Why The Saturating Chinese Smartphone Market Could Work In Apple’s Favor

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Apple’s (NASDAQ:AAPL) iPhone sales to China proved to be one of the key drivers of the company’s stellar Q1 FY 2015 results. Revenue for Greater China – which includes mainland China, Hong Kong and Taiwan – grew by 70% compared to a year earlier, or nearly three times as fast as the Americas and Europe regions. According to research firm IDC, Apple was the second largest smartphone vendor in China during Q4, with its market share standing at 12.3%, up from just 7.4% in Q4 2013. [1] This is quite a feat, since iPhones sell for more than twice as much as the average smartphone sold in China (the iPhone 6 sells at roughly $850). The current growth spurt has come on the back of the company’s new iPhone 6 and 6 Plus models – which helped to satisfy pent-up demand for a large-screen Apple handset and enabled the company to capture market share from premium phablet manufacturers such as Samsung Electronics (PINK:SSNLF). However, that brings us to an important question – can the iPhone sustain its growth momentum in China given that the broader Chinese smartphone market appears to be slowing down? We believe the answer is yes, and although it may seem somewhat counterintuitive, we believe that the saturation could possibly even work in Apple’s favor.

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Mix of High-End Handsets Could Increase As Upgrade-Driven Sales Rise

China’s smartphone market – which is the world’s largest –  appears to be slowly saturating. According to IDC, more than 80% of China’s 885 million mobile phone users are now using smartphones and the Chinese smartphone market is expected to grow at just 10% this year, down from around 20% in 2014. ((Heydays’ in China’s smartphone market are over, CNBC, December 2014)) Upgrade-driven sales are likely to slowly account for a greater portion of Chinese smartphone shipments. Low-end and mid-range smartphones – which cost under $300 unsubsidized – account for a bulk of the installed base in China. First-time smartphone buyers from a few years ago are likely to upgrade to more capable and possibly premium devices, and this gives us reason to believe that the high end is where much of the activity (and growth) will occur in the next few years. The importance of the high-end market is also evident from the strategy of large Chinese handset vendors. For example, China’s fourth-largest handset vendor Huawei said that it plans to largely focus on producing high-end smartphones, while market leader and value handset champion Xiaomi has also been increasingly launching high-end models such as the Mi Note and Mi Note Pro. [2]

Apple Shipments Could Grow, Needs Balance

We believe that Apple could be the biggest beneficiary of growth in the high end of the Chinese smartphone market. The company already dominates the premium market in China, with 80% of handsets sold in the $500+ price range during 2013 being iPhones. We expect that the proportion likely remained at similar levels or grew through 2014. [3] Although smartphones appear to have matured as a product category, with devices across different vendors offering similar functionality, Apple has been able to differentiate itself through strong design, its polished operating system and user experience, and its vast software and device ecosystem.  Moreover, Apple enjoys a strong brand cachet and the aspirational value of the company’s products among China’s growing middle class remains very high. Apple’s branding strategy in China has also been strong. For instance, the company resisted pressure to introduce a cheaper smartphone for the Chinese market – a move which helped avoid diluting its premium image and margins. We believe that the company will be able to continue its volumes (and earnings) growth in China as long as it treads the line of being able to build more mainstream popularity, without hurting its premium positioning and luxury cachet.

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Notes:
  1. China rings up 420M smartphones in 2014, Xiaomi takes market lead,ZDNet, February 2015 []
  2. Huawei to Focus on Higher-End Smartphones, WSJ, January 2015 []
  3. Of the 27% of Chinese phones that cost >$500, 80% are Apples, Fortune, March 2014 []