For my first post on this new Forbes column, I'd like to address something I haven't seen discussed in much depth (although I'm sure I'm not the only one thinking about it).
Recently, Apple has been taking heat over its labor practices at the Chinese factories that produce its uber-popular iPhone, iPad, iPod products. (Ok maybe its a little more than just taking some heat.) First, this criticism is not new; we've been hearing about labor conditions and wage issues in China for years, but I'll put that aside for now and focus on the question Apple stockholders really care about:
If the allegations are true, which they now seem to be - and Apple has to do something (whatever that may be) about them - how is that going to hurt the firm's financials?
But first, the qualitative/subjective:
Even if Foxconn and Apple officially implement labor protections (work hours, etc) its almost impossible to enforce anything in China, especially when Apple has so much clout with (local) politicians. Unless they're forced/compelled to bring in a truly 3rd-party independent firm that has autonomy and authority to ensure compliance with labor practices with hundreds of people monitoring every shift at Foxconn, for a long period of time, I don't think wages/labor practices are going to get to the (unrealistic) point where critics want them to be. Wages are rising rapidly in China, at least in the big factory cities, but for the most part, labor practices in China (and much of developing Asia) would still probably give Upton Sinclair a heart attack. Broadly, I doubt we'll see that change much in the foreseeable future.
I'm also not sure the Fair Labor Association is remotely effective, even if they have the authority and autonomy, but that's another conversation for another time. Even if Apple truly thinks this is a legitimate image problem that's going to hurt sales (which I doubt, see picture below), how much are they really going to invest in addressing it?
How many people are going to buy a Samsung Galaxy Tablet instead of an iPad2 because of some recent press coverage focusing on Apple's labor practices? As far as I know, its not like there's competing products made right here in the good ol' U.S. of A. by highly-paid workers in pristine factories. Ultimately, when even the protestors carry multiple Apple products (the cognitive dissonance, etc is impressive, no?), do we think Apple is really worried about causehead attrition? Are these people (and those possibly influenced by them) really going to be caught dead with a non-Apple phone/tablet?
I doubt it...
Ok, now on to what you've been waiting for, the numbers (simplified, otherwise this post would go on forever):
Looks like (without stripping out some ancillary revenue) in the last quarter of 2011 (see pg. 25), Apple's average iPad revenue/unit is around $600 ($593 by my division). IHS iSuppli estimates material costs for the 32gb iPad2 version at under $350 and labor costs are $10 per, which I initially assumed, generously, worked out to somewhere around $1.11/hour if you assume an 8-hour day. I think for analytical purposes, 60 hours/week is probably a more appropriate number, and possibly still generous given reports of 12 hour days, 6 days/week (72 hours/week).
Based off the report from IHS iSuppli pinning labor costs for an iPad2 at $10, and $1.11/hour (with a 40-hour week), that implied that it took 9 hours to manufacture each device. If I'd used a 60-hour week though, and the same monthly wage rate and labor cost, the hourly wage would be $0.77, which means it took ~13 hours to manufacture each device.
Fast forward almost a year, and I think a 60-hour work week is still a fair assumption, but Foxconn's processes and employees may have become more efficient, so let's assume manufacturing only takes 10-12 hours now. A Bloomberg report from this past week says Foxconn has raised wages from ~$185/month when I wrote my initial post last may to $290-$350/month (at current Yuan exchange rates), depending on experience/skill.
Assuming the split among junior and more experienced employees is either 60/40 or 70/30, 60-hour weeks, and the monthly wages quoted by Bloomberg, that puts the labor cost per iPad between $12.83 and $15.70, roughly 28%-57% labor cost increase in under a year.
Even if Apple/Foxconn agree to a shorter work week, say 50 hours, this is still a fair range, although this year the prevailing wage would likely come out near the top of it. Applying these figures to unit costs, we get the following:
These may seem like enormous numbers, but when you compare it to iPad revenues, you start to get an idea of the kind of margins (more on that in a bit) Apple is generating with these devices:
In 2010, the average price/iPad was $665, $628 in 2011, and $593 in the most recent quarter ending 12/31/2011 (Apple is on a September fiscal year). I'm a bit at a loss to explain how the average net sales/unit dropped below $600 last quarter, but I'll leave that up to you to in the comments. Considering the iPad3 is coming out shortly (allegedly), I imagine that should help bring the average revenue/unit back up from last quarter's #, but its probably unlikely the average for this year will get back up to $660. $615-$630 range is probably do-able, anything higher I'd be a bit surprised, but its certainly not outside the realm of possibility.
This, of course, isn't the end of the story, as we still have to consider material costs to get gross margins. Certainly demand for electronic components is high and rising with the popularity of mobile devices across the world, but at the same time, Apple has significant - perhaps the most significant of any company - negotiating power, which may help it offset higher component costs arising from increased demand. Thus, I've assumed material costs will stay flat year over year. You can debate this, and that's fair, but I don't have accurate insight into the actual costs to assume they've materially changed. Thus, we can come up with estimates for basic cost of goods sold (COGS), gross profit, gross margin, and the change in gross margin from last year:
Thus, if we assume the average net sales per iPad this year is $615-$630 as we did above, Apple is looking at taking a hit of 220-350 basis points to its gross profit margin from higher labor costs at Foxconn on the iPad line alone. This of course assumes that Apple is absorbing all of these higher costs, which given their aforementioned significant negotiating power is probably unlikely. On the other hand, if we assume Apple can pass off all of the increased costs, the picture changes fairly significantly:
If Apple can pass off all of the increased labor costs, and the average sales per unit is again $615-$630, gross margin will be anywhere from about flat to -120bps over last year, which is purely a function of the average selling price being flat to lower.
If Apple sees similar margin pressure on its real cash-cow, the iPhone, then it might behoove investors to start paying attention, considering the iPad and iPhone together accounted for 62.3% of total net sales in 2011 and a whopping 72.5% in the most recent quarter, a trend I expect to continue or at the very least remain around current levels. Total revenues can grow faster than a rocket sled, but if margins on the vast majority of those revenues drop, and continue to do so, it will invariably put pressure on earnings and earnings growth.
In the grand scheme of things, Apple's position as a market leader makes it the biggest target for critics, and pressures it to be the leader in not just pricing but pay and business practices as well. Insofar as competitors have to - or feel like they have to - follow Apple's lead, rising wages and higher costs for better working conditions should impact them more than Apple.
I don't think the public relations issue about Foxconn's labor practices will hurt Apple (absolutely or relatively) too much, as consumers seem to be obsessed with its wares regardless of well-documented suboptimal working conditions on the assembly lines. Even if it does, and Apple/Foxconn respond, we have a fairly good idea of what the impact on Apple's financials will look like. As long as sales growth continues at a breakneck pace, we should still see strong EPS growth, tempered by gross margin pressure. Whether investors choose to account for this in Apple's valuation multiple is yet to be seen, though.
Maybe I'm totally wrong about all of this, and The People will be so affected by a look into Chinese labor practices/wages that the news will cascade throughout social and traditional media to the point where Apple (and its competitors/suppliers) are forced to make drastic and immediate changes. Call me a cynic, but developed countries have enough of their own issues to deal with, so I doubt we'll see any sustained outrage over emerging market labor practices, outside of those countries at least.
