Why Apple Could Be In A Heap Of Trouble

Apple Inc. AAPL may beat its numbers, but long-term the company’s market share will keep slipping.

On the latest earnings report, Apple showed growth where it counts because it gamed the system. This time last year, the numbers were US-centric. This year, they include sales into China’s massive market. Year over year sales were blistering and the next will be even more so thanks to holiday shoppers.

Yet problems are arising, starting this quarter. Apple has done well as a high-margin, large-volume niche brand, but is rapidly losing market share in China to the country’s home-grown handset makers. Worse, those Chinese companies are bringing the fight to the US and EU markets. In the next few months, China’s top brands are launching full-blown US/EU campaigns.

Simply put: Apple offers a very compelling value proposition via cutting edge technology that cuts across multiple products, but its technological edge is eroding more quickly every time it launches innovations. Ultimately, the phone is a commodity product and margins are coming under further pressure starting this month.

Chinese Handset Makers: Stunning Value Proposition

Ever wonder why Chinese handset makers have come to dominate the Chinese domestic market, pushing aside Apple and Samsung? Here’s a side-by-side spec comparison of three recent flagship releases: Xiaomi’s successful Mi 4c phone, Samsung’s S5, and the top-of-the-line Nexus 5X (Google’s brand).

Xiaomi offers a better phone (same software, better hardware) for 30% lower price. As for build quality, Xiaomi phones are built by Foxconn, the same company that builds the iPhone. It’s not alone either. Huawei – a major Chinese telecom hardware company – is producing similar quality phones, with similar specs and prices. For one, it’s making Google’s flagship phone, the Nexus 6P.

Naturally, Chinese consumers are responding to the value proposition. Huawei and Xiaomi have captured 31% of the market, up from 17% in 1Q 2014. Samsung has slipped to barely 10% share, down from 20% in 2014. These companies are also launching products this quarter in the EU and US markets. Not only are traditional handset makers losing the China battle, Chinese handset makers are bringing the fight to them.

History Lesson: What The HP/Dell/ASUS PC Progression Tells Us

Hewlett-Packard used to dominate the PC market. Thanks to HP’s buying volumes, everyone’s PC component prices dropped. Dell wasn’t quite able to get the same low prices, but it more than compensated with slimmer infrastructure and a low-inventory, build-to-order model.

Since everyone used the same components, HP’s competitive edge was limited. Even better, HP invested capital and resources to get parts developed. Dell was able to ride their coattails, sourcing the same parts shortly thereafter with almost no R&D costs required.

In the next stage, everyone turned to companies like ASUS to assemble the PC. Though, at some point ASUS decided to launch its own brand and cut out the middleman.

That same progression is underway in smartphones. We have reached the HP/Dell point where the hardware and software components are the same and everyone is using the same assemblers to build the devices (except for Samsung which relies on Vietnamese assemblers). Product differentiation is harder than ever and technology advantages don’t last long. Apple’s fingerprint technology was included by the competition in less than six months and its new 3D pressure technology in less than three months.

The First Casualties

At this point, the first casualties are fellow Android handset makers. Lenovo (aka Motorola) has almost no value proposition other than brand name. Samsung is better positioned thanks to vertical integration and in-house parts (memory, processors, screens), but it will face the inevitable margin squeeze. The Chinese handsets are as good as or better than Samsung’s best products, but at a fraction of the price.

Lenovo won’t give up without a fight. The smart move would be to vertically integrate, like buying Sharp’s LCD unit (although Foxconn recently made a play for that). My prediction is that Lenovo is the next Nokia: 12-24 months away from implosion and going to sell off its IP to Huawei.

Samsung will likely introduce lower-end models to compete. Unfortunately, history shows that it’s easier for companies to move upstream (Toyota launched Lexus) than it is for companies to move downstream.

Apple Under Pressure

On the one hand, Apple has successfully resisted the Google Android onslaught. Despite losing the market to Android, Apple has grown strongly. It may be a niche player but it’s a big niche and the sales and margins are fantastic.

But Apple isn’t immune to the Android market fight. The key part of the company’s continued success is its ecosystem. Once someone invests in an Apple product, they can easily move their world across tablets, phones, computers, TVs, watches, and so on. It’s an investment that pays off.

We can’t say that about Android products. Many companies claim to offer equally compelling suites of integrated products, but they don’t. There is no equivalent portfolio and software environment to Apple’s, and that’s a powerful edge.

In addition, Apple’s products always lead in terms of hardware and software features. Yet the competitive edge keeps shortening. Apple’s technology lead used to be 9-12 months. Today, four months is a stretch and product developments are more evolutionary than revolutionary. Stronger glass, faster chips.

It’s similar to Dell: Apple invests in developing next-gen technology and within a few months everyone has it. Many experts claim that Android products now lap Apple’s from a hardware spec standpoint. It backs Apple into a corner, leaving them with only two advantages: new products/software and user experience. Meanwhile, new products have fizzled. The watch is a dud (from a sales standpoint) and the iTV keeps getting pushed out.

Continuing Story Of Chinese Companies Exporting Deflation

We saw this with Japanese cars back in the 1980’s. They had excellent build quality at a fraction of the Detroit price. Cadillac and Lincoln continued to charge high premiums because of their lifestyle connections. Then the Lexus arrived and Detroit’s game was up. We saw it recently with Korean companies like LG and Samsung.

Now it’s China’s turn, except instead of cars, the starting point is smartphones. Chinese companies are ready to enter US and EU markets directly. Their experience selling in other markets will enable them to sell other white goods products (refrigerators, appliances, washer/dryers, etc.). Chinese companies will compete with their customers (like Whirlpool and GE).

The trend won’t spark a change in consumer spending the way it does with falling food or oil prices. Durable goods don’t get purchased as frequently. However the knock-on effects are margin pressure on current suppliers.

Consumers will benefit from even slight deflation.

How To Play It

Apple is a sitting duck next year as the pressure advances. Samsung is in even worse shape.
The arrival of Chinese products will accelerate next year. That’s bad for GE and Whirlpool.