Apple’s Miss Isn’t a Demand Problem

It's a supply problem, thanks to start-up production constraints

Apple (NASDAQ:AAPL) missed analyst expectations when it reported its Q4 earnings yesterday. This is the second straight quarter that’s happened, taking some of the shine off the tech powerhouse.

Revenue of $36 billion was right on target, but EPS of $8.76 was lower than the expected $8.81 (although Apple’s own guidance was for EPS of $7.65). Also worrying investors was Apple’s forecast for the next quarter: EPS of $11.75 on revenue of $52 billion, both also lower than had been expected.

All About AAPL: Our Experts Weigh In
All About AAPL: Our Experts Weigh In

The news sent Apple’s stock down 2.5% after the earnings call, hitting $585 at one point before it recovered.

So, what’s going on in Cupertino? Why the slipping profit margins, and why the lower-than-expected revenue in the next quarter despite a slew of new products? Is demand waning for iPhones, iPads and Macs?

Actually, that huge array of new products announced and/or released this quarter is a primary reason behind the slipping numbers. Apple is being hit by supply issues.

As CEO Tim Cook noted during the earnings call, this has been Apple’s most prolific quarter ever in terms of new product releases. Key Apple gear went on sale in Q4, including the highly anticipated iPhone 5, a collection of new iPods and a class-leading Retina display 15-inch MacBook Pro. As the quarter wrapped up, Apple announced the iPad Mini, another Retina MacBook Pro, a new full-size iPad, an updated Mac Mini and a redesigned iMac that pushes the envelope for a consumer-level desktop PC.

All of these new products entail ramp-up costs, and Apple’s continued focus on cutting-edge design appears to be leading to higher production costs, regardless of any favorable supply and manufacturing terms Apple may have negotiated. Even though the latest round of new products may not go on sale until the next quarter, in most cases Apple has been producing them through Q3, building up a sufficient quantity to meet launch demand.

Take that new iMac. At its edges, the all-in one desktop computer tapers to just 5 mm in thickness. Apple cut the size of the previous-generation model by 40% despite improved performance (although it did sacrifice the optical drive), drastically reduced its weight and added an upgraded display.

What this means at the factory are new processes, new components, intense tolerances and increased quality-control requirements.

That cuts into margins, especially during early stages of manufacturing when new parts can be more expensive and the production process isn’t yet optimized. It can also cut into supply — when tolerances are so strict, fewer panels and other critical components make the cut and there’s a greater chance of finished product being rejected.

Apple experienced the latter problem in a big way with the iPhone 5. Manufacturing partner Foxconn admitted that quality control on what it called “the toughest product Foxconn has ever assembled” resulted in ongoing constrained supply. Cook has already gone on record as predicting limited supply means Apple may not be able to meet iMac demand for the quarter.

According to AppleInsider, one of the two suppliers tapped to make the iPad Mini’s multi-touch display is experiencing yield issues. Rumors also swirl about production issues with its anodized aluminum body — not hard to believe given the trouble Foxconn had with the iPhone 5’s similar, easily scratched, material.

Low volume of displays and manufacturing challenges are likely to lead to constrained iPad Mini supplies through the holidays. The ultra-high-resolution Retina display offered on the new 13-inch MacBook Pro has also been giving suppliers fits, leading to lower than expected production volume. Apple has undoubtedly factored these challenges into its predictions.

Should investors be nervous that consumers are losing interest in Apple’s gear? I don’t think that’s the case. Apple is selling pretty much everything it can make. The lower profit margins are more likely a blip caused by what Cook describes as the start of the manufacturing curve for the record number of new products. As manufacturing efficiencies improve, costs will come down and product volume will increase.

That’s good news because supply issues are usually temporary and much easier to fix than waning demand. It may take another quarter for operations to normalize, but expect Apple’s revenue to regain momentum and those margins to improve.

As of this writing, Brad Moon didn’t own any securities mentioned here.

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