Don't Dismiss Apple Inc.'s China Troubles

By Markets Fool.com

During Apple's (NASDAQ: AAPL) fiscal 2016, the company's revenue in the Greater China region plummeted 17%, hitting approximately $48.5 billion, down from around $58.72 billion in the year prior.

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Image source: Apple.

On the company's most recent earnings call, CEO Tim Cook offered the following explanation for that precipitous decline:

Also, as you probably know, the fiscal year 2016 performance was hurt by the devaluation of the currency, which affected it about 3%, so the underlying business performance was 14% down. And so why was it down? There's lots of reasons, but the largest one, in our view, is that when you look at what happened in 2015 in China, we had a surge of upgraders that came into the market for the iPhone 6 or iPhone 6 Plus, and the upgrade rate increased relatively more in Greater China than elsewhere around the world. And so, when that upgrade rate in fiscal year 2016 returned to a more normal upgrade rate, which would be akin to what we saw with the iPhone 5s as a point, it had further to fall. And so that's the main reason in our view that you see a difference.

Let's give Apple back the 3% currency-related impact. That, of course, still leaves a business that dropped 14% year over year. The hypothesis that the unusually strong iPhone 6 cycle led to a pull-in of demand that otherwise would have been satisfied during the iPhone 6s-cycle also seems reasonable, right?

No, it's not. I'll even take it a step further and call it a deflection from the underlying problem.

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It's called market share loss

Per a fresh report from Strategy Analytics, shipments of smartphones in China "grew a healthy 15% annually from 105.0 million units in Q3 2015 to 120.9 million in Q3 2016."

Strategy Analytics also pointed out that Apple managed to grab only 6% of the market during the third quarter of 2016, plunging from the 10% share it captured in the year prior.

Just so we're clear, the overall market for smartphonesgrew, but Apple's unit shipments managed to fall. That alone suggests market share loss, but the magnitude of the market share loss that we're talking about is enormous -- a full 40% drop.

When a company sells fewer units in a growing market and sees its market share cut nearly in half year over year, there is much more going on than an upgrade cycle that's being pulled in; this is a fundamental deterioration in the demand for Apple's products relative to the demand for products from its China-based competition.

Apple's not placing blame correctly

The worst thing Apple's executives can do is convince themselves that plunging share in a key growth market is due to a pull-in of a product cycle. This kind of thinking will allow Apple's management team to believe that its China problems aren't due to its own execution but rather to forces outside its control. That's a dangerous way to think, because it means the company won't take the appropriate steps to try to fix the issue.

So what's the underlying problem?

Apple was outmaneuvered and outclassed

Apple releases one new pair of flagship smartphones each year. If those phones prove to be sufficiently better than what the competition has in the market, then Apple can get by selling those models for a full year. If those models don't deliver a compelling set of features, both in absolute terms and relative to what the competition is selling, then Apple and its shareholders are stuck paying the price for the entire year.

That's what I believe happened with the iPhone 6s-series smartphones, which were outgunned in several key ways by devices offered by Chinese smartphone vendors well before Apple had the opportunity to launch the arguably much better positioned iPhone 7-series phones.

The good news for Apple is that the iPhone 7-series devices are exceptionally good products that appear to be much more differentiated relative to the competition than the iPhone 6s-series phones were relative to their contemporaries a year ago. The bad news is that even though the iPhone 7-series phones are phenomenal, the major China-based smartphone makers don't release new devices once per year -- they release new flagships approximately every six months, giving them the opportunity to catch up with or even surpass Apple in areas that consumers care about.

Apple, on the other hand, must wait until the iPhone 8-series phones launch next fall before it can "respond" to what those fast-moving China-based smartphone vendors put out. I believe the iPhone 7-series phones will hold up quite a bit better than the iPhone 6s-series phones did, but it's not clear if they'll be enough to allow Apple's iPhone business to perform in line with the China smartphone market, let alone outperform it.

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Ashraf Eassa has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Apple. The Motley Fool has the following options: long January 2018 $90 calls on Apple and short January 2018 $95 calls on Apple. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.