Apple's challenge: growing the iphone in China

A customer tried out an iPhone 6S smartphone at an Apple store in Shanghai, China.PHOTO:QILAI SHEN/BLOOMBERG NEWS

(THE WALL STREET JOURNAL) China, powered by a swelling middle class, last year becameAppleInc.’s biggest market after the Americas. To keep growing as China’s economy cools, though, Apple needs to reach people like Wang Tian, a waitress near the southwestern city of Chongqing who isn’t part of the brand-conscious market that has made the iPhone a booming success until now.

Ms. Wang makes about 1,000 yuan ($152) a month, putting Apple’s flagship iPhone 6S, starting at 5,288 yuan, out of reach, she said. “It’s just not worth the money.”

The iPhone and soaring sales in China vaulted Apple into the world’s most profitable and valuable company.But it has trimmed orders for the latest iPhones amid signs of softer-than-expected global demand.On Jan. 19,China said its 2015 economic growth was its slowest in 25 years.The combination has sent Apple shares down 25% since July.

As Chief ExecutiveTim Cookprepares to release results on Tuesday for Apple’s quarter ended Dec. 26, investors are focused on the iPhone’s prospects in the world’s largest smartphone market. “People will be paying attention to what Tim Cook has to say about China,” said Mizuho Securities analyst Abhey Lamba, “and whether they can buck the trend of what’s happening in the macro economy.”

Mr. Cook’s challenges: how to keep growing in China’s saturated smartphone market without the red-hot economy that made Apple’s pricey product attainable, how to persuade budget-conscious consumers to move from lower-cost domestic brands, and how to continue maintaining good relations with a government whose policies are sometimes at odds with the West’s.

Apple declined to comment for this article.

A key market

It is hard to overstate China’s importance to Apple’s growth.It represents about 25% of the company’s global sales.In the three months around Lunar New Year in 2015, Apple sold more iPhones in China than in the U.S.

In the fiscal year ended Sept. 26, Apple recorded $58.7 billion in revenue in China, up 84% from a year earlier. In the rest of the world, Apple grew 16%.

In August, as Apple shares declined amid concerns about China’s growth,Mr. Cook took the unusual step of assuring investors its business there remained strong.In October, he said Apple was not “largely dependent on minor changes” in China’s growth rate.

Apple’s China success contrasts with experiences of some U.S. tech giants.Amazon.comInc.has struggled against local competitors.MicrosoftCorp.andQualcommInc.were targets of antitrust investigations.Qualcomm settled with regulators last year; Microsoft’s investigation continues. Sites ofAlphabetInc.’s Google,FacebookInc.andTwitterInc.aren’t directly accessible in China.

Apple’s consumer products are less politically sensitive than technology such as networking equipment or social-media platforms, which are monitored closely by the government.

And Apple has thrived on the rising prosperity of China’s urban upper-middle class, defined by McKinsey & Co. as households with annual incomes between 106,000 yuan ($16,000) and 229,000 yuan—36 million households in 2012. By 2020, it projects 193 million such households.

These consumers, with disposable income and a penchant for brand cachet, have madeApple China’s third-largest smartphone seller after homegrown rivals Xiaomi Inc. and Huawei Technologies Co. Apple has said the iPhone is also serving as a gateway to its other products in China, trumpeting strong sales of iPads and Mac computers in recent quarters.

The iPhone, a status symbol like a Prada bag or Rolex watch, is sometimes called a “street phone” in large cities for its common sightings in the streets. “If you don’t have one,” said Dong Lin, a 48-year-old Chinese-army officer outside a Beijing Apple store late last year, “it feels like you are missing out on something.”

But that traditional turf of Apple’s may not sustain the company’s growth, said Cowen & Co. analystTimothy Arcuri.“Apple has gained pretty much all the market share that it’s going to gain in China,” he said, estimating Apple holds about two-thirds of China’s high-end smartphone market. Any growth, he said, will come from lower-end markets Apple has avoided in the past.

That would mean Apple needs to reach people like Ms. Wang, the waitress, who is from Chongqing’s remote Changshou district of 900,000 people. Ms. Wang, 40, uses aNokiaphone with only basic functions that can be bought used for under 100 yuan. She says her colleagues at the restaurant tend to avoid iPhones because “our generation is more frugal so we don’t want to spend that much money.”

Non-smartphone users like Ms. Wang represent the last largely untapped customer base amid a stagnating overall Chinese smartphone market. Research firm IDC estimates the Chinese smartphone market grew 1% in 2015, the segment’s slowest since inception.

Such consumers of domestic lower-end brands are also moving upmarket to Apple rivals like Huawei, which is pitching more premium offerings. And the Chinese smartphone market increasingly comprises consumers who are replacing their smartphones rather than buying their first, which means Apple’s growth will partly hinge on taking share from Huawei on the higher end and Chinese brands like Oppo and Vivo in the midtier.

Peng Xiu, a saleswoman at a China Mobile store on Changshou’s modest main street, said the iPhone is a tough sell there. “The iPhone is for young people and the nouveau riche,” she said, and customers tend to select phones from Oppo, whose flagship model has a large screen and half the iPhone’s price.

“It’s very difficult to get share” from domestic rivals, saidNicole Peng,a Shanghai-based analyst for research firm Canalys, who said Apple needed to find new ways to keep customers loyal through services and apps tied to the iPhone while shortening the time between new phone purchases.

Apple is, indeed, expanding into services and apps to curry customer loyalty. In September, it started selling movies and books through iTunes for the first time. It introduced Apple Music, its new streaming-music service, at a steep discount to the rest of the world. In 2015, China passed the U.S. as the world’s biggest market for apps downloaded to Apple’s mobile devices, according to research firm App Annie.

Apple has been taking steps to expand beyond big urban markets. The majority of its 31 stores in China, including Hong Kong, are outside so-called tier-one cities of Beijing, Shanghai, Guangzhou and Shenzhen. By midyear, Apple plans to have 40 stores.

The move into smaller cities, said Joseph Foudy, an economics professor at New York University’s Stern School of Business, presents “more virgin territory for Apple and an even greater opportunity for growth.”

Apple officially entered China in 2001 with a Shanghai-based trading company. Early on, it struggled for a computer-market foothold but won a following among urbanites by the time itopened its first Chinese retail store in 2008.It started selling the iPhone in 2009.

Ron Johnson,former head of Apple’s retail business, remembers harboring doubts about opening stores in inland China when he flew to Chongqing in 2010. His doubts disappeared as his plane descended on the sprawling municipality of 30 million people. “It looked like Manhattan,” said Mr. Johnson, now CEO of e-commerce startup Enjoy. “All we could do was laugh at how uninformed we were about the potential opportunity for Apple.”

Local preferences

Over time, Apple has molded products and marketing to Chinese preferences. Until 2013, it made the iPhone in two colors. Then it added a gold-color iPhone 5S version, because “many Chinese consumers like the color gold,” Mr. Cook told Bloomberg Businessweek last year.

In 2014,Apple opened its iPhone software to virtual keyboards created by developers outside of Apple,addressing complaints the iPhone keyboard wasn’t well-suited for Chinese characters.

That year, after years of negotiations,Apple reached a deal with state-ownedChina MobileLtd., the country’s largest carrier, helping Apple expand the iPhone’s reach by tapping China Mobile’s nationwide network of branches.

Apple also released its first television commercial specifically for China last year ahead of Lunar New Year. The spot is similar to a U.S. ad featuring a young woman using Apple products to create a new version of an old song to play on an iPad for her grandmother.

NetflixInc.CEOReed Hastings,who wants a license to operate in China, has repeatedly cited the iPhone as a model for how patience is necessary to break into the country.

Navigating the current economic risks in China, Apple is also arguably better equipped to handle the political risks because of lessons from early missteps.

In 2013, state-run China Central Television accused Apple of skirting warranties and offering Chinese weaker service policies than elsewhere in the world. It criticized Apple for repairing iPhones with replacement parts instead of providing new replacement phones.

It was the type of charge that state-run media sometimes level against Western companies and that usually elicits apologies. Apple didn’t apologize immediately, trying to explain its warranty and saying it was operating within Chinese law. That triggered angry editorials in state media. Two weeks later,Mr. Cook apologized and vowed to change customer-service policies in China. Apple agreed to replace faulty iPhones under warranty with new handsets and restart the warranty periods. Apple has no such policy in the U.S.

The uproar ended. “Some of what’s important here,” said Mark Natkin, managing director of technology-market-research firm Marbridge Consulting, who has been in China since 2002, “is demonstrating a certain sense of humility, an understanding that having market access here is important and a privilege.”

In 2014,CCTV called the iPhone a “national security risk” because of a feature that can track user locations.The earlier dust-up in mind, Apple a day later said it “appreciates” CCTV raising an issue the company cared about and explained Apple doesn’t have access to user locations. A month later, Apple said it had moved Chinese customers’ data from overseas into a domestic facility operated byChina Telecom,assuaging some of Beijing’s security concerns. At the time, Apple said the move would improve performance for its Chinese customers, noting the data are encrypted and not accessible by China Telecom.

“There’s no alternative,” saidDuncan Clark,chairman of BDA, a Beijing-based business consultancy. “If you’re going to be a certain scale in the country, you just have to” house data locally.

Apple complies with Beijing’s wishes in other ways. Inside China, its App Store doesn’t carry apps involving theDalai Lamaor certain apps from free-speech activists. Apple blocks its News app from working in China.

Mr. Cook has also fostered personal connections, traveling to China more than any other country in the past three years. He is on the advisory board of Tsinghua University’s School of Economics and Management. He opened an account onSina Weibo,China’s version of Twitter, and sat at the head table at September’s Washington, D.C., state dinner for PresidentXi Jinping.

Despite China’s sputtering economy, many consumers remain cachet-conscious, positioning Apple’s strong brand to continue profiting among them. In a January Bank of America Merrill Lynch survey, 39% of 1,093 Chinese consumers said they expected their next smartphone purchase to be an iPhone; 25% said Huawei.

Canalys said Apple sold 11% of China’s smartphones in the 2015 third quarter, compared with Huawei’s 16% and Xiaomi’s 15%. A year earlier, Apple’s share was 5%.

Carl Pei, co-founder of OnePlus, a Shenzhen-based smartphone manufacturer, said Apple distinguishes itself with a “culturally relevant” brand to which consumers flock because it represents something meaningful to them.

“Once people reach a certain economic level,” he said, “they will select products that they have an emotional or cultural connection to instead of just price.” In an economic downturn, he says, people may forgo big purchases like cars but still buy smartphones.

Apple’s three Chongqing stores include one in a pedestrian mall that resembles Apple’s Fifth Avenue branch in Manhattan. A glass cylinder with Apple logo appeared to float above a plaza surrounded by flowers as shoppers lined up last fall for preordered iPhones.

Pan Jiahui, a 23-year-old personal trainer who owns an iPhone and Apple Watch, explained the long lines. “The iPhone is not just a phone. It’s a fashion statement,” he said, adding that Apple products’ cachet overrides the financial burden of buying them.

“Whatever Apple releases, people will buy it.”