Apple Inc.'s Next iPhone Just Hurt This Supplier's Profits

Apple (NASDAQ: AAPL) is expected to launch a trio of new iPhones in September. These new phones are expected to incorporate significant internal enhancements compared to the models that launched last fall, including support for super-fast gigabit LTE download speeds.

Two companies are expected to supply the cellular modem chips that'll enable those speeds -- Intel (NASDAQ: INTC) and Qualcomm (NASDAQ: QCOM). Qualcomm was long Apple's only cellular modem supplier, but beginning with the iPhone 7-series smartphones launched in the second half of 2016, Apple began sourcing modems from both chip giants.

Fast Company reports that about 70% of Apple's cellular modem needs for the new iPhones will be supplied by Intel. In perusing the company's recent quarterly filing, I noticed something quite interesting related to the cellular modem that Intel is expected to supply for this year's iPhones.

Apple chip takes a bite from Intel's profits

Last quarter, Intel reported that its Client Computing Group (CCG) suffered an operating-profit decline of around 8%, even as revenues grew by 3%. The good news from the company's strong sales performance was more than offset by issues related to initial production costs of chips built using its 10-nanometer technology. But what's interesting is that there was another big detractor from operating profit year over year -- initial production costs of the company's upcoming XMM 7560 LTE modem.

Intel said in its quarterly filing that it saw a $115 million year-over-year reduction in CCG operating profit due to "lower gross margin from adjacent businesses, primarily due to initial production costs of our new modem product."

As you may recall, the XMM 7560 modem is the first Intel modem to be manufactured using Intel's own 14-nanometer chip production technology. The prior Intel modems that Apple has used in other iPhone products have been manufactured by a third party.

If we go back to Intel's quarterly filing from a year ago, we see that Intel didn't call out production of the modems that were going to power the current iPhones as a year-over-year drag on operating profit.

What this suggests, then, is that Intel is facing yield-rate issues (in other words, a large percentage of the chips produced are unusable) as it begins manufacturing the XMM 7560 LTE modem.

Fast Company's sources were good

Interestingly, Fast Company reported just a little while ago that Intel was, indeed, facing yield-rate issues as it tried to manufacture the XMM 7560. The issues are so severe, Fast Company says, that "only just more than half of the chips being produced are keepers."

Considering that the XMM 7560 is being manufactured on a technology that has been in mass production for about four years now (meaning that the yield rates of properly designed chips should be quite high), this points to a problem with the implementation of the modem design in Intel's 14nm technology.

If I had to guess as to why the XMM 7560 implementation appears so problematic, I'd say that it's because the Intel modem design team -- which has historically designed its chips for easy-to-use third-party manufacturing technologies -- had trouble adjusting to the complexities of trying to design chips on Intel's manufacturing technology.

Fast Company says that engineers within Intel are confident that they can get the yield rates up on this modem before they have to increase production. If they do, then that'll help Intel's gross profit margins as it ramps up modem shipments to Apple, and allow it to sell Apple as many modems as it's willing to buy.

If Intel's designers can't fix the yield-rate issues, then this will hurt Intel's profitability on each unit sold, since lower yield rates increase the average production cost of the salable chips. It could also mean Intel simply can't produce enough of the chips to meet Apple's demand; this would mean lost business for Intel, as Apple would likely react by increasing its orders from Qualcomm.

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Ashraf Eassa owns shares of Intel and 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 recommends Intel. The Motley Fool has a disclosure policy.