After peaking at $700 in September 2012, Apple (NASDAQ:AAPL) has declined by almost 30% in four months and is now trading below $500 for the first time in almost a year. A big reason for the current dip has been multiple press reports about Apple cutting component orders for the iPhone 5, which have fueled concerns over a possible slowdown in iPhone demand. Considering that the iPhone is the single biggest driver for Apple and accounts for over half of the company’s value by our estimates, the intense market nervousness is understandable. However, while cutting orders may mean that Apple is starting to see competitive pressures on iPhone demand, it is not necessarily the only reason why Apple may have wanted to slow the production.
Firstly, Apple could have placed a huge manufacturing order for the iPhone 5 initially anticipating supply chain bottlenecks and that the smartphone may have been difficult to manufacture with good yields initially. As yields improved over time, however, Apple may have decided to cut orders to avoid channel overfill and manage its working capital better. Secondly, coming off a potentially strong holiday quarter, iPhone demand is naturally expected to see a slight slowdown in the next quarter. Thirdly, there has been speculation that Apple could release a new iPhone every six months instead of its usual yearly cycle. If so, it would make sense to cool down manufacturing in the quarter ahead of the new phone’s launch.
Additionally, going forward, we see untapped opportunities in China (an in-the-works deal with China Mobile should be the catalyst) and the enterprise contributing heavily to Apple’s growth both in terms of iPhone and iPad sales. Accounting for that as well as the subsequent margin pressures due to rising competition in a maturing market, we maintain our $710 price estimate for Apple’s stock, about 45% ahead of the current market price.
China Key To Sustainable iPhone Demand
With the smartphone market in developed regions such as the U.S. getting more saturated (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. This was borne out by the opening weekend sales for the iPhone 5 in China last month, which crossed the 2 million mark and made it Apple’s best ever launch in the country. We expect the launch to help shore up Apple’s market share in the region, which dropped to the sixth place in Q3 as people deferred purchasing an iPhone in anticipation of the new release.
However, Apple currently sells the iPhone through the smaller two of the three carriers in the country, China Unicom and China Telecom. A deal with the largest wireless carrier in the world, China Mobile, remains elusive until Apple can work out a subsidy deal with the carrier. How soon that will happen is open to speculation considering the Chinese government’s possible opposition to the huge iPhone subsidies. (see Apple’s China Potential Could Be Limited By A Subsidy Compromise With China Mobile) But knowing that the carrier’s 3G growth has been hurting due to unavailability of the iPhone, such a deal should not be too far along. This deal is very important for Apple as it can instantly double the iPhone’s current addressable market in China and act as the next big boost to its stock. (see Apple Could Have A $750 Fair Value If China Mobile Deal Works Out)
The important thing to note here is that despite not having a China Mobile deal, Apple hasn’t performed too badly in China so far. Revenues from greater China, which includes mainland China, Hong Kong and Taiwan, in the September quarter grew 26% year-over-year and accounted for 15% of Apple’s revenues for the fiscal year. This brought Apple’s FY2012 revenues from the region to about $24 billion, about 80% growth over FY 2011.
As the country grows and the average Chinese 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. Penetrating China could however mean margin pressures as the company negotiates carrier subsidies with China Mobile and competes with the increasingly popular Android phones. With cheap Android smartphones seeing huge demand and the pricing war gradually dragging prices down to sub-$100 levels, Apple will do well to avoid this segment for as long as it can without sacrificing growth. It therefore bodes well that Apple is only just getting started in China and has ample opportunity to drive sales in the country without having to drop prices anytime soon. A deal with China Mobile is however key to unlocking most of that potential.
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 iPhones and Android smartphones were sold in 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 – implying an increased comfort level of enterprises with the iOS. 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 should continue to help Apple take a bigger share of the enterprise market going forward.