Apple (NASDAQ:AAPL) shares plunged more than 5% on Tuesday after China's central bank moved to devalue its currency, the yuan. The 2% devaluation represented the first time China had devalued its currency in more than two decades. The yuan fell about 1% further on Wednesday.
To some extent, the Apple stock sell-off may simply reflect a belief that this devaluation is an indicator of worsening economic conditions in China. However, many investors and analysts seem to think that the devaluation itself is bad for Apple. On that point, they probably are mistaken.
How China's devaluation could (theoretically) hurt Apple
China is an important and rapidly growing market for Apple. Last quarter, Apple's sales in the Greater China region -- which includes Hong Kong and Taiwan as well as mainland China -- more than doubled year over year. The region accounted for 26.7% of Apple's quarterly revenue.
The pessimists believe that this large and growing revenue exposure to China means that a weaker yuan could hurt Apple's sales growth. As international currencies weaken, Apple has to choose between two unpalatable options. Either it can keep its local-currency prices constant and receive less cash when converting those sums into dollars, or it can raise local-currency prices and risk a drop in unit sales.
Apple has a powerful brand and thus has significant pricing power. That said, a falling currency is usually a symptom of a relatively weak economy. Raising prices in that environment risks driving away a significant number of customers.
These issues have led to a lot of ominous headlines this week. For example, The Wall Street Journal announced: "Devalued Yuan Set to Take Bite Out of Apple" and the San Jose Mercury News wrote, "China's devalued currency could hit Apple hard."
This is a minor event
While a big devaluation in China could hurt Apple's revenue, a 2%-3% currency swing would not normally be news. It has only attracted attention because China manages its currency so tightly and hasn't devalued it in a long time.
Last month, Apple CFO Luca Maestri noted that falling foreign currencies created an 800 basis point revenue headwind last quarter. Apple still reported strong results. By contrast, the recent yuan devaluation would impact Apple's revenue by less than 100 basis points: not an especially significant amount.
Even a large devaluation probably wouldn't hurt
Apple bears might argue that even if a 2%-3% devaluation won't hurt Apple much, this could be just the start of further currency weakening in China. Eventually, the revenue hit will be significant enough to become a real worry for Apple investors.
However, most of the market seems to be overlooking the cost benefits that Apple is likely to get from a cheaper yuan. Not only are most Apple products assembled in China, but the vast majority of the components are made there, too. This means that it's cheaper to make iPhones and iPads now than it was at the beginning of the week.
Numerous analysts have noted -- correctly -- that Apple pays most suppliers in dollars. As a recent Moody's report stated, "... [A]lthough much of Apple's products are assembled in China, the company would not immediately see cost benefits from its Chinese sourcing because most of the manufacturing and assembly arrangements are denominated in US dollars." (via Barron's)
Nevertheless, while Apple wouldn't see "immediate" cost benefits, it has huge bargaining leverage over its suppliers, who are mainly providing commodity products and services. When the next round of negotiations comes up, it seems virtually certain that Apple will capture nearly all of the cost savings that comes with a cheaper yuan.
In the next quarter or two, the recent yuan devaluation could potentially hurt Apple -- but only a bit, because the magnitude of the devaluation was so small.
Longer-term, a cheaper yuan is at least neutral and perhaps better for Apple from a profitability standpoint. That's because it will eventually capture the vast majority of the cost savings that would come from manufacturing in China. (Additionally, a cheaper yuan should encourage stronger economic growth in China, which could boost demand for Apple products in the long run.)
As a result, investors should ignore all the noise -- and the panic -- in the market surrounding China's surprise yuan devaluation. This isn't going to hurt much in the near term, while in the long run it could help drive Apple's profit even higher than it already is.
Adam Levine-Weinberg has the following options: long January 2016 $80 calls on Apple, short January 2016 $120 calls on Apple, and short January 2016 $140 calls on Apple. The Motley Fool recommends Apple. The Motley Fool owns shares of Apple. 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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