Apple's Flawed iPhone 5 Design And Its Effect On Stock Performance

| About: Apple Inc. (AAPL)

Apple (NASDAQ:AAPL) has some major quality problems, and if they are not fixed soon, the company shareholders will be the ones to suffer. These issues came to a head on Friday when workers at a Foxconn (OTCPK:FXCNF) plant in China reportedly walked out due to the inability to produce the iPhone5 without scratching it due to design defects:

According to workers, multiple iPhone 5 production lines from various factory buildings were in a state of paralysis for the entire day. It was reported that factory management and Apple, despite design defects, raised strict quality demands on workers, including indentations standards of 0.02mm and demands related to scratches on frames and back covers. With such demands, employees could not even turn out iPhones that met the standard.

The initial report said that over 3,000 workers left the Foxconn Zhengzhou factory in a massive strike. However another article claims that Foxconn has denied that there was a strike in an email. But they did acknowledge that there were some incidents at the plant involving quality issues:

"The instruction to strengthen quality inspections for the iPhone 5 was given by Apple Inc. following multiple complaints from customers regarding aesthetic flaws in the phone," said the unnamed spokesman for the industrial zone that holds the Foxconn plant. Apple has not commented on the incident.

It seems that the reported strike was actually also caused by workers leaving the plant to celebrate the Chinese holiday on Friday. The company said that work during the holiday was voluntary, and those who stayed would receive triple time. However the original reports said that Foxconn demanded that they stay. Whatever the reason, everyone is back at work now. At least until the next problem arises. Foxconn workers rioted at a different Chinese plant last month due to similar pressures and inventory shortage problems. That incident caused a dip in price which many Apple bulls read as a buy signal:

Date Open High Low Close Volume Adj Close
Oct 5 665.20 666.00 651.28 652.59 21,196,000 652.59
Oct 4 671.25 674.25 665.55 666.80 13,240,200 666.80
Oct 3 664.86 671.86 662.63 671.45 15,152,900 671.45
Oct 2 661.81 666.35 650.65 661.31 22,428,300 661.31
Oct 1 671.16 676.75 656.50 659.39 19,414,100 659.39
Sep 28 678.75 681.11 666.75 667.10 19,111,100 667.10
Sep 27 664.29 682.17 660.35 681.32 21,217,500 681.32
Sep 26 668.74 672.69 661.20 665.18 20,589,400 665.18
Sep 25 688.26 692.78 673.00 673.54 18,528,200 673.54
Sep 24 686.86 695.12 683.00 690.79 22,848,800 690.79
Sep 21 702.41 705.07 699.36 700.09 20,413,900 700.09

But I am afraid that this incident may have more of a negative impact on the share price. This goes beyond labor problems, which obviously need attention. Rather, this hurts Apple's reputation for having a high quality beautiful product. A lot of customers are calling the phone flimsy. Some have even said that it feels like a toy. The scratching issue seems to affect the black phones the worst. Evidently the substance covering the aluminum body of the iPhone 5 is not very strong. There have been reported problems about the surface scratching, even during shipping. There are a lot of posts on the social networks about customers opening the box to find a scratched up phone. This is now being dubbed Scuffgate. Some estimate that 40% of the phones are being shipped from the factory already scratched. That is a big deal!

According to CNET, an Apple Vice President responded about the scratches last month:

Apple has reportedly responded to at least one complaint about the scratches and chips being discovered on the iPhone 5.

"Any aluminum product may scratch or chip with use, exposing its natural silver color," Apple Senior Marketing VP Phil Schiller said in an e-mail, according to 9to5Mac. "That is normal."

Schiller apparently made the comment in an e-mail sent in response to iPhone 5 user "Alex." E-mailing Schiller that he loves his new iPhone, Alex asked about the scuffs, scratches, and marks appearing around the band and wondered if Apple had plans to fix the problem. Schiller's e-mail was received and its headers reportedly verified by 9to5Mac to authenticate the Apple VP as the source.

Its very obvious that this is going to be a huge problem. The phones are so fragile that Foxconn workers can't find enough perfect "scratchless" phones to "pass" the old quality guidelines, let alone new stricter controls. This is obviously a design flaw that needs to be fixed right away. A new video scratch test is now going viral. Suddenly analysts are worried.

The chart below really made me see why. Each year, iPhone sales are growing with each new phone release. But the problem is the Y/Y growth of the sales with each new release. The iPhone 5 is the first one to drop since the iPhone was introduced five years ago. It did have a 25% increase, but analysts wanted more. In other words iPhone growth is slowing. And yes, it could be due to a shortage of phones due to quality problems. But if the sales aren't there, the revenue will not be there.

(Click to enlarge)

(Nicholas Carlson / Business Insider)

One writer thinks this market is maturing, and that Apple is not spending enough on Research and Development to stay ahead of the intense competition. According to his research, Samsung spent $29 billion on R&D last year, which is more than ten times the $2.4 billion that Apple is spending. And according to another report:

Apple is 18th on the list, spending $2.6 billion, behind other technology giants such as Microsoft, Intel, IBM, Cisco, Oracle, Qualcomm, Hewlett-Packard and Apple's R&D spending as a percentage of its revenue of $127.8 billion was 2%.

When you are making gadgets, they have to be cutting edge. Something super exiting, to make the customer want to pay to upgrade to something better than what they already have. This expense is extremely important. For instance, a little more R&D would have exposed the fragile coating problem which is causing the scratching.

(Click to enlarge)

This picture of the new iPhone 5 (above right) is from a CNET review of the phone. There are other issues such as the mapping problems and the new smaller charger dock which will not fit any of your other iChargers. But these things are minor compared to Scuffgate.

Chart forApple Inc. (<a href=

Consider that the story did not break about the "strike" until after the market closed on Friday. So investors have not really had a chance to react to the news yet. And the focus of most of the stories has been the fact that the assembly lines were closed, adding to the iPhone5 shortage problems. However, eventually the fact that the scratching, and the inability of Chinese workers to produce black phones without scratches, due to design problems, will come out. This will dramatically impact the price of the stock. Unless there are enough Apple bulls to buy up all of the shares that are sold, the stock will continue on its downward spiral. The cure is simple: find a new "non-chipping" finish for the phone. Until then iPhone5 revenue will continue to decline due to the lack of acceptable inventory.

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.

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