- Apple’s China segment performed poorly this year, so we went searching for a valid explanation.
- The weakness in China can be explained by shifting tourism trends, currency impact, slower pace of upgrades, and weak macro.
- However, Apple has made progress in key areas like pricing, distribution and product features making us upbeat on Chinese results in FY’17.
Determining what exactly went wrong in Apple’s Chinese segment is a little bit difficult to articulate. Some would point to F/X trends whereas others would mention saturation as being an issue. It’s really an amalgamation of problems for Apple Inc. (NASDAQ:AAPL). While the problems in isolation are somewhat tolerable, it’s the combined impact that has led to a rather abrupt decline in shipment growth. I mean, just how do you go from 71% y/y revenue growth to -26% y/y revenue growth in China over the span of a single year (Q2’15 versus Q2’16)? Furthermore, it’s worth observing whether these trends will actually abate anytime soon as Apple derived 25% of its revenue from China in the most recent quarter.
I anticipate that the revenue mix from China will likely shrink for the duration of the year before improving in the next year. Apple should show some pattern of recovery in 2017 as it has been more proactive in addressing market-specific challenges via the launch of lower-priced iPhone’s, and continued store roll out (Apple targeted roughly 40 stores in mainland China by the middle of 2016). These efforts along with the launch of the iPhone 7 should boost consumer refresh. Furthermore, the Apple ecosystem is still strong and should lead to sales in adjacent product categories notwithstanding the ban of Apple iTunes Movies and iBooks.
Deceleration In The Chinese Economy
However, we’re also witnessing a fairly rapid deceleration in the Chinese economy. At least, the most recent data from Bank of America Merrill Lynch (BofAML) implies further deceleration in GDP in the month of April.
The China Activity Coincident Tracker (China ACT) has consistently declined over the trailing 6-month period (5.5 to 4.8 between Nov. 2015 and Apr. 2016). The data implies that when strictly focusing on key economic activity levels pertaining to transport, utilities and durable goods, the pace of consumption has slowed, which points to further deceleration in consumer activity. Relying on government data is a bit dubious at this point, and in many cases, GDP revisions happen quarters down the road, so informal measures can be an earlier predictor than the national figure. Furthermore, the weakness in data corresponds to much of the negative press coming from China, so we have to assume weaker macro will continue to plague Apple’s Chinese segment during the duration of the current fiscal year. There might be room for surprises in discretionary categories, but with the emerging economy showing softness in consumption of core services, I would be skeptical of a U-shaped recovery in the near term.
Goldman Sachs analyst Simona Jankowski punched it out of the park in a recent report by listing all of the qualitative factors leading up to the Chinese meltdown:
1) Decline in Chinese travel to Hong Kong – The number of mainland China tourists to Hong Kong fell by 15% in the March quarter, impacted by the appreciating HKD (which is pegged to the USD) as well as new visa restrictions. 2) Lower iPhone upgrades resulting in share loss to Chinese vendors – iPhone shipments in mainland China fell 12% yoy, resulting in share loss to Chinese vendors Huawei, OPPO and Vivo. 3) Shift from early/high-end adopters to later/mass market users – China Mobile’s net adds fell 13% yoy, while China Unicom and China Telecom’s combined net adds grew 990%.
To put further context behind that quote, the HKD (Hong Kong Dollar) appreciated by 5% when compared to the Chinese Yuan, making the market less price competitive. Also, tourism fueled spending was impacted by regulatory changes that limited the number of permitted entries from Chinese tourists into Hong Kong to 1 per week.
The reason Hong Kong affects demand is due to the pricing difference of iPhone’s as recent checks imply pricing of $830 to $1,080 for the iPhone 6S model (16GB to 128GB) in China. This is in comparison to $650 to $850 for the iPhone 6S in the United States and $720 for the 16 GB variant in Hong Kong. Basically, the iPhone 6S is cheaper by roughly 15.22% without factoring F/X. However, on a currency adjusted basis, the iPhone 6S costs 8.9% less in Hong Kong, which translated into less meaningful cost savings for mainland tourists.
There was also a significant pricing differential to Japan as the base iPhone 6S model was sold for $640: $10 cheaper than in the United States and $190 cheaper when compared to China. The results from the Japanese segment were particularly strong in Q2’16, as revenue grew 24% y/y, which alludes to tourism-themed spending in Tokyo as opposed to Hong Kong. So, we kind of get a sense of what happened, but there’s even more bad news from China alone.
Smartphone fatigue in China
The data on the Chinese smartphone market was broadly weak in Q1’16, as BofAML noted in a smartphone report:
In 1Q16, global smartphone shipments reached 333mn units (-17% QoQ, -3% YoY), while feature phones reached 97mn units (-11% QoQ, -10% YoY). Total handset shipments were 430mn units (-16% QoQ, -5% YoY). Overall, demand for handsets in 1Q16 remained weak. Smartphone growth is slowing due to increasing penetration maturity in major markets like China.
The smartphone market grew by 8% in China according to Goldman Sachs, but Chinese growth wasn’t able to offset global trends and skewed towards bargain brands like Huawei, Xiaomi, Oppo and Vivo. Also, China Telecom and China Unicom both experienced net smartphone adds at the detriment of China Mobile in the past quarter. Since these two telecoms target price-sensitive consumers, the market for high-end phones actually contracted, as consumers are looking to adopt handsets that are priced below $180. The ASPs (average selling prices) of Huawei, Xiaomi, Oppo and Vivo were $186, $135, $210 and $165 respectively in Q1’16, according to BofAML.
The stark difference in pricing and the lack of a compelling feature set for iPhone 6S/6S+ compounded into weak results. We then combine the weakness in Hong Kong tourism, and a softening economy to arrive at -26% y/y Q2’16 Chinese comps. Apple experienced the proverbial, “death by a thousand cuts.” The irony is that the original quote/proverb came from China. And while Apple did get dismantled by China this year, I’m starting to get more optimistic on FY’17 results.
Source: Goldman Sachs
Apple continues to dominate the high-end of the Chinese smartphone market, and if history has taught us anything, Apple tends to dominate 90% of the premium pricing category across PCs and consumer electronics. Apple currently holds onto 55% of the premium smartphone market in China, according to Simona Jankowski. So there’s still upside to penetration when focusing strictly on the higher value/price segment.
It will take a couple of quarters to see the impact from the iPhone SE, but with consumer electronics exhibiting higher price sensitivity/elasticity, the impact should become more noticeable assuming Apple continues to refresh the $450 category at an annual cadence.
As such, I continue to reiterate my buy recommendation and $107.72 price target.