Are Apple Investors Crazy?


So far, investors have been pretty displeased by Apple's recent iPhone update. By the close of trading on Monday, Apple shares had fallen to just $450, more than 10% below where they stood a week earlier.

AAPL Chart
AAPL Chart

Apple 1-Month Price Chart. Data by YCharts.

Apple's fall seems to be largely a reaction to the company's decision to charge $549 for the unlocked iPhone 5c in the U.S. (and more in most foreign countries). Investors are particularly worried that Apple will struggle to grow without a cheaper iPhone.

However, these concerns are overblown. In fact, Apple's pullback over the past week has created a great buying opportunity for investors who missed out on the stock's summer run-up.

Reasons for panic
Most of the investment community was blindsided by Apple's decision to introduce the iPhone 5c at a premium price point, rather than making it an entry-level phone. Many analysts are now worried that iPhone sales will fall short of their prior estimates, due to the lack of a $300-$400 iPhone.

The iPhone 5c turned out to be more expensive than most analysts expected (Photo: Apple)

If anything, the initial downbeat reaction has been increased by the apparently slow pace of iPhone 5c pre-orders. Apple began taking iPhone 5c pre-orders last Friday, and most colors and options are still available for delivery this Friday (the release date).

Moreover, Apple did not release a pre-order total on Monday, as it has generally done for recent iPhone launches. Analyst Gene Munster of Piper Jaffray believes that customers may have pre-ordered 1 million iPhone 5cs in the first 24 hours of availability, far less than the 2 million iPhone 5 pre-orders achieved in the first 24 hours last year.

Don't sweat the demand
There are a few reasons why investors should take all of these findings with a grain of salt. First, the iPhone 5s -- Apple's new top-of-the-line model -- hasn't even been available for pre-order. Devoted Apple fans are more likely to want the 5s rather than its less-powerful sibling. In the U.S., the $100 price difference between the two models is not a big stumbling block, compared to the overall cost of smartphone service.

Second, some analysts have pointed out that iPhone 5 supplies were very tight initially, due to manufacturing challenges. By contrast, the iPhone 5c's plastic casing and similarity to the iPhone 5 have probably helped Apple avoid similar supply constraints. In other words, it's not necessarily a bad thing that the iPhone 5c is still in stock.

Finally, many smartphone users in the U.S. -- still the largest iPhone market by far -- upgrade every two years. Since the iPhone 4S was released in October of 2011, much of the U.S. upgrade demand may be pushed out to October and thereafter. By contrast, the iPhone 4 was released in June 2010, so last year there were plenty of people who had already reached the two-year mark and were ready to upgrade when the iPhone 5 was released in September.

It's also worth noting that Apple's new agreement with Japan's largest wireless carrier, NTT DoCoMo, opens up a large new market. Apple is already the leading smartphone vendor in Japan, and this partnership should further entrench Apple there. A deal with China Mobile, the largest carrier on the planet with over 700 million subscribers, is probably not far behind.

Margin benefits
Thus, the apparently negative demand data that has trickled out over the last week is not so clear-cut. This is not the first time that Apple-watchers have predicted doom, and so far iPhone sales growth has continued. Therefore, I am inclined to give Apple the benefit of the doubt for now.

On the flip side, as I wrote last week, Apple's new iPhone strategy should be very good for the company's margins. The iPhone 5s maintains the iPhone 5 form factor, which should help Apple avoid a repeat of the spike in production costs seen last fall. Moreover, the iPhone 5c is cheaper to produce than the now-retired iPhone 5, because it uses a plastic casing.

One potential hiccup is that yields for the iPhone 5s fingerprint sensor have been low so far. This could weigh on Apple's gross margin, but more importantly could impose severe supply constraints for several months.

Foolish bottom line
If Apple can ramp production effectively this fall (which primarily means improving yields of the fingerprint sensors), the company should be able to return to solid earnings growth. Last year's drop in margin creates relatively easy comparable earnings figures for Apple to beat.

The margin benefits of Apple's current strategy -- compared to the alternative of releasing a cheaper iPhone -- give Apple the ability to grow EPS even without rapid sales growth. This fact seems to have been overlooked amid all of the panic-selling in the past week. (Moreover, iPhone 5s supply seems more likely to be a constraint on sales than tepid demand.)

Apple trades at around eight times expected fiscal year 2014 earnings, if you subtract its substantial cash reserves. This sort of valuation is only appropriate for a broken company. Savvy investors should therefore view Apple's recent drop as a good buying opportunity.

It's the Apple way
Apple has a history of cranking out revolutionary products... and then creatively destroying them with something better. Read about the future of Apple in the free report, "Apple Will Destroy Its Greatest Product." Will Apple really disrupt its own iPhones and iPads? Find out by clicking here.

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Fool contributor Adam Levine-Weinberg owns shares of Apple and is long January 2015 $390 calls on Apple. The Motley Fool recommends Apple. The Motley Fool owns shares of Apple and China Mobile. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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