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Taiwan Semiconductor Manufacturing Company's Risky Apple Inc. Dependence

Ashraf Eassa, The Motley Fool

Today, Taiwan Semiconductor Manufacturing Company (NYSE: TSM) is believed to be the sole supplier of Apple's (NASDAQ: AAPL) custom-designed A10 Fusion and A11 Bionic chips, which are found in the company's iPhone 7-series, iPhone 8-series, and iPhone X smartphones.

Although shipments of A-series applications processors to Apple don't make up the bulk of TSMC's overall revenue, Apple is essentially TSMC's anchor customer for leading-edge chip manufacturing technologies.

Apple's iPhone X.

To put this into perspective, only a handful of companies are currently using TSMC's latest 10nm chip manufacturing technology -- Apple, MediaTek, and HiSilicon appear to be the only companies that are shipping products built using the technology. However, MediaTek's 10nm-based Helio X30 smartphone chip appears to have completely flopped in the marketplace, so TSMC likely isn't building too many of those for MediaTek. Huawei's latest Mate 10-series smartphones are powered by a TSMC 10nm-based Kirin 970 chip, but even though Huawei ships nearly as many smartphones as Apple does in a year, only a small fraction of them are high-end devices with the latest Kirin 970 chips.

In other words, Apple is TSMC's only major smartphone chip customer that ships a meaningful number of chips built using TSMC's most advanced chip manufacturing technology. That's bad for TSMC, but good for Apple.

What if Apple seeks to diversify its chip manufacturing?

In the past, TSMC didn't depend solely on Apple to drive leading-edge mobile chip manufacturing; it was Qualcomm's (NASDAQ: QCOM) main chip manufacturer as well.

Since Qualcomm is far-and-away the leading vendor of chips for high-end Android-based smartphones, TSMC wasn't as reliant on winning 100% of Apple's chip business to continue to justify the development of cutting-edge chip manufacturing technology at breakneck speeds. But, with Qualcomm having seemingly shifted all its 10nm and 14nm orders over to TSMC's rival Samsung (NASDAQOTH: SSNLF), TSMC is now highly dependent on Apple.

Apple isn't the only user of TSMC's advanced technologies; other chipmakers that build non-mobile chips (like data center processors, graphics processors, and game console chips) use TSMC's latest technologies as well. Those customers, however, don't consume anywhere near the kind of sheer chip volumes that Apple does. Moreover, many of those customers intentionally hold back on being among the first to use these cutting-edge technologies. They specifically wait for TSMC to have built tens, if not hundreds, of millions of chips for Apple on a given technology before adopting the technology themselves.

This is a good strategy because by the time TSMC has produced all those chips for Apple, the technology has matured in terms of manufacturing yields and performance. This ultimately translates into better performing and lower-cost chips for the companies that use a technology after Apple has broken it in. If Apple shifts a large portion of its orders away from TSMC, then not only does that negatively impact TSMC's revenue and profits, but it could make it harder for TSMC to retain other customers that need to use leading-edge chip manufacturing technology.

Both TSMC and Apple are likely aware of the importance of Apple's chip orders to TSMC, which should give Apple some solid bargaining power when it comes to pricing and future manufacturing technologies.

Pricing and technology influence

TSMC's dependence on Apple for leading-edge technology business should mean that Apple has solid bargaining power in terms of pricing. This is a good thing for Apple because the lower its component costs, the higher its gross profit margins are, which translates into better profitability for its stockholders. But the influence doesn't stop with pricing -- it likely goes down to the technology level, too.

TSMC is not Apple's personal chip manufacturing arm; it's a contract chip manufacturer that must build chips for a broad set of customers. This means that when TSMC defines the features and capabilities of a given manufacturing technology, it must keep in mind the different -- sometimes competing -- requirements of its various customers. However, since Apple is far and away the largest customer of TSMC's latest technologies, I suspect Apple has an outsized amount of influence over the definition of future technologies.

I'll put it this way: If Apple wants a feature in a new manufacturing technology that'll help it build a better iPhone chip but MediaTek would rather that feature not be put in there because it'd unnecessarily increase its costs, my guess is that Apple gets its feature and MediaTek must deal with the added cost.

Therein lies Apple's power over TSMC, as well as other suppliers that depend heavily on Apple to keep their businesses going.

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Ashraf Eassa owns shares of Qualcomm. The Motley Fool owns shares of and recommends Apple. The Motley Fool owns shares of Qualcomm and has the following options: long January 2020 $150 calls on Apple and short January 2020 $155 calls on Apple. The Motley Fool has a disclosure policy.