Ever since the iPhone 5 went on sale at the end of September, Apple’s (NASDAQ:AAPL) shares have been under tremendous selling pressure. In the last three months, the stock has tumbled by close to 20% despite trading in a quarter that has traditionally been Apple’s best due to the holiday season boost. A number of reasons have been floated by the media to account for the recent fall, including reports about weak PC demand dragging Mac sales down as well as criticism leveled at the iPad mini for not being priced aggressively enough to compete with other low-cost options such as Google’s (NASDAQ:GOOG) Nexus 7 and Amazon’s (NASDAQ:AMZN) Kindle Fire tablets. However, considering that the iPad and the Mac contribute a little more than 10% each to Apple’s value by our estimates, we do not feel that these reasons have a substantial impact on the company’s valuation.
On the other hand, what could pose a significant risk to Apple’s valuation are concerns about a possible supply shortage on the iPhone 5 end which might have caused Apple to potentially fall short of the high holiday demand in 2012. The iPhone contributes about 55% to Apple’s value and, at a time when rivals’ high-end smartphones are being seen as viable alternatives, any supply chain concern in this division could impact Apple’s value greatly. While this concern is valid, Apple’s strong supply chain gives us little reason to believe that the supply crunch has been 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.
In addition, there are concerns that the company’s margins are starting to feel the pressure of competition after Apple guided for the holiday quarter margins to decline by about 400 basis points (4%) sequentially and 800 basis points year-over-year. However, the margin impact will most likely be due to high component costs at the start of any product cycle, exacerbated by the number of new product launches Apple had 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 and 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 35% 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 20% 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 third 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 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) Considering the huge market potential of a China Mobile deal, this might be a compromise that Apple will eventually make – an event that could be the next big trigger for its stock.
While China is a big growth driver for the retail side of the iPhone business, the enterprise is also growing increasingly fond of the iPhone. According to IDC, more number of iPhones and Android smartphone were sold into the enterprise market than BlackBerries last year. Within the enterprise market, while Android was more popular among employees, Apple had a clear lead when it came to employer purchases. Among the phones supplied by employers in 2012, IDC expects that 31 million were iPhones, more than double the number of Android smartphones. With BlackBerry waning in popularity and the BYOD trend catching on, the tight security and the robust app ecosystem of the iOS will continue to help Apple take a bigger share of the enterprise market going forward.