The blessing and curse of being an Apple supplier
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Business is booming at Cirrus Logic, the Texas-based audio chipmaker. Sales are growing by more than 25 per cent for the third year in a row and its shares are up by 70 per cent in the past 12 months.
However, despite running a public company with a market capitalisation of $4bn, chief executive Jason Rhode struggles when explaining to investors the finer details of its impressive results. Even though a single customer accounts for two-thirds of its annual revenues — and as much as 85 per cent in the quarter ending in December — Mr Rhode never dares mention it by name.
On every quarterly earnings call, Mr Rhode trots out the same carefully worded phrase: “While we understand there is intense interest related to our largest customer, in accordance with our policy, we do not discuss specifics about our business relationship.”
Of course, every Cirrus investor knows that the unnamed customer is Apple, the world’s leading maker of smartphones by sales. When Apple revealed strong demand for its new iPhone 7 in mid-September, Cirrus’s shares leapt by 8 per cent in a single day.
Yet Apple’s obsessive secrecy, coupled with the extreme demands it makes of its manufacturers and the competition to join their ranks, means its suppliers dare not put a foot wrong. Apple’s patronage is a blessing when everything is going well but it can quickly become a curse. The consequences of a break-up can be devastating, as London-listed chip designer Imagination Technologies discovered this week.
Imagination’s graphics processors have been a core part of the iPhone since it first launched a decade ago. Its shares lost almost two-thirds of their value on Monday when the chipmaker revealed that Apple “has been working on a separate, independent graphics design in order to control its products and will be reducing its future reliance on Imagination’s technology”. It was one of the most dramatic share-price reactions for a large UK company — previously worth £754m — in a decade.
Imagination’s relationship with Apple has been rocky for a while. Early last year, amid deepening losses as it struggled to adapt to the smartphone market slowdown, its long-serving chief executive Sir Hossein Yassaie left the company. Soon after, it emerged that Apple — which owns an 8.1 per cent stake in the chipmaker — had discussed acquiring Imagination outright but ultimately decided against making an offer.
Today, Apple still accounts for more than half of Imagination’s revenues but within two years it intends to “no longer use the group’s intellectual property”, Imagination said in a statement.
Gene Munster, a longtime Apple analyst now a venture investor at Loup Ventures, compares investing in the group’s suppliers to playing “Russian roulette”. “It’s the classic deal with the devil,” he says. “You know you are going to pay a price for it, whether it is getting left behind completely or squeezed on your profits.”
Apple’s abrupt severance may seem ruthless but it shows how the group is moving to own more of the core technologies at the heart of its products. By making such a drastic shift into graphics processors, Apple is seizing control of a component that is becoming essential to not just video and gaming, but two coming tech megatrends: artificial intelligence and augmented reality.
That will come as little consolation to Imagination, which is facing what one analyst called its “black swan” moment. For many such vendors, though, the pattern is all too familiar.
“This is not the first time this has happened in the Apple supply chain and reminds us that a discount should be applied to Apple suppliers’ valuations,” wrote Morgan Stanley analysts in a note to clients this week. Apple declined to comment for this piece.
An early victim was PortalPlayer, a provider of audio technology to the iPod, which relied on Apple for around 90 per cent of its sales. In December 2005, PortalPlayer was riding high on the success of Apple’s MP3 player, with its chief executive saying it was “well positioned for the year ahead” thanks to its “strong” relationship with its unnamed “leading customers”. Just four months later, Apple switched to another supplier and the company lost half of its value almost overnight. Before the year was out, PortalPlayer had been sold to Nvidia, the graphics chipmaker.
As a result, publicly listed manufacturers who count Apple as a customer, tend to trade at a lower multiple than their peers, analysts say. On Wall Street, this phenomenon is known as the “Apple risk discount”. Last September, analysts at RBC Capital Markets noticed that 10 of 11 suppliers with significant revenues from Apple were seeing their gross margins contract. “We think Apple has been pushing for price discounts from multiple suppliers,” RBC said in a note at the time, as a way to mitigate increases in its own costs due to currency fluctuations.
Yet even for suppliers who know the risks, a contract with Apple is seen as a badge of prestige that will bring in other customers. It also brings huge volumes — Apple will sell more than 240m iPhones this year, according to analysts.
“The best thing is to do the deal with Apple anyway,” says Mr Munster. “Even though you are probably going to get throttled in the end, you will have three years of great times you probably would never have had if you hadn’t done it.”
Nonetheless, news of Imagination’s predicament will have triggered concern across Apple’s supply chain. “Companies working with them in certain areas are really struggling to get financing, because of the risk,” said an executive at one company that has worked with the iPhone maker for many years. “Every bank has every Apple vendor on a watchlist now. The negative impact on [Apple’s] supply chain is huge.”
Imagination is an extreme case because Apple is not just swapping to another supplier — it is taking development of the same technology in-house. Chipmaking is not a new endeavour for Apple, though. Since it acquired PA Semi in 2008, it has developed formidable expertise in crafting the tiny electronic brains inside its devices.
As well as the A-series processors that power its iPhones and iPads, Apple has custom-designed special chips that run in its Watch and AirPods wireless headphones. Analysts see this as a key strategic advantage for the company, given that the huge resources required to make custom processors put them out of reach of many rivals.
Yet creating a new graphics processor (or GPU) is far more complex and ambitious than anything Apple has attempted so far. Only a handful of companies other than Imagination, including Nvidia, AMD, Qualcomm and SoftBank’s Arm, are able to produce the technology at real scale. Apple has been steadily poaching employees from Imagination as it learns to fine-tune its off-the-shelf processors.
“Apple has demonstrated extraordinarily well that its chips can be well optimised for the specific functions of the iPhone,” says Geoff Blaber, analyst at CCS Insight. Ditching Imagination for its own GPU is “just Apple being Apple — they want to customise as much as they can”, he adds. “Given the clear directions Apple is moving in, a GPU is only going to become more important.”
In today’s iPhones, graphics processors are used to make richer video games and more visually sophisticated apps. But the next model will feature a new front-facing camera that can sense the depth in a scene, such as capturing all the features of a face in 3D, according to people familiar with Apple’s plans.
That will enable not only new security techniques, such as a user’s face unlocking the phone instead of today’s fingerprint reader, but also new kinds of features and inputs that are loosely gathered under the buzz term of “augmented reality”. That could mean elaborate special effects in photos and videos, like a supercharged version of Pokémon Go or Snapchat’s selfie masks, which give people dog ears or turn them into a character from a TV show.
Beyond the iPhone, Apple is also researching AR glasses — a new frontier in wearable technology that companies across Silicon Valley are spending billions on to develop. “This [Imagination move] is as clear a nod that Apple has given that it sees a dramatic shift in how people are going to interact with their devices,” says Mr Munster. “This is like the tremor before the earthquake.”
For such a secretive company, Apple chief Tim Cook has been unusually vocal about his enthusiasm for augmented reality, saying it could be “huge”, as big as the iPhone is today. “I get excited because of the things that could be done that could improve a lot of lives and be entertaining,” Mr Cook told the Independent in February. “It’s not a product per se — it’s a core technology.”
A graphics processor is also important beyond images because its architecture is uniquely suited for processing the huge amounts of information that lie behind AI systems, which already appear in today’s iPhones in its Siri virtual assistant’s suggestions and automatic face recognition in photos.
While Apple dreams up new applications for AR and AI, Imagination faces a nightmare scenario from which few suppliers have ever fully recovered. Knowing that it has worked with Apple for so long, it might attract renewed interest from rival smartphone makers, analysts say, while it may yet be able to force Apple to license its intellectual property. Royalties would bring in less revenues than chip sales but command a higher profit margin.
“Imagination believes that it would be extremely challenging to design a brand new GPU architecture from basics without infringing its intellectual property rights,” the company said on Monday, flexing its legal muscles.
Perhaps Imagination might learn from the experience of another British supplier to Apple, audio chipmaker Wolfson. After it lost Apple as a customer in 2008, Wolfson posted five years of operating losses before being bought by a larger rival: Cirrus Logic.
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