Rethink Technology business briefs for July 12, 2018.

In a recent article, SA Contributor George Kesarios asserted that Apple (AAPL) is responsible for about 24% of the trade deficit. In this article, I walk through the calculation step by step and arrive at an Apple contribution to the deficit of 8-12% during Apple’s latest fiscal year 2017.

Source: iDownloadBlog

Follow the money: what Apple pays its suppliers

In his article, Kesarios begins with the fact that Apple had revenue for the “Americas” of $96.6 billion in fiscal 2017. Apple doesn’t report revenue specifically for the U.S., so Kesarios takes a guess that it is about $90 billion. This guess is probably wrong.

Using data supplied by Statista, I compiled a table of estimated U.S. revenue for fiscal 2017:

This revenue must include some contribution from Apple Services, which constituted 13% of Apple’s total revenue, or $29.98 billion. Apple doesn’t provide a regional breakdown of Services revenue, but it’s reasonable to assume that it’s at least 13% of the U.S. revenue of $84.41 billion.

Services revenue should not be included in any balance of payments discussion for Apple, since Apple maintains and provides its Services within the U.S. Thus, only the U.S. non-Services revenue should be taken into account. Using the 13% figure, this is $73.44 billion in fiscal 2017.

The $73.44 billion cannot possibly be applied against the trade deficit with the Peoples Republic of China (PRC), since that would mean that Apple’s gross profit margin was zero. Only the money that Apple actually spends on its suppliers in the PRC can be counted as part of the deficit.

This means that Apple’s contribution to the deficit can be no more than its estimated cost of revenue for the $73.44 billion in U.S. non-Services revenue. Once again, Apple doesn’t report cost of revenue by geographic segment, but it does report it at the corporate level, and this was 61.53% in fiscal 2017.

Since we can’t know the exact U.S. cost of revenues, we’ll use the corporate value as a reasonable estimate. Then, the actual amount that Apple sent to its overseas suppliers was about $45.19 billion.

But this is not the amount of money that Apple sent to the People’s Republic. Apple’s suppliers, Hon Hai (Foxconn), Compal, Wistron, and Pegatron are all Taiwanese resident companies traded on the Taiwan Stock Exchange.

Strictly speaking, this is the end of the money trail and the end of the story as far as the U.S. trade deficit is concerned. Apple’s payments to its Taiwanese contract manufacturers don’t contribute to our trade deficit with the PRC, but rather to our trade deficit with Taiwan. What the contract manufacturers subsequently spend in the PRC to make Apple products is reflected in the balance of payments between Taiwan and the PRC.

According to the U.S. Census Bureau, which keeps track of monthly balance of payments figures for U.S. trading partners, the U.S. had a trade deficit in calendar 2017 with Taiwan of $16.732 billion. So, Apple’s spending in Taiwan is actually quite a bit larger than our total trade deficit with Taiwan. But, of course, we’re not embroiled in a trade war with Taiwan.

Follow the money: what Apple’s suppliers spend in China

It can still be argued that Apple contributed indirectly to our trade deficit with the PRC, although it’s not clear that the Census Bureau tally of the deficit ($375.576 billion in calendar 2017) even includes the Apple indirect contribution. For the sake of argument, let’s try to figure out what that is.

Once again, the Taiwanese contract manufacturers have gross margins of their own, so the spending by Apple of $45.19 billion is not simply handed over to the PRC in the form of wages and sales for PRC companies. However, Apple’s four main contract manufacturers (CMs), Hon Hai Precision, Compal Electronics, Wistron, and Pegatron all maintain very small gross margins, according to their financial reports. The average cost of revenue was 95.82% for this group, so at most, the contract manufacturers could have spent only about $43.3 billion in the PRC during Apple’s fiscal 2017.

In Apple’s fiscal 2017, the trade deficit with the PRC was, according to the Census Bureau, $363.67 billion, so that the maximum indirect contribution to this through the CMs was only 11.9%. This would be even lower if the Census Bureau didn’t include Apple’s indirect contribution.

I used the words “maximum indirect contribution” because there’s good reason to believe that the real amount spent within the PRC is lower than the estimated maximum. This is because the cost of revenue for the contract manufacturers has to include parts and electronic components, most of which are sourced outside of the PRC.

For instance, let’s look at the iPhone X. The Apple A11 SOC is manufactured in Taiwan by TSMC (TSM). The Qualcomm (NASDAQ:QCOM) LTE modem is made by Samsung (OTC:SSNLF) in Korea. The OLED display is manufactured by Samsung in Korea. Many other components are made by semiconductor companies with manufacturing facilities scattered all over the globe. There isn’t that much semiconductor manufacturing currently in China. Most of it is DRAM and flash memory manufacturing in factories operated by non-PRC companies.

Tech Insights, in their iPhone X teardown, prepared a bill of materials for the phone which comes to $341, not including labor. This is considerably less than Apple’s estimated procurement cost for iPhone X of $660 if we assume the 61.5% Apple cost of revenue.

This disconnect has always existed between estimated manufacturing costs by outfits like Tech Insights and what is clearly a much higher procurement cost for Apple. Most likely, the difference between the materials cost and the procurement cost is in labor, but it’s not clear where the labor dollars are being spent. Is it at Apple, or at the CMs? We just don’t know.

Let’s assume for argument that all of the labor dollars are being spent in the PRC, because that’s the worst case in terms of the trade deficit. Including this labor, and assuming that about 38% of materials are locally sourced in the PRC, then about 68% of iPhone X’s estimated procurement cost of $660, or $450 is being spent in the PRC. The rest goes to externally sourced components.

The assumption of local sourcing of 38% of the materials is almost certainly generous. This assumes that the PRC will be the source of the DRAM and flash memory, which may not be the case.

Unfortunately, I don’t have a way to perform a similar cost breakdown for Apple’s other products, such as Macs, iPads, etc. I’ll use the 68% figure as a proxy for all of Apple’s products. Then, the estimated revenue that actually makes it into the PRC from the contract manufacturers is approximately:

$45.19 billion * 0.68 * 0.96 = $29.5 billion

where $45.19 billion is the amount paid by Apple to its contract manufacturers for U.S. products, 0.68 is the estimated fraction of procurement cost spent within the PRC by the CMs, and 0.96 is the average cost of revenue of the CMs.

That brings the estimated indirect contribution by Apple to the trade deficit with the PRC during its fiscal 2017 to just 8%, or about a third of what Kesarios asserted.

Investor takeaways

My point here is not merely that Kesarios has probably over-estimated Apple’s contribution to the U.S. trade deficit with China. The more important point is that a careful analysis of Apple’s procurement spending shows how globalized Apple’s procurement process truly is. Apple isn’t just shoveling buckets of money at the PRC. There are a lot of different fingers in the Apple procurement pie.

Furthermore, this discussion completely ignores the profit that Apple is extracting from its operations in Greater China, which includes the PRC, Taiwan, and Hong Kong. For fiscal 2017, Apple reported revenue in Greater China of $44.764 billion. Assuming that Apple’s corporate gross margin of 38.47% in fiscal 2017 applies to the China revenue, then Apple extracted upwards of $17 billion in gross profit, much of which can freely flow back to the U.S. under the new corporate income tax regime.

The concern here is not only that Apple’s impact on the balance of payments is being inaccurately portrayed, but that articles such as Kesarios wrote are serving to inflame the trade dispute and needlessly heighten investor concerns.

Apple has argued, with some justification, on behalf of its role as a global technology company. Excluding the estimated U.S. derived revenue of $84.41 billion, Apple’s revenue from its global operations was $144.8 billion in fiscal 2017, which generated approximately $55.71 billion in gross profit. Much of this flows back to the U.S. and fuels job growth in Apple’s R&D and product development efforts, which are mainly located in the U.S.

Fixating on the trade deficit with the PRC really misses the bigger picture at Apple and other global technology companies. Globalization has benefited Apple and probably the U.S. economy overall. I remain long Apple and rate it a buy.

Apple is part of the Rethink Technology Portfolio and is rated a buy. Consider joining Rethink Technology to receive exclusive analysis and coverage of technology companies.

Disclosure: I am/we are long AAPL, TSM.

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.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.



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