Apple's Possible Production Nightmare Scenarios

| About: Apple Inc. (AAPL)

Apple longs are counting on continued good times. It's easy to go there. After all, Apple has been the ultimate money machine. The company earned $100 billion in 10 years. Over 40% of the $100 billion was made just in the last year. Why not expect another extraordinary performance? With strong demand for its sensational products, shouldn't Apple keep raking it in?

Not so fast. Investors may be missing Apple's Achilles heel. Before Apple can sell its iProducts, it must get them to market. Apple is exquisitely vulnerable because it doesn't control production. It's hired other companies to run that crucial element. So far, the strategy has worked. I think Apple is pushing its luck.

Apple (NASDAQ:AAPL) sold 237 million iProducts last year - 125 million iPhones, 58 million iPads, 18 million Macs, and 35 million iPods. Analysts expect Apple to sell even greater numbers of iPhones and iPads for the upcoming fiscal year. In fact, their estimates require it. Consensus for this year: Revenue estimates are 22% higher than last year - quite a high expectation.

An example of analyst optimism: Canaccord Genuity analyst Michael Walkley predicts Apple will sell 194 million iPhones and 101 million iPads in 2013.

Apple's Hidden Risk: Partner Dependency

Cupertino outsources its manufacturing. It buys all of the components that go into its products.

That's in sharp contrast to arch rival Samsung (OTC:SSNLF). Samsung manufactures its smartphones and the majority of the cell phone innards (batteries, chips, camera, screen).

Other big corporations handle large chunks of their production: Boeing (NYSE:BA), Exxon Mobil (NYSE:XOM), Dow Chemical (NYSE:DOW), Caterpillar (NYSE:CAT), Ford (NYSE:F) and Deere (NYSE:DE).

For Apple, every piece of hardware and every assembly line has been contracted out. Each Apple device requires an average of 20 components (my count). Therefore, 237 million iProducts involve over 4.7 billion parts seamlessly assembled in a year - a mind-boggling operations feat, all the more amazing considering Apple depends on its partners to make it happen. Imagine if Apple can't get its chips on time. The outcome? No iPhones or iPads. And if the assembly lines go down? Production stops. Screens in short supply? No finished product.

So far, just-in-time operations have worked well for Apple. Like all things, they work until they don't. As Apple's products become more complicated to manufacture, the chance for mishap increases. In fact, in 2012, the iPhone 5 had serious production problems that kept the smartphone out of stock in October and November. Could 2013 see larger snafus? Apple has over a twenty partners. One snafu could create a devastating bottleneck.

Who may be the weak links?

Hon Hai Precision (Foxconn) for assembly.

Arch enemy Samsung for chip fabrication.

Sharp Corporation, LG Display (NYSEMKT:LGL), AU Optronics (NYSE:AUO) for screen.

Nightmare Scenarios?

Depending on others for production sets up the nightmare scenarios - some likely, others unlikely. Together, they should be enough to keep Tim Cook and Apple investors up at night. Here are a few:

1. China and Japan have been on a collision course over nationalist issues - who owns the Diaoyu/Senkaku Islands as well as unresolved anger over WWII. The Chinese boycott of Japanese autos wrecked Toyota and Honda's bottom line. Apple sources its batteries, screens, and camera from Japanese companies. Imagine if Foxconn workers refused to install the Japanese components that go into the iPhone. The result: No iPhones.

2. Hon Hai workers at Chinese plants walk out over wages and conditions; iPhone manufacturing comes to a standstill. Brazilian Foxconn divisions attempt futilely to make up for the disruption.

3. Weak suppliers like Sharp and AUO fail to deliver sufficient panels. All of Apple's products get back-ordered.

4. Typically, Apple contracts with its partners for a period up to 150 days. Per its 10-K disclosure:

Although the Company works closely with its outsourcing partners on manufacturing schedules, the Company's operating results could be adversely affected if its outsourcing partners were unable to meet their production commitments. The Company's purchase commitments typically cover its requirements for periods up to 150 days.

Samsung fabricates all of Apple's chips. The two companies are locked-in a smartphone battle playing out both in the marketplace and the courtroom. Every investor should be asking the question: Are we in day 2 or day 148 of Apple's contract with arch rival Samsung? Suppose Samsung decides not to renew its agreement. If Samsung drops Apple, where will Cupertino find a fabricator able to make 300 million chips in short notice? Apple is rumored to have contracted with Taiwan Semi (NYSE:TSM) for the A6X chip foundry work - but they are only rumors. Without Samsung, Apple may have nowhere to go for its chip production.

5. A supplier delivers flawed components, creating a publicity and production nightmare; Apple recalls millions of iProducts.

6. Apple relies on single source suppliers primarily based in Asia, making production vulnerable to earthquakes, sabotage, labor and geopolitical disputes.

While most companies have supply chain risk, Apple is especially exposed because it has no direct control over any aspect of production. Apple's future rests precariously on numerous partners - even mortal enemy Samsung. 2013 could be a nightmare year for Apple.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. We do not recommend that anyone act upon any investment information without first consulting an investment advisor as to the suitability of such investments for his specific situation.

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