Apple’s Chinese Woes Extend Beyond Regulatory And Macro Headwinds

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Apple published its fiscal Q3 earnings on Tuesday, reporting that revenues fell by 15% year-over-year to about $42.4 billion amid shipment declines across its major product lines, while gross margins also contracted by 170 basis points to 38%, on account of a growing mix of low-end iPhone sales and FX impacts. [1] Although the results were better than expected, the company’s performance in Greater China – a region that has been the biggest source of growth in recent years – was concerning. Revenues from the market (which includes Mainland China, Hong Kong and China) declined by about 33% year-over-year to roughly $8.8 billion, accounting for about 60% of Apple’s overall revenue decline for the quarter. While the decline was partly due to a tough comparison with Q3 FY’15 and the regulatory and economic headwinds Apple faces in China, it could also be reflective of a more competitive and dynamic smartphone market.

We have a $123 price estimate for Apple, which is about 25% ahead of the current market price. We will be updating our model and price estimate to account for the recent earnings.

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Local Vendors Gaining Share With Solid Devices, Shorter Product Life Cycles 

Competition in the Chinese smartphone space has heated up, with domestic players bolstering market share by launching feature-rich handsets at relatively attractive prices, backed up by clever branding and marketing. According to data from Counterpoint Research, Apple’s share of the Chinese smartphone market in June stood at 9%, down from about 13% in June 2015. On the other hand, Chinese companies Oppo and Huawei held 22.9% and 17.4% shares, respectively.

Local players also appear to be innovating more quickly compared to Apple. Vendors such as Xiaomi and Huawei launch new devices every other month, with frequent software updates, making Apple’s annual product updates and biennial industrial design refreshes seem relatively lackluster in comparison. For instance, Chinese vendors have been offering the dual lens camera – which is expected to be the signature feature of Apple’s upcoming iPhone 7 Plus – for close to a year now. Although iPhones are likely to score above Chinese devices in terms of overall user experience and refinement, the cost-to-benefit scales seem to be tipping in favor of these Chinese vendors.

Cloud Based Services Are Undermining Apple’s Ecosystem Advantage

The increasing proliferation of cloud based-services, ranging from streaming music to social media and messaging, are also likely to be undermining Apple’s historical ecosystem advantage. These services are typically platform-agnostic, implying that customers can access them irrespective of the operating system that their devices run. This could be reducing the switching costs for consumers on Apple devices, prompting them to look for lower-priced alternatives.

Macro Uncertainty And FX Headwinds

There are also some macroeconomic concerns in China, amid currency headwinds and a slowing economy. The Chinese Yuan has depreciated by 7% versus the U.S. dollar since August 2015, reducing Apple’s sales in dollar terms. The Chinese economy is also slowing down, with growth projected at just about 6.5% in 2016, and expected to slow further next year. That said, retail sales are looking up, as the government looks to transition the economy towards services and consumption. However this could lead the government to favor home-grown smartphone manufacturers over Apple.

Regulatory Headwinds Could Weigh On Apple’s Fastest-Growing Business

Apple has been increasingly banking on services to drive its top line and earnings, leveraging its 1 billion+ device installed base. Services revenues grew by about 19% y-o-y to about $6 billion during Q3, and the segment is now Apple’s second largest after the iPhone. [2]  However, Apple’s services have been facing some challenges in China, amid increasing interference by the Chinese government. In April, the company had to shut down its iBooks and iTunes Movie services in the country just a few months after launch, while the lucrative App store is also being subjected to increasing regulation. 

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Notes:
  1. Apple Earnings Press Release []
  2. Apple Q3 2016 Unaudited Summary Data []