The biggest threat to Apple

Apple CEO Tim Cook has been celebrated as the supply chain genius who built the foundation on which Apple (Nasdaq: AAPL) can build its innovative products. His guidance has cut down lead times, locked in suppliers, and made sure Apple’s innovative products remain on shelves even in the face of extremely high demand.

Cook has done this, primarily, by outsourcing most of Apple’s production to overseas companies, notably Foxconn, and closing down Apple’s manufacturing plants. This does a few things for Apple. It allows the company to preserve capital, which would have to be used to buy equipment and hire workers if it did its own manufacturing. It also leaves most of the manufacturing details to these suppliers, allowing Apple to focus on what to build and less on how to build it.

Therein lies the problem

Building your supply chain in this way can be extremely effective for a lot of companies and is used for most of the electronics we use today. But the problems it creates are starting to rear its ugly head.

When you send manufacturing to other companies, you have to teach them how to make what you make. If you want to build a great competitor, there’s no better way than to have your competitor build your products.

This week, it came out that Samsung was the only supplier that has been qualified to make screens for the new iPad. That has been disputed, and LG Display (NYSE: LPL) may be a supplier as well. The point is, this is the same Samsung that is actually stealing market share from Apple in the Chinese smartphone market and makes arguably the best competitor in Australia. Since the third quarter, the gap in Chinese market share between Apple and Samsung has grown to 26.8 points, with Samsung commanding 24.3% of the market and Apple holding 7.5%.

What’s to keep Foxconn or even a few employees from Foxconn from taking all that they’ve learned building iPhones and iPads and starting their own companies? That’s how Lenovo and ASUS, two of the largest PC makers, got started.

We’ve seen it before

Remember when Gateway, Compaq, HP (NYSE: HPQ), Dell, and IBM (NYSE: IBM) dominated the PC landscape? One of the reasons they lost control of manufacturing was that U.S. companies began outsourcing production to companies abroad, teaching them how to make their products. The more production that moved over there, the more those companies learned how to manufacture computers on their own.

ASUS was founded by four ex-computer engineers at Acer, and one of Lenovo’s first successes was a circuit board made for IBM. Less than 20 years later, Lenovo would purchase IBM’s PC business when the company decided it no longer wanted to compete in the low-cost PC business that China was starting to take over.

As a result, two of the top five PC companies today are Chinese, and most PC makers outsource at least some manufacturing to China.

Keep it in-house

When I worked as an engineer at 3M (NYSE: MMM), this transfer of intellectual property to suppliers – and even other countries – was a major concern. It’s one of the main reasons manufacturing for some of 3M’s most valuable technologies remains within a short drive of 3M’s headquarters to this day. Instead of moving product manufacturing to China, Singapore, or Malaysia – where costs are lower – the company recognises the value of keeping it in-house and in-country.

Apple took a different approach, outsourcing its production and transferring that intellectual property to competitors and countries that have a history of stealing good ideas.

What this means for Apple

You could argue that Apple’s biggest competitive advantage is its products’ ease of use and how seamlessly they work together. This isn’t something competitors will be able to steal by making Apple’s products, but their devices may improve by learning a few things from Apple. Samsung has clearly become a major competitor in both the smartphone and tablet spaces, while also manufacturing Apple’s key devices in the same categories. Many argue that Samsung’s own products are probably equal in quality.

The threat to Apple may not be imminent. It took 15 to 20 years for the PC market to turn itself over to China. But it is a cautionary tale. Now that Apple is such a big target, competitors will be doing everything they can to replicate its success. If those same competitors are the ones actually making Apple’s product, you know they’re not far behind.

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