Real Analysis Of Apple's Current Supply Constraint

| About: Apple Inc. (AAPL)

If you've been following me, you're already aware of my full support of Apple (NASDAQ:AAPL) and its future valuation. Apple's core business is in designing and selling premium consumer products, including the iPhone, iPad, iPod, and iMac. Its product lines have consistently experienced tremendous demand, quickly making it the most valuable company in the world.

Apple's key driver for success is its skill in creating exactly what consumers want, how they want it. Through their differentiated business strategy, Apple has penetrated and dominated every market it's entered.

Recent events regarding Apple's developing supply constraint on its iPhone 5 have ushered investor pessimism regarding Apple's ability to realize revenue. To make matters more disappointing, Apple "only" sold 5 million iPhone 5s in its opening weekend, a far cry from the expected 8 million sales. Consequently, Apple lost $67 billion worth of market valuation. Before I continue, I just want to make this point apparent: is it really logical for a minor supply chain hiccup to translate into a $67 billion market devaluation?

Apple's supply constraint: A temporary effect

In our highly complex, technology driven business environment, lean manufacturing has become a key driver. Excess inventory ties up capital and creates risk for companies in terms of theft, write-downs, and storage. With the integration of technology into supply chain management, we've seen the birth of a new beast: Just In Time (JIT) supply chain management. Its premise is simple: maximize profits by optimizing supply chain efficiency. It's a very lean and efficient manufacturing process which minimizes costs, but requires complete precision in coordinating the components of the supply chain and accurately projecting market demand . Because it's such a highly efficient process, holding large quantities of inventory isn't required to fulfill market demand; however, if actual market demand outpaces expected demand, companies typically won't be able to fulfill most orders immediately because of reduced inventory holdings.

Essentially, the leanness of the supply chain becomes a double-edged sword. As long as companies, like Apple, can precisely coordinate all aspects of the supply chain and accurately project market demand, everything will run smoothly; however, if even one component of the supply chain fails, it can be damaging in the short-term. Unfortunately, we've seen Apple's largest component of its supply chain experience trouble over the past weeks. Foxconn (OTCPK:FXCNF), who employs over 1 million workers in China, has experienced labor issues with employees literally walking out of work during their shifts. The reason: Apple's demand for quality and quantity of production. Consumer complaints regarding scratches on their brand new iPhone's prompted Apple to demand increased quality control from Foxconn's management, which translated to increased working pressure at the already difficult job site. Essentially, it became the straw that broke the camel's back.

Expected Effects of the Foxconn Situation

So far, Apple has experienced a $67 billion devaluation since issues regarding its supply chain surfaced and flooded the media. From how it has been portrayed, it seems like Apple is on the brink of losing all its iPhone 5 sales just from a supply chain hiccup. This is simply untrue and we've experienced a tremendous market overreaction.

In sifting through the excess 'noise', here's what we know: Foxconn has assigned 250,000 employees to work solely on Apple products; let's assume, for sake of conservatism, that only 125,000 are assigned to the iPhone 5 during its opening debut (although the number of employees are likely to be much higher). From what different reports have stated, the number of employees who went on strike ranges from 300-4,000 which accounts for only 0.24%-3.2% of the total iPhone workforce. Reports also indicate that the strike only lasted two hours of the day, or only 8.33% of a 24-hour day schedule. So, when taking into account the relative size of the workforce and the relative time of the strike, it only affected Apple's production by 0.002%-0.26% of the entire day's production. These figures were calculated simply through logic and reinforce my analysis that Apple losing $67 billion in market valuation has been far overblown and, in my opinion, has created a long-term buying opportunity.

The likely effect of recent events is that Apple will end up deferring a majority of its iPhone revenueinto its December quarter, rather than realizing it in its 4th quarter ending in September. The cause of this is not only because of Apple's supply chain holdup, but also because of GAAP accounting standards, which mandate corporations to realize revenue upon delivery to the end consumer. From what many already know, Apple had to delay much of its pre-order deliveries into the following quarter, which would delay the accounting of revenues into the holiday quarter rather than being captured during the 4th quarter. This accounting practice may also account for Apple's "miss" of only 5 million unit sales, which inaccurately portrays the actual demand for Apple's iPhone 5.

The Bottom Line

The issue really wasn't that demand has outpaced supply, but rather, supply couldn't support the demand during the opening week (there's a subtle difference). It's true that demand for Apple's iPhone 5 has been tremendous; however, because of Apple's JIT supply chain system, even the smallest hiccup in the supply chain causes a larger effect on the production process. Investors are worried that Apple won't be able to deliver its iPhones quickly enough and may lose consumers (thus, affecting the bottom line). Ultimately, this is actually true. Out of the tens of millions of consumers who want the iPhone 5, some will jump to competitors like Samsung and Google (NASDAQ:GOOG) to avoid waiting; however, I'm arguing that this effect will be minuscule. The iPhone 5's release has been the most anticipated smartphone release in history and consumer demand has been tremendous and will remain strong, despite the supply chain issues. I'm also arguing that the extreme pessimism that has surrounded Apple has caused its shares to become oversold and, consequently, undervalued.

Currently, Foxconn has regained control of its production and will have to focus on improving employee training and providing better benefits to avoid similar issues arising in the future. Apple, on the other hand, will have to diversify its supply chain from Foxconn or work on creating a more intimate relationship with its largest manufacturer.

Disclosure: I am long AAPL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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