Apple Sell-Off Looks Overdone

We still see little evidence of share erosion for Apple at the high end of the market, and any shortfall in sales may stem from sluggish macroeconomic conditions or longer replacement cycles as iOS users delay upgrades. Either of these factors could lead to pent-up demand for new iPhones later this year or beyond. We consider Apple's competitive position in mobile computing to be as strong as ever, yet shares around $100 are priced as if the iPhone will never grow again, which we think is possible but unlikely as we see the iOS ecosystem creating customer stickiness. We are maintaining our $140 fair value estimate for Apple and consider it one of the better investment ideas in technology. We will update our valuation after the firm's fiscal first-quarter earnings report scheduled for Jan. 26, which may confirm or refute our near-term thesis. We are maintaining our narrow moat rating.

Ultimately, we think reported production cuts might not be mutually exclusive from Apple's prior revenue forecast or our estimates for near-term iPhone unit sales. We can start our analysis by looking at The Wall Street Journal's report from July 2015, where Apple asked manufacturers to build 85 million-90 million iPhone units for the December quarter (we should note that a similar Journal report from last year, which reported a 70 million-80 million unit build for the iPhone 6, appeared overly optimistic at first but turned out to be spot on). We estimate that Apple's revenue forecast of $77.5 billion (at the high end) from October implies iPhone sales in the mid- to high 70 million unit range, in line with our estimates. If Apple built as many as 90 million iPhones (perhaps prepping for an even hotter 6s launch) but sells "only" 78 million units as we project, then as many as 12 million units of iPhone inventory, or a 13% overbuild, may need to be digested.

We think certain component order cuts appear reasonable in the light of a possible 13% or so inventory build. Avago's forecast essentially called for a low teens year-over-year decline in radio frequency chip revenue, as Apple and Android customers may see sales decline at the same pace. Meanwhile, Dialog Semi, which has enormous customer concentration with Apple, also cut its December revenue forecast 10%.

A Nikkei report suggested that iPhone production in the March 2016 quarter was initially expected to be even with a year ago (a quarter in which Apple sold 61 million iPhones), but will now be down 30%. If we again assume 12 million units of inventory digestion, then Apple could still achieve flattish year-over-year sales in March even if production were cut 20%. A 30% cut, if true, would imply mid-50 million iPhone unit sales in March and a mid- to high-single-digit decline from a year ago. China is the key region to watch for March iPhone sales, in light of the Chinese New Year, and macroeconomic conditions may be muting demand for the device. On the competitive front, Huawei appears to be gaining share in the region, selling 108 million smartphones globally in calendar 2015, and perhaps price-sensitive customers are opting for lower-priced Huawei phones over low-end iPhones. Yet we suspect that Huawei's share gains are even more likely to be coming from other Android players like Samsung and Xiaomi, rather than solely from Apple.

In the end, we can't rule out the possibility that Apple will announce a year-over-year decline in iPhone unit sales. However, if our analysis is accurate, then a dramatic fall-off in iPhone sales might not be happening after all, while the sell-off in Apple's stock would probably be well overdone.