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  • Apple stock is down double digits in 2022.
  • Supply disruptions in China may cap revenue and profit growth this quarter.
  • Recessionary risks could prompt consumers to stick with existing phones, tablets, and Macs longer, reducing demand for next-generation devices.

A tidal wave of COVID-driven demand for mobile at-home work and entertainment propped Apple stock up in 2021. However, large-cap technology stocks like Apple  (AAPL)  have suffered this year because the strong U.S. Dollar has crimped revenue growth, inflation has caused corporate and consumer budgets to tighten, and investors have sold shares to de-risk portfolios. As a result, Apple’s stock has fallen by 18% in 2022. Unfortunately, the sell-off might not be over.

Why Doug Kass shorted Apple stock

Real Money Pro’s Doug Kass is a self-described contrarian with a calculator. His ever-changing investment activity often goes “against the herd,” so his recent decision to short Apple – one of the most widely-owned stocks – to profit from a price decline isn’t surprising.

He recently outlined ten reasons Apple’s stock could be heading lower. Here they are in their entirety, followed by my comments where appropriate:

"1. While the Apple ecosystem remains formidable (no surprise, a "known known"), the company's near-term fortunes (sales/profits) are heavily dependent on the unpredictable pace of the Zero Covid Policy in China. Indeed, supply-chain challenges represent the most important risk to Apple in years.

2. The company's reliance on China to source much of the manufacturing of its core product holds fundamental and valuation risks.

3. Unfortunately, manufacturing sourcing issues (at Foxconn) can not be solved overnight -- the lag time to replace China's sourcing is relatively long and measured in years, not months.

4. Significant sourcing changes from China could not be effected until late 2024 at the earliest."

Kass's focus on supply chain risk makes sense. Apple wants to diversify production of the iPhone, iPad, and other consumer electronics devices away from China, but the necessary manufacturing plants are complex and costly, so it will take a while for suppliers to build them. Even then, the production at new plants may be more of a trickle than a river.

For example, Taiwan Semi  (TSM)  – a major Apple supplier – is building a $12 billion chip-manufacturing plant in Arizona. That plant will produce 20,000 5-nanometer wafers monthly that could supply Apple with M1 chips for MacBooks and, possibly, A16 Bionic chips for high-end phones later. Construction began in June 2021, but it won’t open until 2024. However, at that point, Apple may already be shifting to more complex chips the factory won’t yet produce.

Furthermore, the planned capacity for that Arizona plant is relatively small. It represents just 1.6% of Taiwan’s Semi’s current 1.3 million wafers production. The company already produces 150,000 5mn wafers per month, so most of Apple's chip supply will still come from overseas.

Foxconn – the vendor responsible for assembling Apple devices – has yet to announce a similar U.S. plant, so who knows when Apple will be able to diversify that production.

In the meantime, Apple’s revenue is at risk of production shortfalls due to China’s COVID-lockdown policy and political unrest.

For example, worker protests against COVID restrictions at Foxconn’s large manufacturing operation in Zhengzhou, China, reduced iPhone 14 Pro and Pro Max production by six million units this week. Those high-end, margin-friendly devices are key to Apple offsetting sluggish demand for its less expensive base models because of negative real wages this year.

Back to Kass:

"5. The business cycle is turning down.

6. Unemployment is likely to rise, consumer savings are dwindling, and consumers' elasticity of the demand to a $1,400 smartphone will almost certainly be tested in the quarters ahead."

By now, we’ve all read how recessionary risks have risen because of GDP-busting Federal Reserve interest rate increases. Slowing economic activity due to higher rates could increase unemployment even as inflation forces consumers to shift discretionary spending to essentials. We’re already seeing surging credit card balances and declining savings so it’s not a stretch to wonder how many consumers will “make do” with existing phones rather than upgrade if unemployment increases.

"7. The absolute level of interest rates ("higher for longer") remains an ongoing threat to high valuation and "growthy" equities like Apple."

Kass often cites “Treasuries Are The Alternative” to stocks now that interest rates have increased the 2-year Treasury yield north of 4%. Apple’s paltry 0.6% dividend yield is no competition to that risk-free rate of return, given stock market uncertainty could cause its shares to falter.

Moreover, while Apple’s “cheaper” than last year, it’s arguably not a bargain basement buy. The company’s expected to generate earnings per share of $6.83 next year, giving it a forward price-to-earnings ratio near 21. That’s still substantially above its 5-year P/E low of 12.

"8. That Apple has shown a bonafide interest in acquiring Manchester United  (MANU)  may be a signpost that the company expects that organic growth is expected to slow down.

9. Apple faces the same streaming challenges -- "profitless prosperity" of higher content costs, rising competition, and operating losses that other companies with weakening share prices face (e.g., Warner Bros. Discovery  (WBD) , Paramount Global  (PARA)  and Disney  (DIS)  ) yet Apple's share price has hung in. On this score, Apple might be forced to make a sizeable and costly streaming acquisition to gain critical mass/share. Investors may frown on this!

The news Apple could be kicking Manchester United’s tires was surprising, and Kass worries acquisition chatter reflects management concerns they’ve pulled all the internal levers for growth. Of course, this acquisition is a rumor, but the deal isn’t outlandish. Acquiring one of the planet's most popular soccer (sorry, football) teams provides many content and cross-marketing opportunities. Nevertheless, doing a deal like this may signal Apple’s reached the limit of what it can do on its own to drive growth, suggesting riskier and costlier deals on the horizon.

"10. For some of the reasons mentioned above, Apple is unlikely to meet consensus expectations for revenues/EPS over the next 3-4 quarters."

I’d also add that another risk exists: Threats to its 30% take rate on its app store. This week, Elon Musk took aim at Apple’s app store charges on behalf of his recently-acquired Twitter, citing them as a threat to free speech and onerous to entrepreneurship. If pushback on pricing accelerates, it could dampen profit in Apple’s services segment.

The Smart Play

Warren Buffett is the poster child for long-term investing, and Apple remains his single largest holding. His 895 million share stake represents over 40% of Berkshire Hathaway’s portfolio, and there’s little to suggest that will change, given Apple is a cash flow machine with remarkable brand loyalty.

Last fiscal year, Apple produced $111 billion in free cash flow and nearly $100 billion in net income. Over the past decade, it returned $715.2 billion to shareholders via buybacks and dividends. Yet, it still boasts almost $50 billion in cash and equivalents, plus another $121 billion in long-term marketable securities.

Indeed, Apple’s massive embedded user base suggests it will continue printing money for many years.

However, Kass isn’t arguing against those points. A more active investor, Kass suggests that Apple may struggle to meet analysts' targets over the next few quarters because of supply chain risks and slowing global demand because of a recession. If so, reductions to forward earnings outlooks will increase Apple’s forward P/E ratio, making it less attractive in the short term versus alternatives, such as U.S. Treasuries.

In short, Kass is trading Apple’s stock opportunistically, and he'll buy to cover shares if Apple reaches his downside target. How low does Kass think Apple shares may go? He told me today that this is a “trading rental” with a downside target of $135 to $140. Currently, Apple is trading near $141, so keep that in mind before clicking the sell button.

Active investors who want to follow in Kass’ footsteps and are OK with the unlimited risk associated with selling stocks short can consider shorting Apple into strength, using a buy-stop order to protect against losses if the market runs higher.

Long-only investors should remember that Apple is the S&P 500’s largest holding, so its stock is likely to trade mostly in line with the market. Stocks had a big move recently, and the S&P 500 is currently struggling to overcome resistance near its 200-day moving average. If it fails to do so, it will likely take Apple lower with it. For this reason, waiting for the market to recover resistance before buying could be smart.

Alternatively, investors who want to buy Apple shares could consider splitting up purchases using buy-limit orders at points within Kass’ $140 to $135 cover shorts target. As you can see in the following chart, there’s considerable technical support near Apple's bottom this summer, so perhaps, use a mental stop loss to protect against losses if shares close meaningfully below June’s $129.04 intraday low.

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