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Why Apple (Nasdaq: AAPL) Won't Ditch Controversial Foxconn

Apple Inc.'s (Nasdaq: AAPL) position as an iconic brand, as well as a Wall Street darling, doesn't mean its image stays squeaky clean.

The company suffered a PR headache this week when a worker riot broke out at one of the Chinese factories run by Foxconn, the company that assembles the majority of iPhones and iPads.

The riot, which involved about 2,000 workers, occurred late Sunday at a Foxconn factory in Taiyuan. Analysts attributed the riot at least in part to the same stressful working conditions that led to several suicides in 2010.

Complaints about long hours, low pay, and draconian management at Foxconn's many factories have persisted for years, and reflected negatively on the usually-lauded Apple.

Although Foxconn assembles devices for most of the world's top consumer electronics companies — including Sony Corp. (NYSE ADR: SNY), Hewlett-Packard Company (NYSE: HPQ), Dell Inc. (Nasdaq: DELL), Cisco Systems Inc. (Nasdaq: CSCO), and Microsoft Corp. (Nasdaq: MSFT) — whenever a worker crisis erupts, the focus is all on Apple.

The net result is that Apple – which just launched its biggest product of the year, the iPhone 5, this past weekend – gets tainted by association every time there's trouble at Foxconn.

Over the past several years, that's happened with increasing frequency.

"These workers must be treated with respect," New York-based watchdog group China Labor Watch said in a statement. "And both Apple and Foxconn, with billions of dollars in profits every year, have both a legal and ethical obligation to uphold the rights of these workers."

Clearly Apple would rather avoid these nasty surprises, but a complex combination of factors will keep it lashed to Foxconn for years to come.

The Apple-Foxconn Relationship

Some think Apple should address Foxconn's labor issues either by switching to another assembly company or by forcing Foxconn to raise wages and improve conditions.

But doing either is more complicated than it might seem.

First off, Apple has tried to nudge Foxconn into treating its workers better, and with some success.

Apple joined the Fair Labor Association in January and had several Foxconn factories audited. That resulted in scores of improvements, including the doubling of wages (to about $2 an hour), a reduction in the workweek to 60 hours, and limits on overtime.

Apple CEO Tim Cook even visited a Foxconn factory in Zhengzhou in late March.

Despite being Foxconn's biggest customer, there's only so much influence Apple can have over a company operating thousands of miles away in a different country.

As for switching to a more worker-friendly contract manufacturer, that's an even taller order.

Foxconn is expected build all the iPhone 5s this year, and 80%-85% of next year's shipments, according to Barclays. That's a lot of iPhones, and therein lies the problem.

Few companies in the world have the size and scale necessary to build the millions of iPhones and iPads that Apple needs every quarter. One of those is Pegatron – but it's another Taiwan-based company with labor problems much like Foxconn's.

Some have even suggested – including President Barack Obama at a dinner with late CEO Steve Jobs and other Silicon Valley executives in February 2011 – that Apple bring those factory jobs home to the U.S.

But don't look for that to happen.

No Apple Factories Headed to Your Town

Surprisingly, experts estimate that building the iPhone in the United States would add just $65 to the $300 cost of building the device, which Apple sells to the wireless carriers for an average selling price of about $650.

But while Apple could cope with higher American wages, there are other obstacles.

One complication is that the heart of Apple's supply chain is in Asia, particularly China.

"The entire supply chain is in China now," a former high-ranking Apple executive told The New York Times. "You need a thousand rubber gaskets? That's the factory next door. You need a million screws? That factory is a block away. You need that screw made a little bit different? It will take three hours."

And logistics is only the half of it. China has a very large and flexible work force capable of ramping up extraordinarily quickly.

"They could hire 3,000 people overnight," Jennifer Rigoni, Apple's worldwide supply demand manager until 2010, explained to The New York Times. "What U.S. plant can find 3,000 people overnight and convince them to live in dorms?"

And China has an abundance of the type of specialized workers needed to run such plants. In planning for the first iPhone, Apple executives estimated they'd need 8,700 industrial engineers to assist assembly-line workers.

In America, it would take up to nine months to find that many engineers qualified for that kind of work; in China, the jobs were filled in about two weeks.

There's also the long hours Chinese workers put in –12 hour-days and six-day weeks are common, and many workers complain they can't get enough overtime.

But that's how Foxconn meets Apple's enormous production requirements. It's unlikely a U.S. workforce would be as compliant.

So for the foreseeable future, it looks like Apple and Foxconn will remain joined at the hip.

Apple (Nasdaq: AAPL) Stock Shakes Off Foxconn

The only good news for investors is that Foxconn's troubles have had little effect on Apple's stock price or the pipeline of iPhones and iPads.

Market analysts have been bemoaning "disappointing" weekend sales of the iPhone 5 that fell well short of expectations – 5 million instead of the projected 8-10 million.

In a note last month, Piper Jaffray analyst Gene Munster predicted the Apple iPhone 5 would be "the largest consumer electronics product upgrade in history." He forecast the iPhone 5 will sell 6-10 million units within its first 10 days.

Another analyst, Horace Dediu of Asymco, has projected iPhone 5 sales of about 170 million units over the next year, which would beat first-year sales of the iPhone 4S by about 70%.

Apple stock has slipped about 3% in the past week since news of the riots broke, but is rebounding in trading today (Thursday). AAPL was up almost 2.5% by afternoon trading to $681.65.

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