Apple's Chinese Supply Lines

The company farms out iPod production to Taiwanese-owned plants on the mainland, and it's a mighty demanding customer

As any Apple Computer (AAPL) fan can tell you, the packaging of a new iPod proudly announces that the wildly successful music and video players are designed in California by Apple. But most iPod owners don't really care where or by whom the gadgets are made—which is just what Apple wants. Hon Hai Precision, Asustek Computer, and Inventec Appliances, the Taiwanese electronics companies that assemble millions of iPods in Chinese factories, aren't exactly household names.

Investors looking to cash in on the iPod's popularity, though, would do well to get to know these companies. That's because Apple doesn't make any iPods on its own. Rather, it outsources all production to the Taiwanese—and they have done quite well as a result, thank you very much. "Investors want to keep their eyes on the supply chain, because Apple outsources everything to companies in Greater China," says Tony Tseng, an analyst with Merrill Lynch (MER) in Taipei.

Less Reliant

Consider Inventec Appliances. This subsidiary of Taipei computer maker Inventec makes a range of gadgets, including GPS systems for TomTom (TMOAF), the Dutch specialist in car navigation equipment. But the bulk of Inventec Appliances' income comes from its production of video iPods for Apple. Inventec Appliances, which had sales of $3.6 billion in 2005, depends on Apple production for about 60% of its revenue.

The bigger, more diversified Taiwanese companies are less reliant on Apple. Still, assembly of iPods is an important business for Hon Hai, the world's largest electronics outsourcer (and the No. 2 ranked company in the most recent BusinessWeek IT 100 rankings—see them here).

Hon Hai, which operates under the trade name of Foxconn, manufactures cell phones for Nokia (NOK), game consoles for Sony (SNE), and PC monitors for Hewlett Packard (HPQ). The company produces the iPod Nano for Apple, and that business accounts for 5% of its total sales, which reached $23 billion in 2005. Many analysts think Foxconn will be the manufacturer for the much anticipated iPod phone, which Apple may announce at Macworld this week.

Strict Standards

Compared with other U.S. computer makers, Apple is notorious in the Taiwanese electronics industry as a difficult customer. With their near-obsessive concern about secrecy and quality, Steve Jobs & Co. make life especially hard for their suppliers.

It's not uncommon, for instance, to hear stories of finished iPods getting rejected by Apple because they don't meet its standards. "In terms of quality, service, and secrecy," Apple's requirements are "higher and stricter than anyone else's," says Henry King, an analyst in Taipei with Goldman Sachs (GS).

Still, Taiwanese companies like working for Apple. Typically, Apple contracts with only one Taiwanese supplier for each type of iPod. Hon Hai, for instance, makes the Nano while Asustek makes the Shuffle. (An exception is the Video iPod; Apple now has two suppliers, following its decision last year to give some of the business to Quanta Computer in addition to Inventec Appliances.)

Moreover, the iPod's popularity ensures that orders keep coming in. And at a time when Taiwanese computer makers are struggling to cope with ever-shrinking profit margins, the iPod provides some welcome relief. According to Byron Wu, Shenzhen-based head of China research for iSuppli, Taiwanese manufacturers make only 2% margins on computers. Margins for iPods are at least double that, says Wu.

Sudden Scrutiny

While Apple would prefer that its Taiwanese suppliers keep a low profile, Hon Hai unexpectedly found itself in the spotlight last summer following reports in the Western and Chinese media about abuses at its Chinese factories. Hon Hai denied any wrongdoing, and Apple announced that an investigation found that conditions were generally satisfactory, although the company did say that it had uncovered violations regarding overtime pay and housing for Hon Hai factory workers. (see, 8/18/06, "Apple Answers "Sweatshop" Claims").

Some people believe that the sudden attention to labor conditions at iPod plants in China might help the Taiwanese by giving them some leverage with Apple. If Apple wants manufacturers to improve conditions, this logic goes, then the Americans have to provide more wiggle room with margins.

"If companies are able to come up with a process to increase overall output without the need for more overtime labor, then they can get a better deal from Apple," says one Taipei-based analyst for a Western investment bank who cannot be named because of bank policy. "Apple might give the company more resources for doing the same job."

Wu of iSuppli isn't holding his breath, though. "I don't think the [Hon Hai controversy] can change the rules too much," he says. When it comes to relations between Apple and its suppliers, Apple still has the big advantage. Says Wu: "Apple is the big shot."