Apple’s core problem?

Five years ago, the craze for iPhones in China was taking the black market trade in smartphones to new heights. Such was the Apple phenomenon in Kunming that even the fakers were fooled, Xinhua reported. More than 20 unauthorised stores had been operating so convincingly in the city that their sales staff were shocked when they learned that they weren’t working for the Californian giant.

In other glimpses of the infatuation with Apple we mentioned the man who proposed to his girlfriend with a gift of 99 iPhones (see WiC261) and the desperate teenager who tried to sell a kidney so that he could afford just one (see WiC253).

In the years since, the company’s sales in China have accounted for almost half of its revenue growth. This month the picture was different, though, after Apple announced its worst quarterly results for 13 years, including the first drop in iPhone sales, by far its most important product. Revenues from China had fallen by more than a quarter, it said.

The declines came shortly after news that Beijing had blocked use of Apple’s iBooks and iTunes Movies stores and the mood worsened when major shareholder Carl Icahn announced that he had sold all of his Apple stock on concerns about the unpredictable Chinese market.

“You worry a little bit, and maybe more than a little, about China’s attitude,” the veteran investor told CNBC, predicting that the Chinese government could “come in and make it very difficult for Apple to sell there.”

Company executives were busy this week countering that Icahn’s and others’ fears about Apple’s prospects in China were overblown. So what is going on?

How bad were the results?

Apple’s performance in China is watched closely because the country is such a crucial contributor to its overall business (see WiC280), making up 25% of sales. And the figures from the Greater China market were bleak: revenues fell by $4.3 billion (or 26%) for its fiscal second quarter (ending March), contributing more than half of the full decline for the Cupertino-based firm.

But Apple’s chief financial officer offered a reassuring tone on the analysts’ call in the wake of the earnings announcement, pointing out the results were being compared to a spectacular period for the firm’s iPhone 6 last year, when Greater China sales grew 81%. Tim Cook, the chief executive, then got more granular on the numbers, apportioning much of the blame to Hong Kong, where sales have been curtailed by a strengthening local currency and a struggling retail market. Sales in mainland China didn’t fare quite as badly, he argued, with revenues down about 7% after factoring in the impact of a weaker renminbi.

Cook did acknowledge that conditions in China are tougher than before, and that Apple “may not have the wind at our backs that we once did”. But he insisted that the situation there was “a lot more stable” than people thought. “We continue to be really optimistic about it and would ask folks to sort of look underneath the numbers at the details in them before concluding anything,” he said.

Can Apple keep growing in China?

Global demand for smartphones – now Apple’s core product – has been tailing off, with research firm Strategy Analytics blaming “phone fatigue” for a 3% decline in worldwide shipments during the first three months of this year.

The findings from International Data Corp, another research outfit, were a bit brighter stating 334.9 million smartphones shipped in the period. That was slightly up from the first quarter last year but still the smallest growth on record.

Apple’s smartphone sales come from three sources: customers that are upgrading from previous iPhones, people switching from Android and other operating systems, and those buying smartphones for the first time.

Undoubtedly the boom in first-time buying is over in China, a market where shipments declined by 5%, faster than the worldwide average, according to Strategy Analytics. Most of the people who can afford top-end smartphones have bought them already and in areas where there is still growth potential – lower and middle-end markets in lower-tier cities – local brands like Oppo and Huawei are hard to beat on pricing and distribution.

Cook countered that Apple is going to capture millions more customers, especially from emerging markets. But his main example was India, which he described as “where China was maybe 7-10 years ago”.

Some investors interpreted this as a sign that sales in China had reached their high-water mark, so Cook made the media rounds again this week with the message that this wasn’t the case. There would be 500 million middle-class Chinese in five years time, he said, and many of them will want an iPhone.

In fact Apple’s Chinese market share held up reasonably well in the most recent quarter, unlike those of Samsung, Xiaomi and Lenovo, which all saw declines. The company also said that it grabbed more business from owners of Android phones in the last six months than ever before. These switchers are important because they help Apple to keep growing even if the overall market for smartphones continues to slow.

But the weakness in the wider market puts more pressure on Apple’s other commercial imperative – increasing sales of its newest models to those who already use older iPhone models. It did this spectacularly with the launch of the iPhone 6 in China but most commentators believe that it will be difficult to repeat the achievement because that was Apple’s first large-screen design and it came to market at an opportune time.

Another view is that people are choosing to hold onto their phones for longer because the wow factor of new models is getting harder to generate. That puts the onus firmly back on Cook as he prepares for the launch of the iPhone 7 in the autumn. He insists that Apple hasn’t lost its pizzazz in product design. “We’re going to give you things you can’t live without that you don’t know you need today,” he told CNBC this week.

At the same time Apple has to respond to the rise of the Chinese brands – another of the structural shifts in the smartphone universe. Samsung and Apple still hold the top two spots in global shipments but Huawei is now a serious challenger in third place, and other Chinese manufacturers like Lenovo, Xiaomi, Vivo and Oppo all want their own piece of the action.

Sales of higher-end phones are also getting more competitive, with status-conscious customers more prepared to buy models from Xiaomi or Huawei than they once were. Huawei is at the forefront of this challenge and it has also been taking the battle to other markets, launching its flagship P9 phone as a direct rival to Apple in Europe last month (and getting Scarlett Johansson to endorse it in its commercials).

Could it be time for a change of approach?

The spectre of iPhone fatigue is prompting questions about whether Apple can lessen its reliance on sales of smartphones. Cook argues that it is already doing so, with revenues from services like digital music and TV downloads on iTunes, purchases on the App Store, and online storage on iCloud now the largest sales contributor after the iPhone, jumping by a fifth to $6 billion in the most recent quarter.

“The services business is powered by our huge installed base of active devices which crossed one billion units earlier this year,” he explained on the earnings call. “Those one-billion-plus active devices are a source of recurring revenue that is growing independent of the unit shipments that we report every three months,” he added.

The timing of the news was poor, however, following Beijing’s block on Apple’s Chinese iBooks and iTunes movies platforms earlier in April. This isn’t going to be a disaster for Apple’s bottom line but it does raise questions about the prospects for the new revenue model in China, and particularly whether Apple will have problems selling third-party content like books, films and TV shows there.

Apple has been far more effective in China than American tech firms like Facebook, Google and Twitter, which have been denied access largely. Cook has maintained much closer ties, making frequent visits (unlike Steve Jobs, his predecessor: see WiC258) and Apple has partnered cleverly with state firms, allying with China Mobile, the largest telecom carrier, to push iPhone sales, and joining up with UnionPay, the bankcard giant, to launch Apple Pay.

That made the reversal on the books and films front more unexpected, especially as a senior Apple executive had talked about its “great working relationship” with China only a few months ago, and celebrated the launch of the App Store as proof that it knew how to get things done there.

How significant is the shutdown?

The setback seemed to support Icahn’s warnings last week that China’s political system is going to make it “very difficult to sell there”. But if there really is a new determination to disrupt Apple’s progress in China, it seems strange that it is starting now, when its momentum already shows signs of receding and more consumers are starting to buy homegrown brands.

On the other hand, Icahn’s concerns did seem to be justified by the news that Apple has lost another trademark dispute in China. In 2012, Apple paid $60 million to end a legal tussle over the iPad trademark (see WiC140). Now the US firm cannot even enjoy exclusive right to use the ‘IPHONE’ trademark. The Legal Daily reported last week that a Beijing court has ruled that Xintong Tiandi, a handbag maker, can continue to use the iconic English name. Xintong trademarked “IPHONE” for leather products in China in 2010. Apple filed its own trademark bid – covering electronic goods – for the name in 2002 but it was not approved until 2013.

Apple is now seeking a retrial.

Others share the concern that a rising tide of techno-nationalism could make it harder for Apple to profit. After all, Apple is thought to be on the same watch list as firms like Microsoft, Qualcomm and Intel, whose embedded presence across the economy is said to alarm the Chinese authorities.

The power dynamic will also evolve as Apple tries to make money in new areas. Beijing’s instinct is to govern China’s internet like a ‘walled garden’, demanding that its domestic champions keep order, but shielding them from competition with foreign challengers. It won’t want Apple to upset the equilibrium, nor to establish the same influence in downloads and cloud storage that it has in higher-end hardware.

Hence the interpretation of last month’s ban as a warning shot that the company has to toe the line. The speculation is that there may have been disagreements behind the scenes about the content it offers. Another rumour is that the American firm didn’t do itself any favours in Beijing by releasing Ten Years, a controversial film, on its iTunes store in Hong Kong (see WiC320).

Previously Apple’s main point of contact with the Chinese government was the Ministry of Industry and Information Technology (MIIT), says Paul Denlinger, a longtime China watcher. Relations have generally been good because MIIT officials want to see the electronics sector grow and Apple generates thousands of manufacturing jobs. But the move into the services business – especially books and films – is putting it into closer contact with a different arm of the government: the State Administration of Press, Publication, Radio, Film and Television (SAPPRFT). And the media regulator often takes a more ideological stance, which could create new challenges, especially in the wake of new regulations that limit foreign firms from online publishing.

As Chinese TV station bosses will be able to tell Cook, SAPPRFT is an unpredictable body that has become increasingly trigger-happy in what it bans.

This, perhaps, is the more immediate lesson for Apple. If the company is going to broaden its commercial base into services and content, it is going to have to learn how to play ball with SAPPRFT. When you consider that veteran Chinese media entities are struggling with that task, it could be a tough ask for a relative newcomer like Apple.

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