purpose was for stock repurchases. Given that Intel had just raised their dividend in August and have been aggressively buying back stock with their massive operating cash flows, the offering seemed out of place.

The Wall St. Journal later confirmed that the debt offering raised $5B in total: a number that is familiar to anyone looking to build an advanced 22nm or 14nm Fab. Perhaps Intel’s way of saying they are ready to build an additional fab for a new customer. More on how this can play out in another column.