Much has already been written and speculated about Apple's (NASDAQ:AAPL) strategic investment in GT Advanced Technologies (GTAT), a company that develops high-grade sapphire. The investment includes a pre-payment of $578M, which will be paid back over a five-year period starting in 2015. No secret - you could have read this in about three-dozen different articles published since the deal was made public. But, while the arrangement is new, the mechanics and eventuality of it certainly are not.
Some Interesting Points about the Arrangement:
- GTAT forecasted revenue of $290 to $320M for fiscal 2013, which ended December 31, 2013. Its full-year outlook for 2014 includes revenue guidance of $600M to $800M, with the sapphire segment accounting for 80% of that revenue. So basically, this deal with Apple will boost revenue by 130% year-over-year… that's huge.
- GTAT "expects the arrangement to be cash positive and accretive to earnings starting in 2014."
- Gross margins from the arrangement are expected to be substantially lower than GTAT's historical equipment margins.
- GTAT will be subject to certain "exclusivity terms" during the duration of the agreement.
- The agreement "does not guarantee volumes, [but] it does require GT to maintain a minimum level of capacity…"
Why this Deal is No Liquidmetal
There was great anticipation for what the licensing arrangement between Apple and Liquidmetal Technologies (OTCQB:LQMT) would yield. In short, the reality has been… not much. Unless you consider, a sim-ejector tool to be a significant advancement in personal electronics, the deal (which will expire in February 2014) has not produced the breathtaking mock-ups of alloy devices that were created when this partnership was first announced. And there is still hope that this partnership can produce something substantive for future iDevices, but unfortunately, not many are holding their breaths. It should be noted that Liquidmetal Technologies' components in Apple's devices may go beyond the sim ejector tool, but the fact that nobody has been able to identify core components probably means that the application has been extremely limited.
The GTAT deal is different - I think. First of all, as mentioned, the company has already indicated that the arrangement will have an astronomical effect on its financial statements immediately (revenue will more than double next year). Additionally, GTAT expects the arrangement to be cash positive and accretive to earnings next year as well. Second, Apple is already using sapphire in its products, with significance far beyond a sim-ejector tool. The TouchID button on the 5s requires sapphire due to the scratch resistance of the material. Apple also uses sapphire for the lens cover of its iPhone cameras, which is also made of the durable material.
Third, and perhaps most important, GTAT has already shown significant advancements in its sapphire production capabilities. The big knock on the use of sapphire in things like mass-market consumer electronics devices has always been cost. With Corning's (NYSE:GLW) Gorilla Glass controlling most of the smartphone display market, the volumes have enabled the company to drive-down costs to a level that has created significant barriers-to-entry. With this new arrangement, all signals point to Apple wanting to use sapphire…and a lot of it. Such volume could prove to be the catalyst needed to further get the material down the cost curve and into new mass-market devices. If Apple were to use it on phone displays, it would not be the first. Vertu, which makes ridiculously-priced phones, has used sapphire in its products, but also charges $3,000 per phone.
Control the Supply Chain Without Owning Any of It
Apple's deal with GTAT is an "exclusive" arrangement, which means that any practical application of sapphire coming out of that Arizona factory is restricted to Apple's use. This type of deal may be new for GTAT, but it's all-too-common for Apple. Why buy the cow when you have exclusive rights to all of the milk? Apple has long used strategic partnerships to:
- Block other companies from access to new technology
- Control output without carrying the burden of cost inputs
- Dictate tooling, precision, and processes to reach a level of quality control unmatched in the industry
If that sounds a lot like owning the company in all of the important aspects without digesting all of the potential downsides, it is. The great part for Apple is that they don't carry any of the other burdens of a true acquisition and integration. For many companies, exclusive access to desired technology comes in the form of outright purchases, which inevitably come with premiums. While Apple's $578M "loan" may look like a lot of money, GTAT's market cap was roughly $900M - $1B before the deal was announced. Tack on a 20% premium and you're looking at a $1.1B to $1.2B acquisition. While well within its means, it just would not be "Apple's way" to do such a thing. GTAT has a significant business (approximately 20% by revenue) that Apple has no interest in. Not only is the $578M significantly less than the acquisition would be, it's simply a loan that will be paid back - the cost is nothing more than the time value of money. In other words, GTAT has virtually 'bet the farm' that this deal pays off, while Apple has put-at-risk nothing at all. And the forecasted gross margins for GTAT show that Apple would capture a significant piece of any upside.
Furthermore, Apple is not guaranteeing to buy anything from GTAT, but GTAT is guaranteeing minimum capacity levels. So, if this new sapphire technology proves to be a bust, Apple is not required to buy any of the output. If it turns out to be a hit, Apple will have access to all of the capacity it wants / needs. So what's in it for GTAT, or rather, why would they do this? You can look to industry competitor, Corning, who manufactures Gorilla Glass, for that answer. Ironically, it was Apple that gambled that Corning could scale production of this new glass for the original iPhone back in 2007. That gamble, on Corning's part, has made it the leading manufacturer of smartphone glass in the world.
Supplier arrangements like the GTAT deal are in Apple's DNA - it's just the way they do things. You can look back to Apple's stronghold on the NAND flash memory market, which required multi-billion dollar upfront payments - a move that proved to be genius as personal electronics began the tectonic shift from hard-drives to flash storage. You can also look at its prepaid deals with freight companies to ensure capacity over the holiday season, which can influence worldwide freight costs. More recently, you can look to Asian suppliers / manufacturers like Hon Hai (Foxconn), Catcher, and others that Apple has locked into exclusivity deals that kept many out for a long time. Apple's MacBook Air had a unibody aluminum chassis that was, and still is, the gold standard in the new 'ultra-portable' PC market. Many wondered why Windows PC OEMs could not replicate it and the simple answer is, they could not even if they wanted to. Apple had exclusivity agreements with manufacturers (like Catcher) to produce the extremely complex aluminum unibody designs. In turn, most PC OEMs turned to more traditional and cheap materials like… plastic.
The Bottom Line:
Nobody knows what Apple has in store for the Sapphire from GTAT. Its application could be smartphone / tablet displays for future iPhones and iPads, or on a more-intriguing rumor, a smart-watch face. It could just be that Apple wants to create more lens covers and TouchID buttons, but that's highly unlikely given the volumes that it appears GTAT will be churning out. In any case, anything of value that comes out of that Arizona manufacturing facility will be for Apple's use only, and any of the downside will be absorbed by somebody else - that is the new vertical integration. And that is the Apple way.
Disclosure: I am long AAPL. I have no position in GTAT. 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.