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Will New iPhones Solve Apple's China Problem?

It’s no secret that the world’s most valuable company has been facing challenges in the world’s most lucrative smartphone market. Sales in Greater China, which helped drive Apple’s phenomenal sales growth in 2015, have been a drag on top line performance for the last six quarters. The big question now is whether the new iPhone 8, and particularly the new iPhone X, can turn around Apple’s fortunes in China.

But firstly, a quick post mortem on what happened in China over the last few years.

Screen Shot 2017-09-19 at 3.10.20 PM

There are three categories of smartphone purchasers in China: those who want the best phone that money can buy, those who enjoy the prestige of owning the highest-status phone brand, and those who are price sensitive. The emerging Chinese middle class saw Apple as the highest status symbol in consumer electronics, and lapped up the iPhone.

However, two problems emerged after the blockbuster iPhone 6 supercycle that has plagued Apple globally, and particularly in China. Firstly, Android phones, especially those from Chinese manufacturers Huawei, OPPO, Vivo and (a resurgent) Xiaomi, became “good enough” at the same time as Apple lost its way with respect to innovation, and allowed Samsung to surpass it in terms of technology. The iPhone 6 pulled forward so much demand that the iPhone 6S fell flat on its face, and the iPhone 7 lacked significant differentiation to incentivise existing iPhone users to upgrade their handsets. Apple has pinned its hopes of unleashing a new supercycle on the iPhone 8, and so far, investors have overwhelmingly backed these hopes.

The second problem is more fundamental. WeChat, the messaging app owned by Tencent, has become so ubiquitous in the minds of Chinese netizens that people live their entire social life on the app. Unfortunately for Apple, WeChat works just as well on low-end Android phones from Huawei or OPPO as it does on iOS. Apple has always been the company that sells hardware differentiated by software at a premium, but this development in China put the burden squarely on Apple’s hardware – it is not the iOS platform that users want, it’s the WeChat platform. Since the iPhone 6, Apple has clearly failed the hardware test.

Now, onto the product launches.

The iPhone X was developed specifically to address (crush, even) the first problem. It is a significant upgrade, both in terms of hardware and software, over prior flagship models, with a distinctive appearance to boot that would prevent anyone from confusing your top-of-the-line phone with a two-year-old model. The insane specs have an insane price to match – US$999 for the 64GB model and US$1,149 for the 256GB version. But this shouldn’t turn off the two price inelastic Chinese markets that Apple is targeting – those who want the best phone on the market, and those who want the prestige of an iPhone X.

The bigger unknown is how the iPhone 8 will perform in China, given it is no longer the flagship model and will be priced at a US$150 premium over the once-flagship iPhone 7, or US$130 premium for the iPhone 8 Plus. The iPhone 8 has some upgrades over the iPhone 7, particularly the chipset, camera and wireless charging, but otherwise looks almost identical to its predecessor (remember the importance of distinctive appearance to the Chinese consumer). Although it may be just the phone Apple needs in the rest of the world, whether this middle child can overcome China’s WeChat problem awaits to be seen.

However, one thing Apple has going for it, according to analysis by TalkingData, a Chinese big data analytics service, is that despite Apple’s challenges in China, the iPhone has maintained its active device market share:

Screen Shot 2017-09-19 at 3.10.57 PM

What this suggests to us, is that falling iPhone shipments and sales in China are largely due to users holding onto their existing iPhones for longer, rather than switching to Android. Apple’s status and brand cachet has been maintained; the same cannot be said for Samsung, which has been the leading share donor to Chinese Android brands over the past several years. As launch day iPhone 6’s approach three years old and iPhone 6S’ two years, there is strong reason to believe that the iPhone 8 will finally drive a meaningful upgrade cycle in China notwithstanding the lack of a differentiated appearance. For the third, price conscious category of buyers, the almost identical appearance of the iPhone 6S, 7 and 8 could actually spur sales of the older models (perhaps this was an intentional design choice…). Someone who can’t afford the US$699 starting price for the iPhone 8 can now buy a reduced-price iPhone 7 or 6S, which on first glance would look the same as the iPhone 8, while still conveying higher status as a once-flagship Apple product than the latest Chinese Android flagships.

Having said all this, we believe expectations of the iPhone 8 igniting another global iPhone supercycle are well built into Apple’s share price, which has risen by 50 per cent in the ten months since the post-iPhone 7 trough. Accordingly, we recently trimmed our position in Apple, as the probability of exceeding these already-high expectations (and thus producing material price appreciation) is now reduced, particularly in light of the apparent production delays with the iPhone X.

The Montgomery Global Funds own shares in Apple (Nasdaq: AAPL)

View More Articles By The Montgomery Team

Roger Montgomery is the Chief Investment Officer of Montgomery Investment Management, montinvest.com, and author of blog.rogermontgomery.com.

Roger's step-by-step guide to valuing the best stocks and buying them for less than they're worth, Value.able, is available exclusively at rogermontgomery.com. Skaffold is an online stock-picking application that rates ASX-listed stocks from A1 to C5. Watch a demo of Skaffold at www.skaffold.com.



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