Last month, with Apple (NASDAQ:AAPL) trading near $690, I suggested that the stock was likely to pull back before moving higher. I urged investors to wait for the price to drop to at least $650 before adding shares (with the one caveat that investors should also consider buying if Apple added China Mobile (NYSE:CHL) as a carrier partner). At the time, I was worried about supply issues holding back iPhone 5 sales, the possibility of disappointing guidance for Q1FY13, and the difficulty of year over year comps (all three issues are inter-related).
Since then, Apple shares have pulled back even further and faster than I expected. In the five weeks since my initial call, shares are down more than 10%, closing Friday at $609.84. As I expected, the iPhone 5 launch did not go as smoothly as some expected; massive supply shortages have been the order of the day. Verizon's (NYSE:VZ) management discussed these shortages on last week's earnings call, and suggested that supply could be constrained through the end of the year. One month after the iPhone 5 went on sale, Apple is still reporting a 3-4 week shipping delay for online orders. Given that Black Friday (the beginning of the busy holiday shopping season) is less than five weeks away, it seems very unlikely that Apple will be able to clear its order backlog during the current quarter.
Putting aside the supply constraints, the iPhone 5 has been criticized for a variety of defects. Apple's new mapping software does not work nearly as well as Google (NASDAQ:GOOG) Maps (which it replaced); many users have reported a purple glare in photos; and many iPhones have come out of the box scratched. I expected some post-launch choppiness based on previous iPhone launches. The iPhone 4 launch was followed by "Antennagate"; user complaints about dropped calls due to a new antenna design. Similarly, many users claimed that Apple had exaggerated Siri's functionality after the launch of the iPhone 4S last year. Neither of these previous scandals did any noticeable damage to Apple, as the iPhone's popularity has continued to grow.
I expect the story to play out in much the same way with the iPhone 5. In fact, Consumer Reports, which criticized the iPhone 4's design after "Antennagate", gave the iPhone 5 a very positive review in spite of its faults. Nevertheless, some analysts and investors have recently argued that Apple's growth days are over. Apple bulls, by contrast, think the stock is headed to $1000 in short order. The iPhone 5 supply shortage makes it hard to judge who is right. We do not know exactly how many units are being produced on a weekly basis, and we cannot accurately judge the level of iPhone 5 demand given that the sales rate is being dictated entirely by supply.
Fundamentals-driven arguments about Apple ultimately revolve around the exact level of growth in iPhone sales, because the iPhone contributes the majority of Apple's profits today. I expect iPhone unit sales to be up 25%-35% year over year in FY13 because I think the larger screen will drive upgrades as well as some market share gains vis-a-vis Android. Hitting the high end of that range depends on adding China Mobile at some point in 2013 to better penetrate the Chinese market.
However, iPhone sales would have to reach 48 million in the current quarter (Q1FY13) to hit 30% growth (the midpoint of my FY13 estimate). Given my estimate of the supply situation, I think Apple will struggle to sell much beyond 45 million units this quarter. The bulk of growth will be in Q2 and beyond, as it will take longer to meet initial demand and fill the channel to "normal levels", relative to the iPhone 4S launch. Prominent Apple bears like Doug Kass disagree. Whereas I think the iPhone 5's full strength will not be revealed until Q2 and beyond, Kass makes the exact opposite argument. He claims that the iPhone 5 is a very ordinary device, and that once Apple fulfills orders from enthusiasts this quarter, we will see a sharp drop-off in sell-through. I don't think his representation of iPhone 5 demand is accurate, but we will not know for sure until 2013, when the hard evidence will arrive.
Nevertheless, I think the upside for Apple investors significantly outweighs the downside at this point. Even Apple bears generally assert that earnings growth will slow to the single digits, not that earnings have peaked. But Apple is trading around $480/share excluding cash, only 11X trailing EPS of roughly $44-$45 (assuming analyst estimates for the September quarter are not too far off). At that valuation, the downside is minimal even in a low-growth scenario. So while the stock could dip below $600 depending on the market's reaction to Apple's two big events this week, the long-term downside appears to be minimal.
After my article was released last month, the majority of commenters disagreed. The most frequent comment was that in the past, investors waiting for Apple to pull back before buying have missed out on a lot of upside. At the time, I thought that the risk of a correction outweighed the near-term upside, given the uncertainty of the iPhone's growth trajectory. However, at $610, the risk-reward profile is much more compelling, even though some of the same questions about iPhone growth remain unanswered. At this point, I would agree that waiting for a better price risks missing out on too much upside. Accordingly, I re-opened my long position in Apple on Friday afternoon.