Apple Inc.'s Silent Killer: Obscure Smartphone Newcomers in China (AAPL)
China was once the most promising thing about the future of Apple Inc. ( AAPL). The second-largest economy in the world, China has 1.4 billion people and the fastest-growing middle class on the globe.
That potential was evidenced in the numbers, too. In the fourth quarter of 2015, Apple revenue soared 99 percent in China; geographically speaking, Greater China was second to only the Americas in revenue -- and if it kept growing like that, it would overtake them soon enough.
Two quarters later, everything would start falling apart. Chinese revenue fell 26 percent in the second quarter and 33 percent in the third. Revenue from the iPhone fell for the first time, and AAPL stock began a steep descent.
One might assume that market saturation, plain and simple, is to blame for Apple's fall from grace in China. Once every Chinese citizen who can afford it has an iPhone in their pocket -- poof! -- the growth is gone.
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But that's not the problem Apple is having in China. Apple's problem is competition; in China, a handful of newcomers have been silently but methodically kicking butt and taking names -- Apple being the biggest butt and most recognizable name.
Oppo, Vivo, Huawei and Xiaomi: These are the competitors that pushed Apple to fifth place in the battle for Chinese market share in the second quarter.
In the second quarter of 2015, Apple held a respectable 11.9 percent of the market, making it the third-leading smartphone brand in China behind Xiaomi (17.1 percent) and Huawei (15.6 percent). One year later, Apple had lost nearly a third of its share and owned just 7.8 percent of the market.
The culprits? Two domestic companies that had less than 8 percent of the market share in 2015: Oppo and Vivo. Growing shipments by 124 percent and 75 percent respectively, the two brands now own nearly 30 percent of the Chinese marketplace. Rewind two years, and their combined market share was about 5 percent.
So how did two no-name smartphone newcomers outdo the most profitable company on earth? With shockingly traditional means, it turns out.
At first, several years ago, the Qualcomm ( QCOM)-backed Xiaomi was threatening to "disrupt" Apple and its Asian ambitions: The firm made high-end smartphones that were eerily similar to the iPhone, but sold them online and marketed them through social media -- eliminating tons of overhead costs and making high-end smartphones price-accessible to the Chinese middle class.
Strangely enough, Oppo and Vivo's surge has coincided with a return to brick-and-mortar retail, a model that Xiaomi had once successfully shunned as it attempted to dethrone Apple.
In the last two years, Oppo and Vivo have gobbled up share from both Xiaomi and Apple, realizing that old-school marketing campaigns, celebrity endorsements and point-of-sale distribution still works like a charm.
After all, sometimes the best way to take on Goliath is with a slingshot.
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Another radical strategy that Oppo and Vivo embraced -- and the one that's most impacting Apple -- is reasonable pricing. Both brands make high-quality smartphones with designs and features similar to the iPhone, but for nearly 50 percent less.
Apple has simply priced itself out of being a dominant brand in Asia. Rational consumers are asking themselves why they should pay another $400 for a logo -- especially now that carriers aren't ponying up for those costs themselves.
AAPL stock has traditionally benefited from being a premium brand, but now that it's reached global scale, that philosophy doesn't work as well. The iPhone 7 doesn't have an affordable partner in crime, like the iPhone SE. Furthermore, it got rid of the headphone jack, which will almost certainly drive away cost-conscious middle-class Chinese who don't want to blow $159 on compatible "AirPod" earbuds ... earbuds that last five hours per charge and look easier to lose than Waldo's car keys.
"Apple will do well in China only if its products are good enough to do well in the U.S.," says Ravi Ramamurti, professor of international business and strategy at Northeastern University. "The Chinese consumer will not pay top dollar for products that Chinese copycats can clone in months and sell for a fraction of the price. It will take the next big thing from Apple to revitalize Apple in China."
The fact that Apple's growth hopes in China are effectively dead for the time being is of enormous importance to the AAPL stock price. With a market capitalization greater than $560 billion, Apple's price-earnings ratio (currently 12.2) is unlikely to expand much higher without some compelling growth prospects on the horizon. If the P/E multiplier doesn't rise, that means Apple's earnings themselves will have to improve to drive the stock higher.
Most analysts expect AAPL's earnings per share to fall this fiscal year; Wall Street doesn't even expect EPS to exceed fiscal 2015 EPS levels until fiscal 2018.
But wait: If China can't lend Apple a helping hand, maybe India can? After all, with more than 1 billion people, it's the second-largest emerging economy next to China. Perhaps it can take the place of China as Apple's next growth accelerator?
Unlikely, says Minal Hasan, general partner and managing partner of venture capital firm K2 Global.
"Indian mentality values low price with solid user experience over high price and high-end user experience," Hasan says. Apple has already captured most of the high-end market.
"Lower middle class and lower class remains untapped and hard for Apple to proliferate. The barrier to entry is pricing," Hasan says.
So if China and India can't quench AAPL investors' unquenchable lust for growth, what can? Has Apple gotten too big for its own good? Is it, at its core, rotten?
Of course not. It's always possible that Apple regains footing in China and establishes itself more solidly in India. To do this, it'll likely have to pressure margins with cheaper phones, more physical stores and ramped up ad spend. Cheaper phones, however, dilute the brand.
"Apple has never competed on pricing, but they might have to now. If they do, however, they might lose a key base that is purchasing Apple phones based on brand value and beauty of product. Apple is stuck between a rock and a hard place," Hasan says.
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That said, there is one thing that could solve Apple's problem: Do something new.
John Divine is a staff writer for U.S. News & World Report. He is also a longtime investor, and has previously written about investing and the markets for InvestorPlace and The Motley Fool. You can follow him on Twitter @divinebizkid or give him the Tip of the Century at firstname.lastname@example.org.