Apple Needs To Kick Its Samsung Habit

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Apple's products are undoubtedly well thought out, well crafted, and highly innovative. While many claim that because Apple sometimes doesn't have a feature that its competitors have, good engineering is the art of making the right set of trade-offs for any given product.

While competitors like Samsung are more than happy to cast a wide net to see what works, Apple focuses its energy on a handful of well thought-out designs to be released on a yearly beat rate. That being said, there is something that Apple really needs to do as quickly as possible: dump Samsung completely as a supplier.

Samsung is a significant threat
In 2009, Samsung's operating profit stood at "just" $10 billion, but by the end of 2013, the consumer electronics behemoth is set to post $35 billion in operating profit. With this dramatically increased profitability, Samsung is able to invest more heavily in just about all aspects of computing and consumer electronics. This means it can pump money into more advanced chips, world-class displays, better NAND, and faster DRAM, and it can leverage its position as a device manufacturer to co-optimize just every aspect to produce a tightly optimized device.

Now, while many like to claim that Samsung's devices are "inferior" to Apple's, the progress that the South Korean giant is making in winning the minds and hearts of consumers by building its brand cannot be ignored. Samsung is setting up its own stores across the globe as both stand-alone entities as well as embedded in the world's largest electronics retailer, Best Buy. Apple still has the upper hand and the company's significantly ramped up R&D efforts are certainly encouraging, but it's going to be an uphill battle against Samsung in the smartphone and tablet space.

Apple can cut Samsung off
While Apple has moved away from buying NAND, DRAM, and (to some extent) displays from Samsung, it is still Samsung's biggest semiconductor foundry customer. Indeed, Apple sells about 200 million iOS devices per year, each of which comes powered with a Samsung-built applications processor.

Suppose Apple is paying about $15 per chip (really the purchases are done per wafer, but let's keep it simple), this would then imply that Samsung is generating a whopping $3 billion in annual sales from Apple. Now assume gross margins on this business of 45% (below pure-play Taiwan Semiconductor's (NYSE: TSM) corporate average) and we see that Samsung generates $1.35 billion in gross profit from Apple.

Apple should cut Samsung off
Now, given that Samsung is on track to generate roughly $35 billion in operating profit for 2013, this is hardly much more than a "blip" for Samsung. However, the implications are fairly far reaching. First of all, thanks to the sizable chunk of business that Apple provides in semiconductor logic manufacturing, Samsung feels emboldened to expand both its chip design and its foundry business. This means significant competitive advantages for Samsung's own phones as well as a continued "ownership" of the semiconductor fabrication business.

Also, it's difficult not to see the major competitive reasons for Apple to not want Samsung to see its designs, particularly as Samsung aspires to have its own silicon in all of its phones and to even serve as a merchant chip vendor (as we saw with the HP Chromebook).

But there are no signs of it doing so
There don't seem to be too many signs to signal that Apple will move away from Samsung for chip fabrication in the near future. The Apple A7 was expected to be built on TSMC's 28 nanometer process, but TSMC shareholders got a nasty surprise when they found that it was actually built by Samsung on its 28 nanometer process. The rumor mill now claims that TSMC will have the Apple contract at 20 nanometers, particularly as the majority of the foundries seem to have invested less in 20 nanometers to skip right along to their first FinFET processes.

However, the same rumor mill claims that while TSMC has Apple all to itself at 20, Samsung is back in the game at 14/16 nanometer, with rumors of a potential dual-sourcing agreement. This is probably the right move from a risk management standpoint from Apple (in case one can't deliver), particularly as FinFETs are proving very difficult for the entire industry (except Intel), but it would probably be wise for Apple to keep as much business out of Samsung's factories as possible.

Foolish bottom line
At the end of the day, Samsung is Apple's fiercest competitor, and enabling that competitor in any way, shape, or form seems to be unwise. Apple today really has no choice, but in the future it would be good for Apple to move away from Samsung and toward a pure-play foundry like TSMC for a variety of reasons.

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Ashraf Eassa has no position in any stocks mentioned. The Motley Fool recommends Apple. The Motley Fool owns shares of Apple. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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