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With Apple (AAPL) trading at 22% of its true value, what happens with Apple in China could help determine whether investors ever get to bite into the other 78%. Fortunately labor could account for a mere 5% of the cost of building an iPhone.
Before getting into the five biggest challenges that Apple faces in China, why is Apple's true value closer to $2.5 trillion? The world's most valuable company, at $508 billion, trades at a lowly Price/Earnings ratio of 15.5.
But if it was fairly valued -- that is, its P/E equaled its expected earnings growth of 55% in 2012 -- Apple would trade at a P/E of 55, yielding a market capitalization of $2.36 trillion. In other words, investors are getting only a 22% slice of Apple's full value.
Why is Apple so severely under-valued? That could be due to a massive earnings growth slowdown expected for 2013 -- up a mere 12%. Why would Apple's earnings slow down so much? It's entirely possible that before he died, Steve Jobs set in place a new product slate that would only put Apple's earnings at warp speed for another 18 months.
Another possibility is that Apple's problems in China could cost it some serious earnings growth. Apple got some bad press in January related to fires at the Foxconn factory along with the suicides and overwork of its young employees. I was unable to find any Apple customers who would stop buying its products as a result and the general feeling seems to be "who cares?"
But Apple issued a statement to the effect that it does care. And on February 17, Foxconn announced that it would raise workers' pay by between 16% and 25%. So instead of pulling in $145 a month as they did in 2008, they will earn a whopping $290 a month.
If those workers put in 8 hour days 20 days a month -- probably they work many more hours than that -- their new pay would be $1.81 an hour, about 25% of the New York minimum wage of $7.25 an hour.
While that does not seem like a very big increase in pay, it raises five important strategic questions for Apple management. Here are the issues and some thoughts on each:
- How much will the Foxconn's pay increase raise the cost of manufacturing Apple's products? The answer is, it would add at most 4% to the cost of building an iPhone. The 16GB iPhone 4S costs $196 to make. But a Nokia (NOK) manufacturing expert recently estimated that labor accounts for between $12.50 and $30 of the cost of each iPhone. Holding all the other costs constant, a 25% increase in that $30 would add $7.50 to the cost of making an iPhone.
- Can Apple continue to demand and get 10% annual cuts in Foxconn's manufacturing cost if it raises pay and improves working conditions? Since labor cost represents about 15% of the cost of an iPhone -- and a Nokia expert thinks labor cost is a mere 5% of that total -- then Apple should have plenty of room to negotiate 10% lower costs in the other parts of the iPhone cost structure.
- If not, should Apple shift its production to another supplier that can make its products at 10% lower costs every year? I don't think Apple will need to think about shifting production unless it is forced by bad PR to use a safer manufacturing process -- for example, one that does not involve explosions of aluminum dust. Such a process upgrade could send Apple in search of a manufacturing partner with lower labor costs.
- Should Apple continue to use Foxconn and hold its prices constant -- thus lowering its profit margin? Apple charged $649 for the 16GB iPhone 4S -- yielding a 70% gross margin using the $196 cost to manufacture it. It could certainly afford to accept a lower margin, but would only do so if Apple executives concluded that its customers were highly price sensitive.
- Should Apple raise its prices to consumers to maintain its margins as Foxconn's costs rise? Given the fanatical loyalty of Apple customers, I think the company could get away with raising its price by 1% to pay those workers $7.50 more per iPhone. And that way, Apple could maintain its 70% gross margin with little risk of losing sales at that slightly higher price.
In short, if the Nokia expert is right about the low labor cost component in its products, Apple could easily raise its prices to pay those Foxconn workers a higher wage without losing market share or its gross margin.
And that means that the bigger risk for Apple investors is whether its earnings growth will slow down in the absence of new category-killing products. The market jury is still out on that verdict.
