After months of bad press, Apple (AAPL) and Chinese contract supplier Foxconn have finally reached an agreement to improve working conditions for the thousands of laborers toiling in Foxconn's manufacturing plants. While many view this decision as a deft public relations move by CEO Tim Cook, and it is, investors should not be fooled: this play was not solely about appeasing the public. Like many of Apple's business maneuvers, this move operates on multiple levels. No doubt it will give Apple some street cred as a socially responsible company both at home and abroad, but just as importantly, it has struck a blow at the hearts and income statements of some of Apple's biggest competitors.
The media always zeroes in on the biggest targets when it's searching for its next hard-hitting story, and with all the coverage that Apple has been receiving regarding this latest scandal, it's easy to forget that Foxconn is a major supplier not only to Apple, but also to companies like Hewlett Packard (HPQ), Dell (DELL), Nokia (NOK), and Amazon.com (AMZN). Why does this development matter to all these companies? Because the inevitable consequence of the better working conditions promised to Chinese laborers is an increase in supply costs across the board. After all, someone has to pay for the hiring of new workers and all the extra new amenities they will receive, such as additional time off. As the saying goes, there's no such thing as a free lunch, or even a free lunch break.
Unfortunately for Apple's competitors, a rise in supply costs does not affect all companies equally. Basic math dictates that lower margin companies will get hit much harder by higher supply prices than higher margin companies. When you're running off a high revenue, low margin business model, even the slightest bump in cost of goods sold can absolutely annihilate your bottom line. This problem is compounded when you sell a commodity product where consumer purchase decisions are made primarily based on price. Conversely, companies that enjoy large profit margins and strong brands benefit from a healthy buffer that allows them to absorb small to moderate increases in supply costs without sacrificing dollars on the bottom line.
This isn't the first time the market has seen this phenomenon played out. For the past year, investors in the apparel retail sector have witnessed the exact same thing, as the quarterly profits of major apparel retailers got taken down one after the next by a prolonged spike in cotton costs that absolutely decimated the margins of most companies in the industry. Despite acceptable year over year comps, companies like Abercrombie & Fitch (ANF) and American Eagle Outfitters (AEO) saw each dollar of sales translate into a much smaller amount of profit than they're accustomed to. After having their margins weakened by the recessionary environment, all it took was a hike in cotton costs to deliver the finishing blow. Meanwhile, retailers like Buckle (BKE) that were already operating at peak margins were barely affected at all. Just listen in on a few conference calls to appreciate the difference: for a company like American Eagle, cotton was at the forefront of every Q&A, whereas for Buckle, it was barely a footnote.
How will all this crunch out for Apple and its brethren? Here are Apple's margins versus those of other global technology companies that also contract manufacturing out to Foxconn (data sourced by author):
Notice a difference? Apple's industry-leading margins, far above and beyond anything posted by its rivals, will allow the company to eat increased costs coming out of Foxconn and continue to maintain its earnings momentum without missing a beat. Meanwhile, its major competitors will get crippled, their already rock bottom margins kneecapped even further by a spike in supply costs. Amazon is unique in that it has the luxury of deriving a relatively small percentage of revenue from its electronic products line, so it won't be affected as much as its diminuitive margins would otherwise imply. The other companies on the list enjoy no such privilege.
I'm not alone in believing that not only can such an event transpire, it will. Slate.com's Will Oremus recently published an article advancing the exact same argument. While Slate is a fantastic online magazine that I read regularly, it doesn't usually dispense in-depth investment advice, but in this case Mr. Oremus is spot on. He highlights a very relevant reason why Apple's competitors can't simply set up shop somewhere else: this issue is already in the public eye, and any company that continues to enforce inhumane labor practices for the sake of cutting corners faces an enormous risk of public backlash.
In an interview with Reuters in February, Hewlett Packard CEO Meg Whitman said, "If Foxconn's labor cost go up, their product cost to us will go up. That will be an industry-wide phenomenon and then we have to decide how much do we pass on to our customers versus how much cost do we absorb." By signing this agreement with Foxconn, Apple has effectively forced its competitors into a lose-lose scenario. If they absorb the costs, their margins will get destroyed. If they pass them on to customers, the value proposition of their products versus Apple's own premium line up will become impaired. By taking a small hit to its own margins, Apple has put enormous pressure on its biggest rivals with a single stroke. Apple's deal with Foxconn may have been engineered to make the company look better in the eyes of the public, but it is also an aggressive, cunning, and brutally effective business strategy that will severely handicap its competitors in a race where Apple is already far in the lead.
Disclosure: I am long AAPL.