Why Apple May Not Dominate China

| About: Apple Inc. (AAPL)

New contributor Weezy Miyagi wrote an interesting article about Apple (NASDAQ:AAPL) and the current business environment in China. So let me first welcome Weezy Miyagi to Seeking Alpha and I will simply say I do not share his/her full enthusiasm for Apple's prospects in China. Do I believe Apple will "fail" in the Middle Kingdom? No, but that does not imply investors should expect anywhere near the success suggested in Weezy's article.

Weezy starts out making a very big mistake in assumptions. While it's true many Wall Street analysts may not have visited China there is enough empirical data with other companies' experiences to know what is likely to happen without visiting China. Apple has been in China long enough to encounter what other large name brands have found to also be true.

I have not been to Canada (technically I have flown over Canadian airspace many times going back and forth between North America and Asia), but yet I have written many articles and studied Research In Motion (RIMM) and have called the fall in price correctly as well as the stabilization too. Apple recently took over as the number one smartphone in Canada. I don't believe I need to travel to Waterloo to figure out RIM better than I can from the U.S.

Weezy's assessment in regards to the Chinese new year is correct. The Chinese New Year is by far the biggest holiday in China and other Asian countries as well. Undoubtedly Apple will also experience the "holiday shopping season" rush and put iPhones in the hands of many Chinese consumers. What Weezy misses is that many of the iPhones sold will not actually be iPhones. Counterfeiting is rampant in China, and iPhone is certainly no exception.

Shanghai is considered by many to be the "example" China uses to demonstrate the enforcement of intellectual property rights. My own experience reflects Shanghai may be the "toughest" city on counterfeiting, but don't think for a moment it means counterfeiting isn't common even in Shanghai.

The situation is so bad in Shanghai that even in malls I could not find genuine DVDs to buy among fake product. I have even toured a "Fender guitar" factory in China, which may be somewhat difficult to understand if you are familiar with Fender guitars, because they don't have a factory in China.

Apple CEO Tim Cook can travel and visit all the leaders he wants and it will likely not have much of an impact. This is a big problem for all name brands, and especially for foreign products. So important of an issue that any projected sales numbers based on population and disposable income must be significantly discounted for this reason alone.

Next, is the actual numbers used as "upper class" in the overall population. In Weezy's article a number of 5% is used as "upper class." Of course I cannot argue there is not a 5% upper class, because I don't know how it's defined in this case. I can say that to use the term "upper class elite" at a minimum is a distortion of a common understanding of the meaning. To assume wealthy elite make up 5% of China's population is simply absurd and a number closer to 1-2% (~40% of the assumption) is a realistic number to work within the next couple of years.

Again, depending on how wealthy one needs to be to be "wealthy," the percentages will change, but if you take away cost of living adjustments like so many statistics use, the numbers fall pretty fast. Are there 3 million "moderately wealthy" people in China? Yes likely, but is there 10 million, 20 million, and how about 28 million? With 28 million you are getting close to 2% (officially China has about 1.4 billion people, but likely significantly higher).

Remember, prices in China are much lower than in United States. This is a double edged sword, as costs are lower (much of the production is local also), but profits are also lower on a per-unit basis. Competition from Samsung, HTC and a host of brands not sold in North America compete in the Chinese market (along with fake iPhones).

Lastly, the issues with Google (NASDAQ:GOOG) and the Chinese government should be considered a risk factor and nothing else. If this isn't a warning sign that things can get bad in a big hurry, then I am not sure what is. While I believe Google will be back in the Chinese market sooner rather than later, it would be hard to make a case that Google is better off for leaving the market. What happens when Apple is faced with a similar situation? It's not hard to fathom, considering the vast amounts of digital content Apple offers, including DVDs.

One may easily get the impression I am bearish on Apple, and that would not be a correct assessment. I believe Apple offers significant upside when bought correctly. First, I would not buy the stock outright, but would write put options as a method of entry. In the money put options offer a means of getting a discount from the current price. A discount in purchase price by default means lower risk. I especially like the June and further back months with strikes about $10-20 in the money. For timing of the sale of put options I would look for pullbacks like we went through last week. The $550 area offers a significant discount from the recent highs, and likely a strong support.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in AAPL, GOOG, RIMM over the next 72 hours.