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iPhone Production Cuts: 3 Key Questions to Ask

By Adam Levine-Weinberg - Jan 10, 2016 at 7:35AM

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Recent reports about deep production cuts may not be as meaningful as they seem on the surface.

Shares of Apple (AAPL 1.24%) have lost more than a quarter of their value in the last six months as investors have worried about a possible iPhone sales slump this year. These worries have intensified in the past few weeks as a slew of Apple's suppliers have provided disappointing sales outlooks.

Is Apple dramatically cutting iPhone production? Image source: The Motley Fool.

In the past week, the biggest damage came from a report in Japan's Nikkei Asian Review that Apple had told suppliers to plan on a 30% year-over-year output cut for its flagship iPhones during the first quarter of 2016.

Investors should take this report with a grain of salt. Three years ago, in the midst of similar reports about iPhone order cuts, Apple CEO Tim Cook warned analysts that supply-chain data was not a reliable proxy for Apple's sales. (For the quarter in question, iPhone sales ultimately rose 7% year over year.)

But even if this new Nikkei report is factual, it's not necessarily as negative for Apple as investors seem to think. The impact of this production cut -- assuming it's real -- depends on the answers to three key questions.

When were production cuts implemented?
The first big question has to do with the timing of any production cuts. Nikkei claims that Apple initially intended for combined production of the iPhone 6s and iPhone 6s Plus this quarter to be in line with its iPhone 6 and iPhone 6 Plus production in the year-ago period.

If Apple only told its suppliers about a 30% output cut in the last few weeks, it probably still has enough component inventory to maintain production at a higher rate during January. And January is the busiest month of the quarter for iPhone production under any circumstances, due to the Chinese New Year holiday (a big demand driver in China) falling in February.

Unless Apple cut its iPhone production at the beginning of January -- in which case it probably would have needed to slash component orders in November -- the actual year-over-year decline in production of flagship iPhones this quarter would be less than 30%.

Are older iPhones picking up the slack?
Second, the Nikkei report stated that the production cuts only affected the iPhone 6s and iPhone 6s Plus. Meanwhile, older models like the iPhone 6 and iPhone 6 Plus "have continued to sell."

That's not especially surprising. If the iPhone 6s and iPhone 6s Plus aren't selling well because consumers don't see them as a big upgrade over their predecessors, it makes sense that the discounted iPhone 6 and iPhone 6 Plus models seem appealing by comparison.

Strong sales of older models could offset sales declines for the flagship iPhones. Image source: Apple.

The real question is just how well these older models have continued to sell. Combined sales of the iPhone 6 and iPhone 6 Plus in this fiscal year should easily exceed sales of the iPhone 5s a year ago. Sales increases for older models could go a long way toward offsetting a year-over-year sales slowdown for Apple's flagship phones.

Is this a short-term inventory correction?
A third question is how long a potential iPhone production cut would last. Even a double-digit sales decline for a single quarter wouldn't be that bad if iPhone sales were flat or rising during the rest of the year. On the other hand, several quarters in a row of double-digit iPhone sales declines would significantly cut into Apple's earnings.

From this perspective, too, the outlook isn't as dire as the headlines suggest. Apple's suppliers were reportedly told that the planned production cut for the first quarter was designed to reverse some unwanted channel inventory growth. By April, production will return to normal, if the story is accurate.

If the rumors that Apple will begin selling a new 4-inch iPhone in April are true, that would further support sales in the second half of the 2016 fiscal year, which runs through September.

No reason for panic
The recent tumult has driven Apple shares back into double-digit territory, where they trade for less than 10 times forward earnings (particularly when you adjust for Apple's still-massive cash hoard). However, investors are wrong to panic.

This week's Nikkei report is a great example of a story that appears extremely troubling on the surface but actually conveys mixed news -- some good and some bad. Analysts who are now projecting steep iPhone sales declines for the rest of the 2016 fiscal year are probably overreacting.

Finally, it's worth remembering the old adage: "The darkest hour is just before the dawn." No matter what happens with iPhone sales in the next two or three quarters, Apple will probably be pumping out record quantities of the iPhone 7 this fall. By then, investors will have completely forgotten the worries that haunt them today.

Adam Levine-Weinberg is long January 2016 $80 calls on Apple and short January 2016 $120 calls on Apple. The Motley Fool owns shares of and recommends 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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