Conflicting tones from J.P. Morgan teams in the U.S. and Hong Kong left Apple (AAPL) shareholders scrambling Monday. The stock’s volatile day was driven by concerns that Apple may, in fact, be of the earth. Reports of order cutbacks at iPad component vendors could indicate the market’s favorite electronics play may not be immune to global economic pressures and may have a measurable market to operate in after all. Previously, the company’s amazing growth and strategic prowess had many believing Apple would continue expanding its market and stealing market share forever. Now, the question has been raised on what appears to be a tangible red flag: Is Apple’s growth tiring? Read on, as I examine the possibilities and explain why I still like AAPL.
Apple shares tumbled 3.2% in early morning trading Monday on a J.P. Morgan Chase report indicating Apple had cut its fourth quarter orders from iPad supply vendors by 25%. The Hong Kong based analytical team covering the vendor firms (not Apple) wrote that this was the first such cut from Apple they had ever seen. The news impacted Apple shares immediately, but before the day’s close, U.S. based analyst Mark Moskowitz, who follows Apple for J.P. Morgan, reaffirmed his projections for iPad unit shipments for Q3 and Q4. The differing tones of the analysts does not resolve for me what appears to be a red flag indicating Apple’s growth may finally be tiring, at least with regard to the tablet market, where it enjoys an unsustainable share of market.
The stock recovered by the close of trading, and ended the day down by only 0.3%, to close the day at $403.17. It would take a lot to drive sustained decline in Apple shares ahead of its pending iPhone 5 introduction, which is scheduled for October 4. Apple fanatics, market players and shareholders have been so spoiled by past product launches that the shares have solid cushion heading into the release.
Still, are investors ignoring what appears to be a significant red flag? Analysts pay close attention to supply chains for the important information they provide, and I know because I was an analyst before repenting. The way things developed in this matter led me to question the integration between the investment offices, and I sensed some firefighting going on from the U.S. end.
In defense of the American analyst, there is more than one reason why a vendor might see a drop in ordering. The most likely is a drop in sell-through, which in this case would be due to demand softness on economic uncertainty and a decline in consumer comfort. Otherwise, I suppose Apple could have moved some business to other vendors, but it seems that information would likely have been known and included in the report.
This seems to also be less likely given that several vendors have reportedly experienced similar cutbacks. It is possible Apple is engineering a faster cycle toward the introduction of the next generation iPad. It could also be that Apple simply wields great power over its vendors, and locked them up with huge orders to keep them from producing product for competitors. Apple is now in such a market share lead that it can pull back such an order before delivery without much threat from competitors this holiday shopping season. Finally, a 25% cutback in orders may still produce enough to satisfy analysts’ forecasts, as only Apple insiders know the difference between what they’ve communicated externally and planned internally.
Gartner Group estimates Apple has roughly 73% of the tablet computer market share, based on sales, with serious competition anticipated shortly from Amazon.com (AMZN). Tablets that use Google’s (GOOG) Android Operating System may have 17% share this year, says Gartner. Unless Apple is about to reinvent its iPad with a completely new look or advanced technology, which perhaps could require it to change vendors (or one of the other strategic options listed earlier is in play), I would have to incorporate into my view for AAPL the risk that the driver of the reduction in orders could be due to a troubled consumption environment. It’s an undeniable reality after all.
And really, how long can this kind of growth for this sized company last anyway? Yahoo Finance has Apple’s earnings growth for the last five years at an astounding average annual pace of 61.15%. The analysts’ consensus for the next five years is 22.5%, again based on Yahoo Finance and its data sources. The P/E ratio for Apple is only 14.6X, giving it a P/E/G ratio of 0.65, which under most circumstances would scream buy to me. The problem is that Apple is now charged with defending large market share positions in its mobile phone and tablet operations. The tablet market position in particular might not be defendable, given well capable competitors. The company is set to release a new iPhone on October 4, which some say will be radically new and remarkable; others see the release as simply an upgraded product. Apple likely has more market share opportunity in the mobile business, where it has already left a trail of destruction striking the likes of Palm, now at Hewlett-Packard (HPQ), Nokia (NOK), Motorola (MMI) and Research In Motion (RIMM).
I would be more cautious on the stock if not for my belief that the company will make a significant, new product market entry over the coming year that could help it sustain stellar growth. This is an intangible, and I’ll cover this idea in a later report, so stay attuned to my article thread.
Given the valuation and the history, I cannot outright mark Apple a sell recommendation today and continue to claim sanity. In fact, despite this news with regard to the tablet vendors, I would continue to favor AAPL at this point, though with less enthusiasm than before the story broke. This certainly bears watching, but given the iPhone release coming in just days and what I expect for the next year, I continue to favor AAPL. Apple’s valuation is attractive for as long as it can sustain its market share position and as long as its markets do not contract, or if it can breach new product markets as successfully as it has in the past.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
