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Apple a Bargain Even With Tepid iPhone 5 Launch

Reports that Apple has cut its component orders could mean that demand for the iPhone 5 is waning, but shares still look undervalued, says Morningstar's Brian Colello.

Brian Colello, CPA, 01/14/2013

We are maintaining our fair value estimate for Apple AAPL after reports from the Wall Street Journal and Japan's Nikkei news service indicate that Apple has cut component orders for the March quarter by as much as half for the iPhone 5. The implication is that demand for the iPhone, especially in emerging markets, is weaker than anticipated, thus adding risk to Apple's near-term earnings and perhaps its long-term growth potential. However, we believe that such bad news is more than baked into Apple's share price today.

We certainly recognize these headlines as adding another layer of risk to Apple's forecast for the March quarter, which will be announced on Jan. 23. However, we don't see the news as having much of an effect on Apple's December quarterly results. 

AT&T's T and Verizon's VZ recent announcements of strong smartphone unit sales in the December quarter bode well for a healthy iPhone 5 launch in the December quarter, at least in the United States.

Regarding the component order cuts, the news articles cite that Apple's forecast was for 65 million iPhone screens in the March quarter. If accurate, we suspect that such a forecast would have been unrealistically high to begin with and that some degree of order cuts should have been expected. Using rough calculations, and without knowledge of screen orders in either prior or future quarters, if we assume that Apple made a similar forecast for the prior quarter for at least 65 million screens (which seems reasonable, if not conservative, given the timing of the iPhone 5 launch), and considering consensus estimates for roughly 50 million iPhones to be sold in the December quarter, Apple could have 15 million excess units of screen inventory on hand entering the March quarter, even with a solid iPhone 5 launch. If Apple in fact cut its March screen orders in half to the 35-million-unit range, this implies that Apple could still be reasonably expected to sell at least 40 million iPhones, if not 50 million, in the March quarter, which we would consider to be a strong number. We should also note that screens were believed to be an area of component shortages for Apple just a couple of months ago. As is common in the handset component supply chain, shortages one quarter may lead to double ordering and, thus, order cancellations once supply and demand come back in to balance. The forecast of 65 million units may imply double ordering across Apple's multiple suppliers, believed to be Sharp, Japan Display, and LG Display. The reports indicate that Japan Display will cut its orders by 80% from the December quarter, while orders to Sharp will decline by 40%. Given Sharp's recent financial struggles, double ordering from the other two screen suppliers may have been a case of reasonable risk management, with perhaps additional orders with Japan Display being the backup plan that is now being canceled. We cannot rule out the risk that these supply chain issues may truly be a result of tepid demand for the iPhone 5, especially in emerging markets, and perhaps the news reports rule out the chance of an absolute blowout March quarter for Apple, but we also believe there is a good chance that these supply chain bumps may not be all that closely related to Apple's sales to end customers, and that such a possibility is not factored into Apple's stock price.

More importantly, we believe that these news reports are already priced into Apple's stock price at this point, and we still view the stock as attractively valued today. We believe that a scenario with a tepid iPhone 5 launch with only modest annual growth is already priced into Apple's stock price in the low $500 range. While these news reports provide some evidence of such a bearish launch, we think that Apple's stock price implies that there is no chance that these supply chain issues are just noise and will not hamper iPhone demand in early 2013, and we're fond of such a risk/reward opportunity today. Given the $128 per share of cash that Apple has on hand, our estimates of at least $48 of EPS over each of the next five years, the potential for better-than-expected iPad growth, and perhaps new innovations like Apple TV products, we still see Apple as attractively valued today.

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Brian Colello, CPA is a senior stock analyst with Morningstar.

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