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Now comes the hard part for Apple in China

Obsession
China's Transition
Obsession
China's Transition

Sifting through Apple’s quarterly earnings report for the second quarter of its fiscal 2016, one disappointment stung the most. Revenues from China, which has long been a growth engine for the company, fell for the first time ever on a year-on-year basis. In the first three months of 2015, Apple raked in $16.8 billion in sales, but one year later, that figure has slipped 26% to $12.5 billion.

Luckily for Apple, iPhone sales in China will likely slow at a less alarming rate than elsewhere. As a status symbol in a status-driven country, its brand positioning is enviable. iPhones were the most-gifted item among Chinese in 2014, the year when Xi Jinping’s crackdown on corruption caused luxury brands to lose popularity.

But the growth Apple experienced in China over the past five years will likely elude it over the next five. Not because people no longer want iPhones, but because the most obvious opportunities for growth have already been seized.

China is saturated, and India is no substitute

China marked a massive opportunity for Apple when it entered in 2009. The country was and remains home to a middle class of over 100 million people who can afford Starbucks lattes and other luxuries like iPhones. China’s smartphone market was growing, too, as many former button-phone owners were buying smartphones for the first time. In 2011, two years after Apple entered the Middle Kingdom, it generated $12.7 billion from the country, amounting to about 11% of its annual revenues. Four years later, it’s getting almost a quarter (pdf) of its total sales from China.

But China’s smartphone market is now plateauing. According to research firm Canalys, shipments grew 2% between 2014 and 2015, and are expected to grow just 5% throughout 2016.

Problematically, there’s no replacement for China in sight. Many have pointed to India as the next untapped opportunity for Apple, citing its large population. However, India’s internet and retail environments are far less mature than China’s.

In 2009, about 28% of China’s population was accustomed to shopping online (pdf, p. 7), according to data from CNNIC, a state-affiliated Chinese research organization. But India’s e-commerce penetration won’t reach the same heights until 2018. This means Apple will have to rely more on offline sales to crack the market. And it has yet to open its first Apple Store there.

India is also far less wealthy than China. The average annual salary for a Chinese person in 2009 was $3,650. In India, it’s currently $1,570.

All of this can be seen in the smartphone buying habits in India. The average selling price of a smartphone is just $120—well below the price of an iPhone.

Apple’s iPhone SE, priced at Rs 39,000 ($586) in India, is almost certainly intended to appeal to price-sensitive Indian consumers who have avoided pricier models. But even if the iPhone SE is a success, it will likely skim the surface of a new market, rather than barrel through it. The pool of consumers that might purchase an iPhone in India is simply much smaller than the pool in China.

In Tuesday’s earnings call, Apple CEO Tim Cook said he sees India as seven to 10 years behind where China is today.

There are no more China shortcuts

Other strategic decisions that Apple made to spur growth in China can’t be easily repeated.

When Apple unveiled the large-screen iPhone 6 in 2014, many Americans balked. But consumers in Asia rejoiced. Phablets, as mocking Westerners called them, were exploding in APAC—between 2012 and 2013, shipments grew sixfold, according to IDC.

Making bigger iPhones helped Apple poach customers that would have otherwise gone for high-end Samsung phablets. In Japan, China, and Korea, the new iPhones were huge hits—in Korea, where consumers strongly favor domestic brands, Apple overtook LG in market share and chipped at Samsung’s dominance.

But you can only make a screen bigger so many times before it becomes an iPad.

The move that proved to be Apple’s biggest boon in China was arguably the most obvious from a strategic perspective. Despite entering China in 2009, for years it had no partnership with China Mobile—the nation’s largest carrier. Apple’s deal with the telco in 2013 meant that 760 million consumers—almost half of the population—would be eligible to purchase subsidized iPhone compatible with their current plan.

The introduction of big screens and the deal with China Mobile helped make 2014 and 2015 golden years (literally, some might say) for the iPhone in China. Revenues increased about 33% between the last quarter of 2014 and the first quarter of 2015—the period covering Single’s Day, China’s online shopping bonanza.

But amidst a slowing market and no more low-hanging fruit, there are now no more obvious pathways for Apple to keep its stellar growth in China going.

“There are a lot of things about the iPhone’s rise that are not about the iPhone but that are about distribution. They’ve done big screens, and they’re in China,” says Ben Thompson, an analyst who writes at Stratechery. “Now that those problems have been solved, it’s just going to be a long, hard slog to get people to switch from Android.”

What’s next?

In lieu of a hit device, Apple has begun investing heavily in “services” like media and payments. It’s hard to imagine that these offerings will ever come close to eclipsing what it makes off of hardware. But expanding into these areas will be even more challenging in China than elsewhere.

Even more so than in the US, China’s internet companies already dominate parts of the services Apple has invested in. Apple Pay launched in China in January this year, but the Alibaba-affiliated Alipay already processes 83% of China’s online transactions.

Meanwhile, China’s music streaming and video streaming industries are each fragmented and barely profitable. And the recent shutdown of Apple’s movie and e-book stores in China signals a tighter crackdown on foreign companies offering internet services. So even if Apple TV or Apple Music become hits around the world, in China, it’s possible they’ll get shut out of the market entirely.

Apple’s recent forays into new hardware products have not yielded strong results, either globally or in China. Five years after its launch, iPad sales have remained stagnant. Apple Watch sales, meanwhile, are expected to be equally lukewarm, as consumers question its actual utility.

Many of the problems Apple will wrestle with in China are similar to the problems it faces in the US and other countries. With the iPhone reaching peak popularity, the company is set to undergo an identity crisis.

As for the Middle Kingdom, Apple’s strong brand and quality products will help maintain its popularity for some time. When the iPhone 7 launches, it’s realistic to expect more growth as China’s Apple lovers upgrade their phones to the latest flagship model. But China is no longer the massive, untapped opportunity it once was for Apple. The company—and its investors—will have to adjust expectations accordingly.

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