Here's One More Reason to Ignore iPhone Supply Chain Rumors

By Markets Fool.com

For more than three years, Apple CEO Tim Cook has repeatedly warned Wall Street analysts not to try to predict iPhone sales based on supply chain rumors. Supply chain rumors aren't always wrong -- but they are unreliable. Due to the complexity of Apple's supply chain, it's dangerous to assume that any one data point is representative of Apple's underlying performance.

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Perhaps unsurprisingly, the analysts have ignored that advice. In the race to get a leg up on rivals, analysts spend countless hours talking to iPhone suppliers in the hope of getting hints about how Apple's flagship product is doing.

Analysts are always looking for data to help them predict iPhone sales. Image source: The Motley Fool.

iPhone sales forecasts based on supply chain data are particularly error-prone the further in the future analysts are trying to project. That means investors should take Apple analysts' recent predictions about iPhone 7 sales with a big grain of salt.

Apple analysts try to guess about iPhone 7 sales

In the past few weeks, a number of Apple analysts have commented on Apple's prospects for getting iPhone sales growing again this fall. Most are relatively pessimistic, based on supply chain data such as year-over-year declines in iPhone component orders.

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However, the evidence isn't clear-cut. Apple has multiple suppliers for many components. Furthermore, Apple's component orders depend on its own inventory and expected component failure rates in addition to its sales projections. Indeed, analysts at Bank of Montreal countered earlier this month with evidence that Apple's supply chain orders have stabilized recently.

This highlights one of the big risks of relying on supply chain data -- namely, that analysts are only seeing a small part of the broader picture. Analysts looking at different parts of the supply chain can draw conclusions that are diametrically opposed.

Initial build plans are virtually meaningless

Even if analysts correctly predict how many iPhones Apple plans to build, Apple could be wrong about demand. Since it has the flexibility to adjust production fairly quickly, even its internal forecasts for demand a few quarters down the road can be an inaccurate indicator of future iPhone sales.

Around this time last year, Apple was planning to build about 85 million-90 million units of the iPhone 6s and iPhone 6s Plus by the end of 2015, according to The Wall Street Journal. By contrast, it had ordered components for only 70 million-80 million iPhone 6 and iPhone 6 Plus models a year earlier.

Apple rapidly boosted iPhone 6 production in 2014 after demand outstripped supply. Image source: Apple.

As it turned out, it underestimated iPhone 6 demand in 2014. However, it was able to raise its production plans as the strength of demand became clear. By contrast, it likely overestimated demand in 2015 and subsequently cut its production plans near the end of the year.

Thus, evidence that Apple's initial iPhone 7 component orders may be flat or down slightly on a year-over-year basis is more or less meaningless. If demand is solid, Apple should be able to ramp up production this fall -- just as it did two years ago -- and thus deliver significant year-over-year iPhone sales growth during the fall quarter.

It's all about demand

The key takeaway here is that watching the supply chain is no substitute for trying to estimate demand. Forecasting demand is extremely tricky, too, but the advantage is that demand -- not supply -- is the primary driver of iPhone sales.

There are some good signs here. For example, there are still a lot of pre-iPhone 6 smartphones in use. Each new model launch increases the chances that users will upgrade these older phones. Apple may boost the base storage configuration to 32GB for the iPhone 7, providing users with 16 GB phones a reason to upgrade irrespective of whether the new iPhone has innovative features.

Furthermore, while many users are holding on to their iPhones longer, a good number still upgrade every other year. With Apple having sold more than 85 million iPhones between the mid-September 2014 launch of the iPhone 6 and the end of 2014, there will be more users reaching this two-year upgrade window this fall than ever before.

Finally, Apple's unique ecosystem is attracting new users as quickly as it ever has. The lower-priced iPhone SE could help Apple appeal to more price-sensitive customers around the world, supporting this trend.

Ultimately, customers will decide just how much iPhone sales grow this fall, if at all. Supply chain leaks can't provide any useful information about the only thing that really matters: customer demand.

The article Here's One More Reason to Ignore iPhone Supply Chain Rumors originally appeared on Fool.com.

Adam Levine-Weinberg is long January 2017 $85 calls on Apple. The Motley Fool owns shares of and recommends Apple. The Motley Fool is long January 2018 $90 calls on Apple and short January 2018 $95 calls on 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.