"All Components Face Price Pressure" - Apple Forces Suppliers To Accept Price Cuts, As JPM Cuts Production Estimates

In the latest confirmation that the long-awaited rebound in demand for AAPL products keeps getting delayed, even as a surge in low-priced Chinese competition continues to steal market share, overnight the WSJ reported that the tech giant is forcing its suppliers to accept both price cuts and volume reductions in order to preserve profit margins: "as Apple Inc. grapples with falling iPhone sales this year, it is pushing to cut better deals for parts with its suppliers, while carriers in the crucial China market have mobilized to push iPhone sales with deep discounts. In recent months, Apple suppliers say the Cupertino, Calif., company has told them to accept price cuts for parts destined for the next-generation iPhone while cutting forecasts for order volume. This is likely to hurt some suppliers’ earnings in the second half of the year."

And while AAPL is preparing to wage tax battle in Europe, it is engaged in a far more critical for its future profitability war in China, where in the past two weeks, China Telecom has started selling unlocked 16-gigabyte iPhone 6s models for 4,288 yuan (US$642), based on checks at its retail outlets, the WSJ reports. That is below a price of 5,288 yuan listed on Apple’s China website. Rival carriers China Mobile and China Unicom Corp. have also offered fresh iPhone discounts, although they aren’t as steep as China Telecom’s. In the U.S., major telecommunications operators sell the unlocked 16-gigabyte iPhone 6s for US$649.

While carriers typically discount iPhones before new-model launches, it is rare for iPhones to be cheaper in China than in the U.S., as a combination of import duties on components and value-added taxes boosts prices.

While Apple's recent woes in China are nothing new, these moves highlight the difficulties Apple faces to shore up demand for its products as global demand slows and upstart Chinese companies become serious rivals. As a reminder, in Q3, Apple’s profit slumped 27% from a year earlier amid weaker sales especially in China. Meanwhile, Samsung, its biggest rival, reported its most profitable quarter in two years in the second quarter as it got a head start on shipping its latest Galaxy S7 smartphones.

Worse, by forcing its supply-chain to "eat" the decline in top line growth in order to preserve margins, Apple risks alienating key suppliers as well as adversely impacting their own supply-chains and operations, resulting in further production delays.

But the biggest surprise is not the price cut demands, but the corresponding volume declines: according to the WSJ, suppliers say this year Apple pushed to cut both component prices and order volume. The company told suppliers that despite the volume cuts, orders would rise significantly after new-device launches. But given that iPhone sales have been falling this year, suppliers say they are wary about betting on a smash hit. The demands for discounts have irked some suppliers, many of whom get a large proportion of their sales from iPhone parts.

“The reason why everybody is extremely unhappy about it recently is because they played a ‘double cut,’ cutting both the price and the volume of orders,” said a person at one of Apple’s suppliers.

While the ongoing cuts may help boost near-term results, over the long run AAPL's strategy is likely to backfire: analysts say the discounted parts will likely help shore up Apple’s earnings in the second half, but damp profit outlooks for suppliers including iPhone assembler Foxconn Technology Group, metal casing manufacturer Catcher Technology Co. and chip-processing company Advanced Semiconductor Engineering Inc. While a few hard-to-replace Apple suppliers have strong bargaining positions—such as chip maker Taiwan Semiconductor Manufacturing Co. and camera lens module maker Largan Precision Co.—Apple has multiple sources for other components, giving it leverage to seek better prices.

Negotiations over cuts in component prices started in January, suppliers said, and have already begun to affect earnings figures for Apple and parts makers. The price cuts helped Apple beat analysts’ estimates in its latest quarter, analysts said, with gross margins coming in at 38%, in line with its estimate of 37.5% to 38%. Apple has forecast gross margins of 37.5% to 38% for the current quarter that ends in September.


Some component makers say Apple told them it could cultivate less-costly Chinese suppliers if they didn’t accept the price cuts.


Apple generally cultivates several secondary suppliers for each component, except for a few important parts—such as the processor—for which it is hard to find alternatives given the complexity in manufacturing.


“With global smartphone growth slowing, Apple needs to find a way to maintain its high gross margins,” Fubon Financial analyst Arthur Liao wrote in a note in July. “In our discussions with…the supply chain for the iPhone 7, all components except [the camera lens] face price pressure.”

Finally, adding insult to injury, in related news moments ago JPM analyst Narci Chang released a note in which he warned of "hiccups" in iPhone 7/7 Plus production, and cut its iPhone 7 production estimate for H2 to 70mm, down from 85-90mm last year for new models. 

Based on our recent supply chain visits, we believe there could be supply hiccups at certain components (i.e. display BLU, casing, and EMS assembly); hence we expect some modest change to iPhone production build. Our expectation of iPhone 7/7 Plus build in 2H16 is now approaching 70mn units, down from 85-90mn level last year for new models, also down slightly from our previous expectation of 75-80mn units. However, total iPhone build stays roughly unchanged at ~110mn units in 2H16, suggesting strength in iPhone SE. For total iPhone production build, we now expect 45mn in 3Q and around 65mn in 4Q, respectively. Upside risks include (1) Impact from Apple Upgrade Program and (2) More Apple Store openings. New iPhone unpack event is scheduled for September 7, 2016.


Should this adverse trend continue, Tim Cook may be forced to do the unthinkable, and begin considering broader iPhone price cuts around the world, not just China, something which many have warned over the years, could be the beginning of the end for the company's heretofore untouchable business model.


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