Why Investors Should Be Optimistic About Apple's China Rebound

By Evan Niu, CFA Markets Fool.com

Last year was rough on Apple's (NASDAQ: AAPL) business in China for a few reasons. The ongoing strength in the U.S. dollar continued to weigh on results, which also affected Apple's performance in Hong Kong (which is included in Apple's Greater China segment), since the Hong Kong dollar has been pegged to the U.S. dollar for over three decades. In terms of investor sentiment, 2015 was so strong that Apple faced tough comparisons throughout 2016.

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But the Mac maker is mounting a rebound in the Middle Kingdom. On the last call, CFO Luca Maestri noted that mainland China revenue was "even with the all-time record results from a year ago, and grew in constant currency terms." Local rivals Oppo and Vivo, which are both owned by BBK Electronics, enjoyed a precipitous rise last year as Apple fell to the No. 5 spot in China. Despite intense competition from low-cost rivals, investors have reason to be optimistic about Apple's rebound.

Word on the Street

Morgan Stanley analyst Katy Huberty put out a research note (via Tech Trader Daily) earlier today, in which she believes that Apple will be able to win over switchers from Oppo and Vivo. Huberty estimates that 20% of smartphone users that are currently using Chinese brands will switch to the iPhone the next time they upgrade. With expectations running high for this year's 10th-generation iPhone, combined with Chinese consumers' sensitivity to form factor changes, Apple could enjoy extremely high upgrade and switcher rates.

iPhone 7 Plus. Image source: Apple.

Huberty's surveys show that 24% of current Oppo users and 28% of current Vivo users are already planning on switching to the iPhone. Including surveys that cover other local brands and an assumption of a two-year upgrade cycle, she believes that upwards of 127 million non-Apple smartphone users in China will be looking to upgrade or switch for this iPhone cycle. Meanwhile, Apple enjoys much higher loyalty among its users -- 74% of surveyed customers are sticking with Apple -- a commonly cited competitive advantage.

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Brand loyalty is hard to come by in China

While Apple's high customer retention rates aren't news, they are more impressive when you consider the context. Chinese consumers have historically been notorious for extremely low brand loyalty rates, although this has started to improve more recently.

For instance, McKinsey noted in 2010 that while Chinese consumers are brand conscious, that doesn't really translate into loyalty. Kantar observed something similar in 2012. In the years since, there has been a growing subset of consumers that are "becoming loyal to single brands," McKinsey said in 2016. Here's McKinsey principal Fang Gong in April of last year:

A couple years ago, when we talked to our clients in the consumer and retail industries, we heard a lot of complaints about the low loyalty level of Chinese consumers. Today, based on the reports, we cannot say that it's completely changed, but we can say that the loyalty level of Chinese consumers has been improving. Probably not to a single brand, but to a short list of brands that are in the consumer's consideration set -- and not only in their daily consumption category, such as food or apparel, but also in big items, such as automotive.

This is most prevalent for premium brands, and Apple certainly qualifies as a premium brand. Throughout most of the developed world, Apple enjoys this same dynamic: capturing consumers from rival brands and retaining them much better, resulting in a slow but steady increase in its installed base. The fact that Apple can do this in a region known for low brand loyalty is particularly impressive, and goes to show that despite negative storylines, Apple's business in China still has room to run.

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Evan Niu, CFA owns shares of Apple. 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. The Motley Fool has a disclosure policy.