Apple Inc. (AAPL) Supply Chain Rumors Point to New Products

Apple Inc. (NASDAQ:AAPL) CEO Tim Cook has offered some sage advice to analysts: even if a supply chain rumor is accurate, it's impossible to interpret accurately what it means for the overall business.  This hasn't stopped analysts from trying, however.  In a survey of Apple Inc. (NASDAQ:AAPL) supply chain rumors going back more than a year, I found that they were a very poor predictor of financial performance for any given Apple Inc. (NASDAQ:AAPL) product or for Apple Inc. (NASDAQ:AAPL) as a whole.  However, I did find that the rumors correlated well with subsequent new product introductions.

Apple Inc. (NASDAQ:AAPL)

Supply chain momentum

It's not always easy to see the correlation, since the rumors often erupt months in advance of the actual announcement of the new product.  This is because there's a lot of lag built into the procurement process for any given Apple Inc. (NASDAQ:AAPL) device. The iPhone 5 that a consumer buys today contains some parts that were ordered as much as 6 months before the purchase.  Think of the supply chain as a huge, fast-moving freight train.  Bringing the train to a halt requires applying the brakes long before its expected to stop.

Google Inc (NASDAQ:GOOG) has recently gotten a lesson in supply chain management courtesy of Motorola Mobility.  Google Inc (NASDAQ:GOOG) execs noted at their last earnings conference call in January that it was taking a lot longer than they expected to work through Motorola's product pipeline, fully 7 months after the acquisition was finalized. In Q4 2012, Google Inc (NASDAQ:GOOG) reported an operating loss for Motorola of $353 million.

Survey results

I searched for “Apple Inc. (NASDAQ:AAPL) supply chain rumors” on the web and pulled results going back as far as 2011. As you might expect, the rumor results occurred in clusters in which the source of the rumor was re-reported many times by other sites.  I found 5 clusters of rumors pertaining to the iPhone and iPad, in 2011 and 2012, all reporting significant drops in component parts orders.

Various explanations for the order decreases were offered in the rumors. In 3 out of the 5 clusters, new product introductions were anticipated, while the other two cases were attributed to weak demand.  In 4 out of the 5, including all the cases where new products were anticipated, the rumor clusters were followed in about 6 months by a new generation iPhone or iPad.

The rumors of cutbacks in the supply chain due to weak demand (2 out of the 5) were either partly or completely wrong.  In November 2011, DigiTimes reported that iPhone 4s component orders were down due to weak Q4 demand.  In fact, iPhone unit sales rose spectacularly by 133% y/y to 24.4 million in the quarter.  In September 2011, JPMorgan Chase reported iPad 2 order cuts due to reduced global demand.  In Q4 2011 iPad sales increased by 99% y/y, although there was a new iPad rolled out in March 2012, so the rumor may have been partially correct.

My conclusion from this limited review of supply chain rumors is that while they aren't predictive of financial performance, as Tim Cook pointed out, they are predictive of future Apple products or product changes.

And now, the new batch

The distinguishing characteristic of the supply chain rumors that have appeared since the beginning of the year is their generally pessimistic tone.  Although in most cases reports have acknowledged that order cutbacks could be due to a new product introduction, the reports have tended to push reduced demand as the most likely explanation.  This shift in interpretation was undoubtedly due to the perception that Apple was losing market share and sales momentum in smartphones and tablets to devices using Google Inc (NASDAQ:GOOG)'s Android operating system, and this was borne out by market share survey results by Gartner Research and IDC shown in the charts below.

What the market share results don't show is that because the overall smart device market is expanding rapidly, Apple's unit sales still grew vigorously in Q4, 22% y/y for iPhone and 48% y/y for iPad.  Declining market share didn't equate to reduced demand for Apple products, and it remains to be seen whether Apple has suffered any year over year declines in Q1.

iPhone:  Rumors of reductions in iPhone 5 component orders started in January with a report in the Wall Street Journal that attributed the cuts to weaker than expected demand.  This was followed on March 15 with Sterne Agee analyst Shaw Wu cutting his price target for Apple, although he did attribute the order cutbacks to preparations for a new iPhone.  Recently, the Wall Street Journal let fly with reports that “Apple plans to begin production of a refreshed iPhone similar in size and shape to its current one in the second quarter of the year...” and went on to project a possible summer launch.

My take:  The order cut backs for iPhone 5 were in preparation for iPhone 6, not due to reduced demand. More importantly, the rumors of cut backs in iPhone 5 screen orders that came out of Sharp (accompanying the iPad rumors discussed below) indicate to me that iPhone 6 will have a significantly larger screen, in the 4.5-inch range.  Although Apple has needed a low cost iPhone, they need the larger screen iPhone even more to fend off Android “phablets” and protect their position at the premium end of the market.  The iPhone 5 will become Apple's low-cost compact alternative, in the way that previous generations of iPhones have. Except for the larger form factor, iPhone 6 will look almost the same as iP5, using the same anodized aluminum body construction.

iPad:  Rumors of order cut backs of fourth generation iPad screens began in January with a report from Reuters on Jan. 18 that Sharp had cut its iPad screen production to the bare minimum.  Once again, a variety of explanations were offered, but “decreased demand” was front and center.

My take:  The order cut backs were in preparation for a new iPad (fifth generation), which will get the full iPad mini make-over, including a near edge-to-edge screen.  This would require a redesigned screen, which is why the orders to Sharp were cut.   Like the iPad mini, the new iPad will be thinner and lighter and may even be a bit smaller, even as the screen size remains the same.

Apple may or may not exceed the Street's expectations for the current quarter.  We'll see soon enough. But in trying to divine financial performance from the supply chain rumors, the analysts squander what little value the rumors have as glimpses of Apple products to come.

Mark Hibben has a position in Apple. The Motley Fool recommends Apple and Google. The Motley Fool owns shares of Apple and Google.

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