Apple already has a China problem. Here's why it could get worse. (AAPL)

July 28, 2019

Apple already has a China problem. Here's why it could get worse. (AAPL)

Apple CEO Tim Cook

China has become a big problem for Apple.
For years the company benefited from cheap labor there and a growing consumer market.
But its sales there have fallen off a cliff in recent quarters, and it could be hit hard if President Trump follows through on his threat to impose yet another round of tariffs on China.
Some analysts aren't as worried as others about the China situation, thinking it will eventually blow over.
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Apple's got a China problem.

The hope is it will get better soon. The danger is that, thanks in part to President Trump's trade war, it could get a lot worse.

Over the last two decades, the iPhone maker has been one of the biggest beneficiaries of China's integration into the world economy. Now, Apple is among the companies that are most vulnerable as China's ties with the US become increasingly frayed.

"China remains the wildcard in the Apple story," said Dan Ives, a financial analyst at Wedbush who covers the company. "Apple," he continued, "is going to go up or down — [its business] fundamentals as well as the stock — depending on China."

Indeed, Apple's stock is trading about $20 to $25 a share lower than it otherwise would be, due to concerns about the trade war, Ives said. The company's stock closed at $207.74 a share on Friday.

The tech giant will offer a glimpse at how China is continuing to affect its business on Tuesday, when it releases its fiscal third quarter earnings report. Analysts expect Apple to post a drop in its per-share profit on flat sales, with a third-straight decline in revenue from its China region weighing on its results.

Most of Apple's products are made in China

Apple's vulnerability when it comes to China comes down to two primary factors: It manufactures nearly all its products in China; and the Asian country has become a major market for Apple's goods and services.

On the manufacturing front, Apple has reportedly been exploring shifting some of its production out of the country. But analysts including Ives estimate that shifting even just 10% of its iPhone manufacturing out of China could take years. That's an important obstacle, because iPhone sales represent around 60% of Apple's total revenue.

Read this: Here's why Apple's plan to escape Trump's tariffs by building iPhones outside of China won't actually be possible anytime soon

And the company has actually been moving in the other direction. Apple drew praise earlier this decade when it announced it would make the Mac Pro, its professional desktop computer, in the US. But after that model and design largely failed, the company has decided to make its successor in China.

mac pro wwdc The company saw huge benefits from shifting its production to China starting around the turn of the century. It was able to streamline its production and, thanks in part to low-cost labor, boost its profits markedly.

Now, though, the company's big bet on Chinese manufacturing could come back to bite it, thanks to the ongoing trade war. Already, Apple has asked — and President Trump has rejected, via a tweet — that parts for its new Mac Pro be exempted from the existing tariffs. Meanwhile, if the president goes through with his threat to impose another $300 billion in tariffs on goods made in China, Apple could be hit even harder, because those new impositions would be levied on the company's core products — phones and computers.

If the administration does enact the new tariffs, Apple will be faced with a choice, just like every other company so affected. It could pass along the additional costs to consumers or it could decide to swallow them and take a hit to its profits.

Apple's price hike is catching up with it

But Apple may actually have less latitude than other companies. The electronics giant boosted the price of its smartphone lineup significantly with the launch of the $1,000 iPhone X in 2017. Although Apple's unit sales initially held up after that price hike, they fell off a cliff last fall, a fact that analysts attribute at least in part to the company's phones being too expensive for many of its customers.

So, the company likely can't hike prices even more to account for the tariffs without seeing another big hit to its unit sales.

"You've kind of hit a ceiling on how far you can keep jacking up the prices on the phone," said Daniel Morgan, a portfolio manager with Synovus Trust, which owns Apple shares.

The other part of Apple's China problem has to do with its sales to consumers there. For years, Apple's Greater China region, which includes Hong Kong and Taiwan in addition to the Chinese mainland, was one of the company's fastest growing geographic segments and it has become a huge part of the company's business. In Apple's most recent fiscal year, Greater China accounted for 20% of its sales, which was a greater share than Japan and the rest of the Asia-Pacific region combined.

However, the company's business in China took a nosedive starting last fall. Its sales in the region plunged by 27% on an annual basis in the holiday quarter, then fell at a 22% annual rate in the March quarter. Wall Street's expecting Apple to report another drop in sales in Greater China for the June quarter.

The high prices of Apple's products certainly played a big part in the drop in its sales in the region. The flagship iPhone XS, which costs $1,000 in the US, initially cost around $1,300 in China. The supposedly more affordable XR model, which starts at around $750 in the US, cost around $967 in China.

Those prices would be expensive even by US standards. But they're even more so in China, where the average workers make a fraction of their American counterparts. And the prices stood out even more, because Chinese phone manufacturers including Huawei and Xiaomi have been releasing competitive models there at much lower prices.

Apple "had pricing hubris," said Ives. Given that the company's latest smartphones didn't offer any must-have new features, he continued, "a Chinese consumer's not going to spend half a months' paycheck to a full month's paycheck for the next iPhone."

Chinese nationalism is ramping up

But Apple may be facing other challenges than just its pricing in trying to sell its products to Chinese consumers. The country is experiencing a wave of nationalism both among its populace and in its government, people who have traveled in the region say. The focus of that nationalism is on US-made goods and companies, they say.

Already today, but particularly going forward, Chinese companies and consumers are likely to choose alternatives to US-made products, said Melissa Guzy, managing partner at Arbor Ventures, which recently moved its headquarters from Hong Kong to Singapore. Although the trade war has helped to augment the trend, it goes well beyond that dispute.

"It's not temporary. It's a long-term shift that's happening," said Guzy. She continued: "I think most Chinese don't believe they need the US for anything."

Should Apple's sales in China continue to slump, that could threaten another part of its business. In recent years, as the smartphone industry has matured, Apple has been touting the growth of its services segment. That segment actually is composed of a motley collection of different businesses and partnerships, including the revenue it sees from sales through its App Store, subscriptions to Apple Music and its iCloud offering, and the deal it has with Google to make the latter's search engine the default on iPhones and iPads.

Apple's services revenue is directly linked to the number of iPhones and iPads in use; a big part of the growth in that business has come from convincing more of its customers to sign up for an increasing number of its services. If its user base actually declines in China thanks to the drop in sales there, the company could see its services revenue likewise take a hit.

Some analysts think this will all blow over

Some analysts, though, think the fears about the trade war and Apple's sales in China have been overblown. With his economy slowing dramatically recently, Chinese President Xi Jinping will be under increasing pressure to strike a deal with Trump to end the tariff battle, said Scott Rothbort, president of LakeView Asset Management. That will relieve a big overhang on Apple's stock.

"There's a lot more bark than bite when comes to all these tariff issues, and it will settle out," said Rothbort, who owns Apple shares. "And China understands it will have to settle."

While nationalism may be on the rise in China, it's not predominant, Ives said. He estimates that only about 10% of the drop in iPhone sales has to do with Chinese consumers turning away from an American company's goods. Ives thinks there's a good chance Apple's overall iPhone unit sales will be flat next year, instead of continuing to fall, and may actually start to tick back up.

Skeptics "have made investors believe in China they're throwing iPhones into the fire and protesting [against] Apple," he said. But if you visit an Apple store in the country, he continued, you'd realize that "couldn't be further from the truth."

And many Apple investors and analysts are bullish on the company's services business, regardless of what's happening in China. Ives, for example, expects that segment to continue to grow by the mid- to high teens, percentage-wise, going forward, boosted by Apple's recently streaming video business, which is set to launch this fall.

With Apple, "it's now all about the services," Rothbort said. "Everybody is so focused on the iPhone sales and all the other hardware sales that I think they're missing the forest for the trees."

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