Apple (AAPL) is Losing its 'Cool' in China

August 14, 2012 3:10 PM EDT
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Undoubtedly, China is the future for Apple's (Nasdaq: AAPL) iPhone. However, while the company has had early success in the populous country all is not what it's cracked up to be and now the company may be losing the "cool factor."

UBS analyst Steven Milunovich notes that Asia is key for iPhone growth. Smartphone penetration in North America and Western Europe is over 60% and growth has slowed to 15-20%. Meanwhile, Asia-Pacific has smartphone penetration of about 30% and growth of 77% in 1Q.

The analyst notes that Apple's iPhone has had early success in China, where about two-thirds of Apple's Asia sales occur. iOS penetration in major cities like Beijing, Shanghai, and Guangzhou has exceeded 10%. More notable is that penetration is already approaching 10% in Jiangsu and Zhejiang, provinces with a combined population of 133mn.

UBS estimates their are 22.5-25mn iPhone users in China, up from 2 million in 2010 and 8 million in 2011.

Given that the iPhone is a luxury brand in China and often customers have to dip into savings to get the phone, bad news could lie ahead if there is not a drop in price. That said, the top decile is well over 100 million subscribers and iPhone penetration is only around 20% currently.

"To compensate for the extra expenditure, upper middle-to-high income urban households would need to use 30-45% of annual savings to afford an iPhone, whereas the top decile urban household would need to deplete 19% of annual savings to afford an iPhone," the firm notes.

Commenting on the 28% sequentially decline in F3Q Apple sales in China, Milunovich notes that while the company said the economy was not to blame, he blames the iPhone inventory build going into the quarter and "seasonality." While the company argues the demand for older iPhones even at lower prices is not high he is concerned that 4S demand "seemed satiated fairly quickly."

Going beyond functionality, there is a "cool factor" to the iPhone in China. The phone suggests a level of affluence given its cost. Speaking anecdotally, Milunovich said Apple might not be as popular as it was 6-12 months ago.

"Interest in new iPad seems underwhelming though it is too early to have supporting figures. The Galaxy S is perceived by some as having trumped the iPhone in features, so the iPhone 5 will need to leapfrog. Lower-end phones from Huawei and Xiaomi among others provide much of the same phone functionality at a substantial discount, making the "good enough" threat real. Indeed, the fickleness of consumers as witnessed in video games and past cell phone cycles means that Apple has to earn its premium brand reputation every product cycle."

Commenting on a China Mobile deal, the analyst said despite speculation that the iPhone 5 will support TD-SCDMA, the technology of China's 3G network, he does not expect China Mobile and Apple to form a strategic alliance soon. "China Mobile even might not ink a deal until it receives an LTE 4G license, which could come in 2014. Also, discussions with China Mobile suggest less interest in the iPhone today." He notes in terms of handset availability, the worst has passed for China Mobile and handset subsidy costs for the iPhone pressure China Mobile’s margins and earnings.

While they see nothing near term with China Mobile, they assume a deal will likely come in 2H/13 and have included significant sales in our F2014 numbers. "Whenever it happens, we estimate that formal China Mobile support could contribute $13bn to Apple’s annualized revenue and roughly $6.00 to annualized EPS."

UBS is maintaining its Buy rating and price target of $740 on AAPL.

For an analyst ratings summary and ratings history on Apple click here. For more ratings news on Apple click here.

Shares of Apple are up 0.7 percent today to $634.55.

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