For over a month now, Apple (NASDAQ:AAPL) has been seeing its stock price decline steadily. It’s now below $600, not long after scaling to over $700 in September. A big reason for the recent fall has been concerns regarding a possible supply shortage for the fast-selling iPhone 5, which might cause Apple to fall short of the high holiday demand this year. In addition, there are concerns that the company’s margins are starting to feel the pressure of competition after Apple guided for fourth quarter margins to decline by about 400 basis points (4%) sequentially and 800 basis points year-over-year. There has also been much criticism around the iPad mini, which many believe has not been priced aggressively enough to dissuade consumers from purchasing other lower cost options such as Google’s (NASDAQ:GOOG) Nexus 7 and Amazon’s (NASDAQ:AMZN) Kindle Fire tablets.
While many of these concerns are valid, Apple’s strong supply chain gives us little reason to believe that the supply shortage will be so severe as to cause customers to purchase rival handsets instead. We see most of the unmet iPhone 5 demand, if there is any, being deferred to the following quarter; so the overall impact on Apple would likely be minimal.
The margin impact this quarter will likely be due to the high component costs at the start of any product cycle, exacerbated by the number of new product launches Apple has planned for the holiday season. Over the next few quarters, we expect margins to rebound as component costs fall, but in the long run margins might see a steady decline in a maturing market. Longer term, we also see China contributing heavily to Apple’s growth both in terms of iPhone as well as iPad sales. Accounting for the largely untapped smartphone market in China as well as the subsequent margin pressures due to rising competition, we maintain our $710 price estimate for Apple’s stock, about 20% ahead of the current market price.
China supports iPhone growth story
At close to 55% of Apple’s value, according to Trefis estimates, the iPhone is the single most important product for the company. The iPhone’s global mobile phone market share has steadily increased from zero at the start of 2007 to around 5.4% in 2011 as iPhone unit sales have been growing at an average annual rate of about 90% every year. This year, however, we estimate iPhone sales to grow at less than 45% for the full year despite accounting for what we think will be a strong Q4.
With the smartphone market in developed regions such as the U.S. saturating (U.S. smartphone sales grew y-o-y by just 9% in Q2), Apple will be looking to tap the fast-growing emerging markets such as China to grow at historical rates. China, despite being only in the early stages of smartphone adoption, has already pulled ahead of the U.S. as the world’s largest smartphone market by volume. This is an incredible statistic given that 3G penetration in China stands at only about 18% currently. Considering the huge 2G subscriber base that the Chinese carriers are looking to upgrade to 3G, the potential for Apple to ride the boom is huge.
Apple’s revenues from greater China, which includes mainland China, Hong Kong and Taiwan, grew 26% year-over-year in Q3 and accounted for 15% of Apple’s revenues for the fiscal year.
As the country grows and the average Chinese buyer sees an increase in buying power, we expect to see a growing shift in demand from 2G to 3G smartphones. The iPhone can help Apple tap this phenomenal growth in demand. Currently, the iPhone is available on only China Unicom and China Telecom, the smaller two of the only three Chinese wireless carriers. A deal with the remaining carrier, China Mobile, which is not only the biggest carrier in China but also globally with about 700 million subscribers, could almost double Apple’s addressable market in China. But it seems Apple might have to foot a part of the subsidy bill and take a hit on margins for such a contract to happen. (see Apple Faces China Mobile-Sized Stumbling Block Limiting China Upside Potential)
iPad Mini largely neutral to Apple’s value
The margin pressure that Apple has guided for this quarter is partly because of the launch of lower-margin products such as iPad Mini. While this increases the risk for Apple in case the iPad Mini cannibalizes sales of the higher-margin $399 iPad 2, it should also help Apple defend its tablet share better in the face of increasing competition from the lower end of the tablet market. At our current estimates, the iPad contributes about 13% to Apple’s value but a rapid expansion of the tablet market together with margin improvement due to falling component costs can lead to a bigger iPad contribution. Accounting for the cannibalization risk, however, means that the iPad mini sales upside would, to an extent, be offset by lower iPad 2 sales, indicating only around a 5% upside to our price estimate for Apple’s stock. (see Debunking iPad Mini Rumors – Part III)
In the higher-margin arena, Apple faces a very potent threat in the form of Microsoft’s Windows 8 platform. Microsoft’s recently launched Windows 8, which is being made available on both PCs and tablets, should see a lot of PC and smartphone manufacturers jump in to tap the nascent tablet market. Microsoft has a widely installed PC base in place that it can leverage to incentivize app development and pose a big threat in the young market. Moreover, it can also leverage its Windows Phone partnership with Nokia to push for an integrated experience across all devices, mobile or PCs, in order to create a viable third ecosystem.