Apple's Achilles' Heel in China is Rapidly Improving Local Apps and Services (i.e., WeChat)

Apple's success in China has been spectacular. Truly outstanding. But while the "Apple in China" story is usually told in terms of the rise (and now leveling off) of iPhone sales, it has also been just as big a success in terms of brand building.

Apple today is known and loved by China's increasingly wealthy urban middle class. And the company has a commanding position in the lucrative "affordable luxury" market segment. Apple’s success in rising consumer China is even better than its growth numbers imply.

However... (you knew it was coming)

While capturing Chinese consumers has been a big accomplishment, the critical question now is “can they keep them?” And a big part of the answer – and their biggest risk going forward I think – is whether or not they can address their lack of services and software in China.

I will expand on this with the below points - and then I will propose a few potential solutions:

Point 1: Apple is well-positioned in one of China’s most attractive market niches, “affordable luxury”.

Affordable luxury in China is not selling BMW cars or fine art, which are still beyond the means of the vast majority of the population. Affordable luxury is Coach bags, vacations to Thailand and new iPhones, not the refurbished or fake ones.

These types of luxury purchases are not that pricey and are rapidly becoming affordable for much of China's populace. They are also directly benefiting from the transition of urban consumers from bargain-hunters of life's basics into more emotional and loyal consumers. Sellers of affordable luxury products and services can not only command premium prices, they can also benefit from the steadily increasing disposable income of urban households.

The sale of iPhones to Chinese consumers, and this demographic in particular, has resulted in surging growth for Apple over the past five years. China is now the company's third-largest market by revenue (2016). China was also the source of half the company's growth. All the while, gross margins have remained around 40% globally. This is fairly amazing. OnePlus co-founder Carl Pei speculated that 90% of the profits in smartphones were probably going to Apple.

However, analysts have increasingly been discussing a plateauing of iPhones sales in China. I think these comments miss an important point that the iPhone remains very expensive in China relative to average income levels - but these income levels are rising. iPhones are still in the process of becoming affordable to a wider and wider base of consumers, so the trend line remains attractive.

Additionally, Apple's unique position in Chinese affordable luxury creates an important side benefit in application development. While Apple's iOS operating system may be dwarfed in the Chinese market by Google's Android (like 85% is Android), Apple has the customers who will actually spend money to buy apps and add features. This means Apple gets developer attention in China, beyond its actual market share.

Point 2: Unfortunately, the smartphone market of China is getting much more difficult.

There is a lot of pessimism about smartphones in China recently. I’m just going to skim through this as it's pretty standard stuff. Feel free to skip to Point 3.

After years of rapid growth, flatlining sales are resulting in a painful shake-out.

There was a 5% contraction in smartphone sales in the first quarter of 2016 (Strategy Analytics). And as this comes after five years of stellar growth, there is likely a post-boom shake-out happening. Smaller players are exiting or consolidating (especially if they only make phones).

Chinese smartphone companies are dominating - and moving upscale.

Go back to 2011 and 70% of the smartphones in China were foreign (mostly Samsung, Apple and Nokia). Today the market is dominated by Chinese phone makers. Apple is really only one of 2-3 foreign smartphone makers still alive in the Mainland. And unfortunately for Apple and Samsung, the Chinese are now moving upscale into premium phones.

No barriers to entry for basic smart phones.

The situation is even worse in discount smartphones. It is getting easier and easier to enter this business. Xiaomi showed that by going from a start-up to a big success in three years. Oppo and OnePlus have both entered in the last couple years and have risen quickly.

We are now even seeing “micro runs”, in which local companies are creating and selling batches of 20,000-30,000 phones with an office and just a few staff. So the competition in cheap smartphones is getting more intensive, while the premium market is being invaded.

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Against this worsening situation, I think Apple is still mostly staying above the fray. As mentioned, they have captured a huge number of particularly valuable Chinese customers. They do have a unique brand and reputation. And premium smartphones do require constant upgrades and technological advances, for which Apple deploys $10B in R&D annually in R&D and does frequent technology acquisitions.

So I give Apple the benefit of doubt that they will likely stay at the frontier technologically. And in China, I do think they have, to some degree, what Warren Buffett calls a “share of the consumer mind”. The iPhone is the quality phone to have in China today. And Apple can keep reinforcing this with their massive marketing spend and their fantastic China stores.

But my main point is that selling smartphones without services is just a very difficult game in China. And going forward, this market and Apple’s position look increasingly at risk – mostly because they lack the stickiness from software and services that they enjoy in the West.

Point 3: Apple in China is exposed. They largely lack the services, software and platforms that give them competitive protection and customer retention in the West.

In China, Apple basically sells hardware - lots of iPhones and some iPads. And other companies, mostly Chinese, populate them with services and software. Apple in China largely lacks the services and platforms that give it competitive protection and "customer stickiness" in the West.

Chinese iPhone users simply do not worry about losing movies or music purchased from Apple should they change brands. Nor do they worry about losing friends in iMessenger or files stored in iCloud. They are mostly not using those Apple services.

Software and platforms can create network effects and other switching costs that protect Apple from the unpredictability of successfully developing and selling a cool new smartphone model every year or two. And they create a buying relationship on a daily or weekly basis.

Without software and services in China, there is no real guarantee that Apple can keep the valuable Chinese customers it has so successfully captured. Consider the chaotic shifts in market position over the past years that have seen Nokia, Samsung Electronics and Xiaomi each rise to the top before falling.

In economist-terminology, Apple in China doesn’t have the high switching costs and network effects (both two-sided and complementary) that keep their customers from year to year. While Apple may make $140B in iPhone sales globally, it is their +$20M in software and services that really locks in their customers.

Point 4: Apple is also facing additional threats that are more unique to China.

The transition from touch to voice as the primary phone interface appears to be happening fast in China. This is perhaps because typing in Chinese is more difficult? And while Apple does pretty well with its Siri personal assistant in English, it is behind on Mandarin as a voice input.

One company to watch here is Baidu. It appears to be moving fast and is focused on developing high quality Mandarin recognition. If the primary interface for the iPhone in China becomes another company's Mandarin-recognition application, this would be a problem for Apple.

China has also become the world capital for mobile payments, with Tencent's WeChat commanding a particularly high level of engagement in this area. That is daunting for Apple. Apple Pay's doesn't get a lot of usage in China.

Point 5: WeChat and other rival gateways are a particularly big threat.

Beyond payments, WeChat is becoming the app that contains and controls the other apps a smartphone user might want, effectively becoming an alternate homescreen. This is a direct threat to Apple's control of the user experience of Chinese iPhone owners.

Additionally, China is also now the leading market for on-demand transportation (i.e. Didi Chuxing). And this service incorporates mapping, payment systems and other commonly used services. Ctrip is also becoming a mega-app that contains lots of functions. All of these big apps shift the user from the homescreen into the app as an alternative homescreen.

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Thus, in service and software, Apple is being outrun in China's innovative mobile world. This is reducing it more and more to a pure hardware company, exactly the direction Apple does not want to go in terms of securing its current customers.

How Apple can breakthrough in China software and services

Apple today appears to be searching for entry points into China services. Its investment in Didi Chuxing could be seen as part of this? It has also been attempting to expand Apple Pay, iCloud, iTunes Movies and iBooks in China, all without too much success. Everyone in China uses Baidu for maps, WeChat for instant messaging, its affiliated Tenpay service or Alibaba Group Holding's rival Alipay for mobile payments and so on.

An unspoken part of this is the big role of the government in these markets. Many of these services are political and the government cares who wins. The combination of fierce local competition and active state involvement is frequently fatal for foreign internet companies in China.

Apart from this, the strength of Apple in China itself is perhaps a concern for the government. The authorities are simply not going to allow Apple to have direct, uncontested control of the phones of some 200 million Chinese.

However, Apple does have options for breaking into software and services in China. And they can leverage their big strengths: an enviable reputation, a broad customer base and a huge cash pile.

One strategy would be to emulate Intel Capital's successful approach in China. This would mean investing in early-stage mobile tech and services companies across the country. The goal would be to increase the use of Apple's technology and ecosystem. Like Intel, Apple could position itself relative to other venture capital investors as an attractive, long-term partner which can provide introductions to other large tech companies and offer access to a global network of engineers, technologies and customers.

Apple could also do more Didi-type investments. They have the cash to keep buying into successful later-stage service companies. There is no reason Apple cannot do 10 more such deals. But for this to solidify its current China business, it needs an operational tie-in or technology agreement.

Another option is a larger partnership in China, say with Xiaomi. Such partnerships are how virtually all foreign media and Internet companies operate in the country. It would also give it a mainstream brand to complement its premium brand. The deal Xiaomi unveiled in 2016 with Microsoft, which includes a pledge to install Microsoft apps on Xiaomi phones, is worth watching in this regard.

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Ultimately, Apple in China today is not the Apple of Tim Cook and Steve Jobs in the West. It is more like the Apple of 1982. It is a story of meteoric success but a somewhat precarious year-to-year existence based on new product launches on a rapidly shifting terrain. Deliver a great product and it's boom time, as happened with the Apple II personal computer. Deliver a dud and the dark days are back.

Services and software will be key to minimizing this volatility, securing Apple's large existing customer base and preserving its exceptional success in China. It does not need services as a new source of revenue growth as the really big money will continue to be in selling handsets. But their big China business and cash flow need better protection.

Article reposted with permission from Nikkei Asian Review, link here.

 Thanks for reading, jeff

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I write and speak about "how rising Chinese consumers are disrupting global markets - with a special focus on digital China".

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If you would like my recommended China reading list, you can get it at www.jeffreytowson.com. You can also get a free chapter of my One Hour China Book there as well.

Some previous posts include:

• "Why Chinese Moms Are the World's Most Important Consumers"
• Why Did Apple Invest in Didi? Because That’s How Big Companies Start Dating.
• Want Real China SOE Reform? Let AB-InBev and the Crazy Brazilians Run Snow Beer.
• How China's Increasingly Emotional Consumers Are Shaking the World
• How I Went From NYC to Working for Prince Alwaleed
• What To Do When You Fail in China (Pt 1): Danone vs. Carlsberg

About: I am a Professor of Investment at Peking University Guanghua School of Management in Beijing. I am also an investor, consultant and former executive / slave to Prince Alwaleed.

?Photo by eltpics / Christina Martidou, Creative Commons license with link here.