Apple's Big Opportunity: China's Not Going Anywhere

Sep.16.13 | About: Apple Inc. (AAPL)

One's outlook on Apple (NASDAQ:AAPL) in China depends somewhat on psychology. It's a glass half empty or half full scenario. With negative sentiments circulating among the media outlets after the latest release it's not surprising people have turned negative on Apple's outlook, citing stiff competition, loss of market share, or bad strategy on Apple's part. However, this perspective is largely rooted in the short-term. In contrast, keep in mind Apple's earnings beat estimates recently.

Numerous articles have been written on the newest iPhone release and how underwhelming it was. The case for the iPhone 5C being too expensive for consumers, especially in emerging markets including China, has been flushed out across the various media outlets. We've all seen it. It's understandable. Despite the criticism what is lost in the buzz around Apple's newest releases is a long-term perspective on what China means to Cupertino. Being one of the largest smartphone markets Apple has largely not reached its full potential in China. Many writers and most media pundits are focused on short-term events or very recent quarterly results which, yes, were unimpressive. Many point to the fact that Samsung has a dominating market share and point at Apple's failure but their analysis ends there.

Samsung and its Android devices are winning the battle now in China but the war isn't over. Apple is just getting started. Lost among the noise is how serious of an opportunity China is. With a relatively low market share to work with China is still, and will remain, an important market to grow revenue for a long time. China represents just a single case but could be the biggest opportunity as it is the largest market that provides great potential for Apple.

Weighing The Short-Term With Perspective

Revenue growth in China and the Asia-Pacific in general, excluding Japan, has slowed down recently for Apple. Slumping 43% from the previous quarter and 14% year over year (Y/Y) in China analysts are quick to contextual this in terms of Samsung vs. Apple. Apple's earnings in a four to five year period illustrates a different story however:

Asia-Pacific Q3 Data

Quarter

Revenue $M

Year/Year Revenue Change

Q3' 2013

6,687

-15%

Q3' 2012

7,887

25%

Q3' 2011

6,332

247%

Q3' 2010

1,825

160%

Click to enlarge

Apple has made tremendous strides in growing revenue in Asia. Many focus on the single bad quarter Apple had recently but it is important to understand that this is only a single data point in what is going to be a very long timeline for Apple. Markets fluctuate and there just isn't enough data to safely conclude that this is indicative of a long-term declining trend in revenue growth. Basing a bearish analysis on a single assumption from one bad quarter in China is risky. Apple's revenue also doesn't just come from China either. Past performance is an indicator of future success, which is why analysts clamor over Apple's recent slump, but the trend unquestionably shows that Apple is more than capable of growing revenue with its current pricing strategy in emerging markets. What critics don't mention is that Apple, like Samsung, can introduce a lower-cost smartphone model anytime it wants to if Apple decides to sacrifice margins and brand for higher sales.

Apple Is Just Getting Started in China

Back in January CEO Tim Cook signaled publicly the importance of the Chinese market to Apple.

"China is currently our second largest market. I believe it will become our first. I believe strongly that it will."

Undoubtedly, China will become the key strategic focus over the next several years. A plan certainly follows along with such statements but on balance Apple's presence is still primarily in its home turf of North America with 253 retail outlets there. The iPhone has captured 25% of the market share in the US. In comparison, there are only 11 Apple stores in China which is a very telling figure that its strategy in China is barely getting started. If Cook is honest about making China Apple's largest market look for substantially more investment and Apple stores there in the future. Apple has done fairly well in Asia relative to the number of retail outlets it invests in North America. There are plenty of indicators of past success for Apple stores. Going forward, as more stores open in China, it will be important to see how revenue changes as 2012 figures has Apple leading in sales per square foot for all retail outlets.

Apple in Asia is a relatively new phenomenon. People enjoy pointing out the Samsung vs. Apple rivalry in terms of market share. It's important to compare these businesses in other aspects to measure future revenue growth. Apple's strategy in China has only recently started to unfold with its first store opening in 2008. Reuters reports that Samsung opened its first office in 1985. Samsung has more distributors and a greater presence. It has a 23 year head start in building its distribution networks and reputation with consumers. As Apple's presence develops and matures in China so will its consumer base, market share, and revenue. There are plans to double its stores during the next two years. These stores are an important element in the success of Apple in North America as not only are they distribution outlets where customers can get a feel for its products, which is something that is important to Chinese consumers, but they also provide a customer service experience at its 'Genius Bars' that is second to none. This part of its strategy is barely in its infancy and needs time to grow.

Apple is now only close to striking a deal with China Mobile (NYSE:CHL), the country's largest provider, after passing an important hurdle in gaining approval to access its wireless network. Analysts expect this development to help stabilize earnings but what is unknown is how large of an impact will this have over time. It could be a major catalyst for growth as Apple improves its retail outlets in the future.

Long-Term Market Growth and The Big Opportunity It Presents

It's going to be a real big cake, ask Jim O'Neill from Goldman Sachs (NYSE:GS). Don't get entranced too much by quarterly market share numbers. Market share matters of course but in the case of China, since its markets are growing fast, even a slight decline Y/Y in market share could mean an increase in revenue growth for Apple.

Top Five Smartphone Vendors, Shipments, and Market Share, 2013 Q2 (Units in Millions)
Vendor 2Q13 Unit Shipments 2Q13 Market Share 2Q12 Unit Shipments 2Q12 Market Share Year-over-year Change
Samsung 72.4 30.4% 50.3 32.2% 43.9%
Apple 31.2 13.1% 26.0 16.6% 20.0%
LG 12.1 5.1% 5.8 3.7% 108.6%
Lenovo 11.3 4.7% 4.9 3.1% 130.6%
ZTE 10.1 4.2% 6.4 4.1% 57.8%
Others 100.8 42.4% 62.8 40.2% 60.5%
Total 237.9 100.0% 156.2 100.0% 52.3%
Click to enlarge

Source: IDC Worldwide Mobile Phone Tracker, July 25, 2013

International Data Corp (Pending:IDC) reveals how we are seeing this happen in the worldwide smartphone markets where as a whole shipments increased 52% since 2012. Apple's market share went down 3.5% during that period but Apple shipped 20% more iPhones Y/Y.

It is true both Samsung and Apple face stiffer competition by local smartphone companies in China. To name a few this list includes Lenovo, Coolpad, Yulong, Huawei, and Xiaomei. Even if there is competition most smartphone companies are going to get a bigger slice as the cake grows. Samsung has a larger market share in China as estimates put Samsung ahead but the smartphone market is growing significantly as a whole. According to another IDC report their 2013 Q1 data has Samsung leading with a 19% total market share and Apple at 10%. That same report projects all mobile shipments to grow around 6% Y/Y in China. By 2017 smartphone shipments will be a $117.8 billion market. The demand for smartphones is certainly increasing. Apple is in a position to take a bigger slice especially when its China strategy is in its initial stages.

Looking ahead, macroeconomic data could raise a few eyebrows. The IMF projects China's GDP per capita to increase from $10,011 in 2013 to $16,231 in 2018. As GDP per capita increases so will discretionary spending. For a country with well over 1.3 billion people this kind of growth is remarkable. It isn't an understatement when some people say that tectonic plates are shifting. McKinsey & Co. provides research on how China's future middle class will shape global markets. This data could confirm the role of the upper-middle class, or people above this strata, are having on global markets today which includes Apple. We've seen Apple's quarterly Q3 earnings in Asia rise from $1.8 billion to $6.68 billion from 2010 to 2013. In context this is happening at a time when discretionary income will further increase. By weighing this perspective with arguments that Apple products are too expensive for consumers in emerging markets so far it is hard to say that Apple's pricing strategy has been unsuccessful. There certainly are plenty of people in emerging markets who can't afford Apple products but there are also many people who can. In the case of China in the future more people will be able to afford an iPhone as well.

Conclusion

The glass is half full. People instinctively look at the market share data and base their analysis on a few assumptions. Circumstances change and things change quickly in an economy that grows 8% every year. The argument that people in China or other emerging markets can't afford to pay a few extra hundred dollars for a higher priced product for reasons of quality, or brand, is simply eroding away as each year passes. There are of course people who can't afford an iPhone. However, there are plenty of people who can afford to buy Apple products in China and they have been doing so for the past several years in significant amounts. People want to look at the recent quarterly slump or latest releases and tell a story but the more credible story is what Apple has been doing over the past several years in terms of revenue growth in Asia. Apple has only recently started to expand in China. Macroeconomic trends are also favorable for Apple as the smartphone market is growing globally.

China's market is not only here to stay for Apple, as consumers buy or replace their phones, it is actually growing substantially in the future as more people can afford smartphones. There are of course unknowns with forecasting the future but it is precisely this which allows investors to profit. As Apple slowly and methodically increases its presence in China it's hard not to be tempted by cheaper Apple shares. The opportunity for revenue growth in China is simply enticing. It's a slight risk and some reward type bet but like all bets there is the possibly of huge payoffs if Apple becomes a hit in China like in North America. Apple's strategy in China is still in its initial stages. A lot also rests on Cupertino to develop and execute a viable China strategy. Past growth could be an indicator of future success but not always. Some of Apple's biggest strengths however is its brand, huge pile of cash, and quality. Those features are certainly what many Chinese consumers respect.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in AAPL over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.