Tim Cook’s Chinese whispers

“The only companies that report better quarters pump oil,” Apple’s chief executive Tim Cook boasted to colleagues last week, after announcing the company’s latest results.

In fact, Apple’s $13.1 billion profit was the world’s fourth best, with only Gazprom, Shell and Exxon-Mobil enjoying better quarters in corporate history.

Charged with what many onlookers regard as the almost impossible task of taking over from Steve Jobs, Cook delivered the record profit in Apple’s most recent fiscal quarter.

So perhaps he can be forgiven for feeling a little miffed that the news was greeted with an 11% slump in the Apple share price. In fact, the company’s stock has been in decline for months – mostly on fears that its days of supercharged growth may be behind it.

There are, of course, still some bulls out there, and the über Apple fans remain steadfastly hopeful the stock will eventually hit $1,000. But as Tim Cook has probably realised, getting the stock heading back in that direction looks increasingly dependent on Apple delivering big sales growth in China. To pull this off Cook has some big strategic decisions ahead. The most important? Whether to broker a possibly game-changing deal with China Mobile.

So why is the share price down?

Sellers of Apple’s shares argue that revenues failed to meet market expectations for the third successive quarter. Gross margins also showed signs of substantive decline, while unit sales of 47.8 million iPhones came in below expectation too. Although the quarterly profit of $13.1 billion set a new record, it was only marginally up (by $14 million) on the previous period.

Apple stock is now down more than a third from its most recent high of just over $700 last September. Its boosters are fighting back on two main fronts. In the short run, the analyst community is being blamed for overhyping their revenue and profit forecasts (a piece in Fortune magazine suggested that “Apple’s analysts did worse than the company this quarter”). But the other response is that, in the longer term, it’s unrealistic to expect Apple to keep on delivering growth at recent levels, as the law of large numbers is bound to have a braking effect.

Michael Moritz, chairman of investment firm Sequoia Capital, said something similar in the Financial Times on Monday, warning that it was hard for such a huge company to keep growing quite so fast.

Attacking the “mewling and mindless pandemonium” of the company’s critics, Moritz also pointed out that if Apple were a country, its revenues would rank it 45th in GDP terms, above Pakistan and New Zealand.

“Almost enough to make you think Apple should have a seat in the UN,” he quipped.

How about China’s contribution?

Revenues from China were celebrated as a highlight, and for the first time Apple broke out the data for a new Greater China sales territory – which it defined as China, Hong Kong and Taiwan.

Perhaps that was because the results were the best ever, with sales of $6.8 billion – 67% up year-on-year, much faster than the global average. Sales of iPhones also doubled in the quarter.

Apple now looks fully focused on the China market, after a long period in which the country seemed a lesser priority (see our Focus Issue The Magnificent Seven for a fuller discussion).

As WiC has also reported before, Steve Jobs never visited China in an official capacity but Cook made his second visit in less than a year last month, telling the local press that he expects China to overtake the United States as Apple’s largest market soon. “I cannot accurately predict when that will happen, but I have no doubt that it will,” he told Sina, an internet news portal.

Any clouds on the horizon?

Despite the record revenues, Apple’s critics say it is locking itself out of the fastest-growing area of the Chinese market by refusing to offer lower-price smartphones.

Much of last week’s media coverage picked up on this concern, usually citing a December report from market researcher IDC, in which Apple dropped from third to sixth in smartphone sales, behind rivals like Samsung, Lenovo, Huawei and ZTE.

Because most of the unit growth in China is coming at the lower end of the market, IDC estimates that Apple’s market share fell to 4.2% in the quarter ending last September, from 5.8% in the same period a year earlier.

The concern is that Apple is pricing itself out of the market, as more and more Chinese opt for cheaper handsets, many of them running on Google’s Android.

Aside from its better-known competitors, Apple was outsold too by China Wireless Technologies, whose Coolpad handsets each retail for about Rmb700 ($112). Prices for the iPhone 5 start at Rmb5,288, and even former insiders say that the gap should be a wake-up call for the company’s management. Apple “needs to adapt to where the growth is,” onetime chief executive John Sculley told Bloomberg last month. “It’s got to learn how to sell products that are priced for the price point that the emerging middle class in Asia can afford.”

But isn’t Apple choosing margin over market share?

Asked during the earnings call whether Apple should be selling cheaper smartphones, Cook appeared to reject the idea, claiming that he had no interest “in revenue for revenue’s sake”.

Phil Schiller, senior vice president of marketing, told the Shanghai Evening News something similar recently, saying that Apple won’t develop cheaper phones to grab market share.

But with new smartphone sales in China expected to reach 240 million by the end of 2013, the question is whether Apple can afford to ignore the entry-level market.

Steven Millward, writing at the Tech In Asia blog, warned that doing so might see Apple repeat the early error in software strategy that made Mac OS into a fringe platform, dwarfed by the widely used Windows. Will it miss out on the millions of potential customers who can’t afford to pay out two or three months’ salary for the latest iPhone, he asked?

Cook’s likely response is that Apple is trumping its smartphone rivals in revenue and profit comparisons, and so has little reason to descend to their level. Despite trailing China Wireless, the maker of the Coolpad phone, in market share, Apple’s net income of almost $42 billion over its fiscal 2012 period tells a very different story. China Wireless reported profits of just under $20 million in its own most recent earnings announcement, for the first six months of last year.

Nonetheless, there are unsubstantiated rumours that Apple is working on a lower-priced phone it will launch in the coming months. Not that Cook said anything to confirm this during the earnings call, but he did highlight that Apple has a history of offering different products at different price points, citing the release last year of the iPad mini. He also insisted that the Californian firm has never feared cannibalising its product portfolio, with the launch of the iPhone cutting into iPod revenues, and sales of the iPad displacing some for the MacBook.

The counterview is that Apple will struggle to develop a smartphone priced low enough to pick up significant new market share – and that it would be foolhardy to even try, because of the impact on profits. Company guidance is already that higher sales volumes for the iPad mini this year will pull down gross margins across the company. Launching lower-priced iPhones would accelerate the decline.

One alternative is to keep prices where they are but make payment an easier undertaking. Apple’s recent launch of China payment plans is an attempt to do just that: customers wanting to buy products from its online store can now pay in up to 12 monthly instalments, on an interest-free basis. The service, which is offered to holders of China Merchants Bank credit cards, also allows for payments over longer periods (up to 24 months), although in this case interest charges apply.

What would a low-price iPhone mean for Apple’s brand?

The other risk in lower pricing is the potential for damage to Apple’s cachet, as millions of less affluent customers start to take ownership of its products.

In a market more brand-obsessed than most, Apple enjoys luxury status. For example, according to the Chinese Luxury Consumer Survey in the latest Hurun Report, the brand was the second most popular choice for those giving gifts to men, up from the fourth place last year. (It couldn’t beat the mighty man-purse, with Louis Vuitton taking number one spot.) Much of that luxury reputation is derived from its higher price and, to a lesser extent, the scarcity value of owning something that others aspire to.

In the same way that it would be a surprise to see Louis Vuitton trying to sell millions of new bags at a fifth of the price of its core offering, Apple will be thinking carefully about the dangers of sullying its higher-end appeal by selling cheaper products.

After all, it was only a year ago that sales at its flagship store in Beijing had to be halted, when unruly crowds came close to rioting at the debut of the latest iPhone. In April, Xinhua picked up on more disturbing evidence of ‘Apple obsession’, when a 17 year-old from Hunan sold one of his kidney’s to raise funds to buy the firm’s latest gadgets. It put a rather dark spin on Apple’s ‘must have’ appeal.

Cook acknowledged the power of the brand last week too, in his belief that many customers who buy one Apple product end up buying more, in what he described as the “halo effect”.

Of course, the same logic could be applied to a new sales strategy for smartphones, encouraging the purchasers of lower-priced models to gravitate towards more expensive products over time.

But Apple must query where it should position itself in such a crowded marketplace, with Global Entrepreneur, a business magazine, saying that 1,500 different smartphones have now been launched in the Chinese market, many of them at the lower end. There were even reports in the Economic Daily this week that the Taiwanese parent of Master Kong, a leading instant noodle brand, will be next to join the fray. The news isn’t as surprising as it first sounds (Samsung began life as a noodle producer). But it also makes Apple’s preference for premium prices more understandable.

Focus elsewhere…

What else might Apple do in China? One option would be to offer a fuller ‘family’ of products across different formats. Samsung shipped 37 different phones in a variety of sizes last year, according to Karen Haslam at the Macworld UK blog, but Apple’s preference has been to build marketing buzz around less frequent releases.

Screen size is one area where some of Apple’s main competitors have won plaudits, for larger formats that make playing games or watching videos easier, as well as allowing more space for typing in Chinese characters.

“Since I got a big screen Galaxy Note [a Samsung phone], I have never thought about changing it. The time for small screen phones has gone,” one business executive told a reporter from Tencent’s news site this week.

Huawei’s Ascend Mate now has a 6.1-inch format, the largest yet for a smartphone, further blurring the boundary between phone and tablet. But Apple sounds more cautious. Asked about the case for larger screens, Cook said that the iPhone 5’s 4-inch screen is large enough, especially with a retina display offering “the most advanced quality in the industry”.

More likely is that Apple will try to get its future products quicker to market. During his trip in January, Cook visited the Ministry of Industry and Information Technology (MIIT) and Doug Young, author of YoungChinaBiz blog, surmises that Apple is trying to improve ties with the regulator so that it can speed up the release of its new products, after delays of weeks or months on previous global launches.

The problem, Young says, is that the longer it takes the authorities to approve the release of the latest iPhone, the more smartphones will be sold running on Android, including those made by local manufacturers like Huawei and ZTE.

As part of the charm offensive, Apple is also considering the establishment of a new research and development centre in the Chinese capital, says Beijing Evening News. In doing so, Cook would be following other US technology firms like Microsoft and Intel, which have opened similar facilities in China.

A third area for Apple to improve is its distribution. As part of this effort, company executives have highlighted the increase in the Apple’s own retail stores to 11 from six over the past year, with the number of premium resellers also doubling to more than 400 shops in China.

More significantly still, Apple needs to resolve its negotiations with China Mobile, the host carrier to 710 million subscribers or two-thirds of China’s mobile phone market, as well as the majority of its current 3G users.

Cook met with the telco’s chairman on his trip to China last month but the speculation about the potential tie-up between the two companies has been dragging on for years. Subscribers to 3G services tend to be better off, ergo a deal with China Mobile would be a huge positive in snaring sales for Apple too.

But signs of a final agreement have been fleeting. China Mobile may be trying to drive a harder bargain than Apple is accustomed to accept. It also requires the iPhone to be compatible with its domestically developed 3G network, a request that the US firm has previously declined. (Samsung has adapted its own handsets for the proprietary standard, which has 88 million subscribers).

Of course, there would be both financial and technical costs t0 adopting the standard (the engineers in Cupertino could be concerned that the iPhone doesn’t run as well on China Mobile’s 3G standard). But others suspect Apple’s bosses have decided to wait it out. Rather than bet on this older technology, Apple is waiting to build an iPhone compatible with China Mobile’s new 4G network, which could launch later this year.

That could make sense from several perspectives. China Mobile’s 4G standard is viewed as a huge technical improvement on the flaky 3G technology the government forced it to adopt (see WiC174 for an explanation of why even the telco’s management is keen to move to 4G as fast as possible). Sensibly priced, it looks a fair bet that faster and better-functioning 4G will convert existing 3G users (China Mobile’s own, plus those on rival networks).

It could also have a ‘leapfrog’ effect, encouraging a bigger chunk of the telco’s current 2G subscribers to make the switch too. In other words, 4G could trigger demand for huge numbers of new smartphones – and a compatible iPhone could be a huge beneficiary.

That’s exactly the scenario that would get analysts excited about Apple’s growth again…

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