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John Engle
John Engle
Articles (332) 

Apple Falls Prey to Trade War Escalation

The tech giant faces a no-win scenario as the US-China feud intensifies

May 21, 2019 | About:

For more than a year, Apple Inc. (NASDAQ:AAPL) managed to keep itself out of the U.S.-China trade conflict. Aggressive and persistent lobbying efforts, supported by well-timed charm offensives on the part of CEO Tim Cook, had served to keep the Trump administration firmly in Apple’s corner, even as the president’s position grew increasingly bellicose toward China.

Alas, despite its best efforts to steer clear of the conflict, recent escalation has sucked Apple into the rapidly expanding trade war maelstrom.

Trade war heats up

Entering 2019, most market players seemed to think that the U.S. and China would swiftly reach an amicable resolution to their long-running trade dispute. Trump and his trade officials worked to confirm this outlook during the early months of the year.

Yet, as the months wore on, talks continued to stall. As a consequence, the Trump administration has adopted a far more aggressive stance, ramping up tariffs and promising more to come. Unsurprisingly, China did not take this action lying down and swiftly retaliated with fresh tariffs of its own.

Apple suffers the consequences

Apple has fallen prey to this latest bout of tit-for-tat tariff action. The company’s flagship product, the iPhone, is particularly vulnerable. Since the smartphone is built entirely in China, it is now subject to Trump’s new 25% import levy. Apple’s other products, including its laptops and iPad tablets, are also on this latest tariff list.

China has since retaliated to this latest U.S. levy, announcing that it would raise its import tariff on American products to 25% from 10%. This will almost certainly bite Apple, which imports many components to China that are then assembled into final goods.

Warning signals flashing

The iPhone, which made up a whopping 63% of Apple’s sales in 2018, appears especially vulnerable to the latest round of tariff hikes. That is seriously bad news for the company. Apple has already been seeing slowing sales of late, which forced it to revise profit guidance downward earlier this year.

This latest round of tariffs seems likely to exacerbate these issues, as Cowen’s latest research report makes clear:

"[There’s a] very real risk of higher import costs and/or U.S. consumer demand destruction depending on whether Apple decides to pass along some of the tariff cost. Given that the majority of Apple’s hardware products that include the iPhone, iPad, Watch, and Mac systems are assembled and imported from China, the earnings risk could be quite substantial."

Squeezed by both great powers in their mounting trade war, Apple has little power to change the situation. All it can do is adjust its own pricing and strategy to try to mitigate its losses. Unfortunately, it has few good options.

No good choices

Apple could simply raise prices to pass on the cost of the new tariffs to consumers. According to JPMorgan, Apple would need to hike iPhone prices by 14% in order to mitigate the cost of the tariff. Moving production to the U.S. would not help either; according to Bank of America, such a move would likely translate to a 20% increase in iPhone prices.

It may be far harder to pass on the full cost of these new tariffs than observers might first think. Apple’s all-important iPhone already enjoys a considerable pricing premium. Hiking the price much further could well drive customers away. Sales have already slowed for the iPhone recently, so Apple might find the prospect of putting customers’ price elasticity to yet another test rather unpalatable.

Apple’s only other option is to accept lower profits. While that would not be an outright disaster for the wildly profitable company from an operational standpoint, the stock would undoubtedly take a hit.

Verdict

Apple has rarely looked as precarious as it now is. Another drop in profitability would likely force a significant haircut to its premium share price. The market shook off Apple’s profit warning earlier this year, but it is not likely it would be so forgiving a second time.

Investors should tread very carefully.

Disclosure: No positions.

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About the author:

John Engle
John Engle is president of Almington Capital - Merchant Bankers. John specializes in value and special situation strategies. He holds a bachelor's degree in economics from Trinity College Dublin and an MBA from the University of Oxford.

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