Demand Drag Gnaws on Apple

A seasonal slowdown in iPod sales could signal a maturing market.
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If recent developments are any indication,

Apple

(AAPL) - Get Report

could have sour news for investors when it reports earnings next week.

Announcements from two companies in the digital music player sector -- and even from Apple itself -- suggest that demand has slowed in recent months. And some analysts worry that such a slowdown could signal a maturing market. Either way, muted demand could have a considerable effect on Apple, whose popular iPod music players have supercharged the company's revenue and earnings over the last two years.

The indications of slowing growth in the digital music player market have come from multiple sources recently:

SigmaTel , which provides flash memory chips used in lower-end digital music players, slashed its second-quarter revenue outlook last week, citing slowing demand from manufacturing customers and worse-than-expected retail sales of flash-based players. Company officials declined to say whether Apple, which uses SigmaTel chips in its iPod shuffle players, was among those customers whose sales slowed, but the company did say the slowdown was "broad-based."

SigmaTel's announcement came one day after Creative Technology , SigmaTel's second-biggest customer, cut its own revenue outlook. Creative blamed the shortfall on weaker-than-expected demand for digital music players in the quarter and on a decline in average selling prices for its players.

Meanwhile, Apple cut prices on two of its music players last week and began offering a color-screen version of its flagship 20-gigabyte iPod at the same price it previously offered a monochrome version. The company is now charging about $400 for its top-of-the-line 60-GB iPod. Apple has slashed the price on that model twice this year, bringing its overall price down by $200 since February. The price cuts may point to slow demand at Apple for those products, if not for the company's whole iPod lineup, analysts say.

But there are other signs that iPod demand in particular is no longer outstripping supply as it did in previous quarters. Apple now promises to ship every product in the iPod lineup ordered through its online store on the same business day. When the

flash-based iPod shuffle was released earlier this year, consumers had to

wait at least two weeks for one.

And rumors and analyst reports suggest that iPod inventory is starting to build up. Although Apple's overall sales fell sequentially from its first quarter to its second quarter, its total inventory and days sales outstanding swelled over the same period. Analysts suggest that inventory has continued to grow in its just-completed third quarter. While an inventory build can sometimes mark an anticipation of stronger sales in later periods, it can also be a red flag, signifying slowing sales.

"The market has definitely slowed down," says Shyam Nagrani, principal analyst with industry research firm iSuppli. "I have a feeling that

Apple's results won't be as good as they were in the first

calendar quarter."

Nagrani and other analysts chalk up the slowdown largely to seasonal demand. In general, retail purchases tend to slow in late spring and not pick up until late summer, when back-to-school season starts.

But in fast-growing markets, seasonality tends to be much more muted, suggesting that when a seasonal slowdown appears, it can be an indicator that the days of breakneck growth are coming to an end. Analysts who think iPod sales will resume their previous growth rates in coming quarters and into next year are "totally in denial" of what's happening in the overall market, says Shaw Wu, who covers Apple for American Technology Research, which doesn't do investment banking.

"Apple's warned of it, that they're not going to grow like they did last year," says Wu. "I agree with

the company."

Even though Apple's stock is down about 20% from the 52-week high set in February, it's still trading at what might be an unsustainable premium, Wu says.

"That's why we're not recommending the stock," says Wu, who has a hold rating on Apple shares but doesn't personally have a stake in the company's stock. "Why pay a high multiple when growth is clearly slowing down?"

Apple representatives declined to comment.

However, even with the possible slowdown in the MP3 player market, Wu doesn't expect Apple to miss the Street's estimates for its just-completed quarter.

And not everyone is convinced that the digital player market actually slowed significantly in the second quarter. NPD analyst Stephen Baker argues that the problems at SigmaTel and Creative are likely company-specific and don't reflect a broader market problem. Apple's move to cut prices and build inventory may simply be a strategic effort to maintain its dominance of the digital player market, he says.

"I would warn people that making judgments off of the second quarter ... tends to be fool's gold," says Baker, adding that he "didn't see anything that would tell me that there's some kind of demand saturation in the market right now."

And most observers would concede that the market for digital music players is still growing overall; it's just the rate of that growth that likely decelerated in the second calendar quarter. Indeed, analysts generally agree that market growth will rebound later this year, boosted by back-to-school and holiday sales.

"It's possible that vendors in the MP3 player market may have overestimated demand for the first half of 2005," says Susan Kevorkian, a senior analyst at IDC, an industry research firm. "I still expect this market will fare well in the second half."

If it doesn't, what may be a sour taste in the mouth of Apple investors next week could turn bitter.