Why Apple Needs China

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Apple had a crazy earnings call this week. The company nearly doubled quarterly profits, vastly exceeding Wall Street expectations.

Apple’s stock price will probably now reverse course and head back into the stratosphere, and for one reason: China.

Apple sold 35.1 million phones during the quarter worldwide, which provided half the total revenue reported by the company. Half!

Chinese phone sales in the reported quarter were, incredibly, five times higher than the same quarter last year. What’s surprising about this growth is that Apple still hasn’t signed a long-awaited deal with China’s largest carrier — the world’s largest carrier — China Mobile.

So it has become clear to everyone that Apple’s highest-revenue product ever has enormous future sales potential in China.

Also: Apple feels that it has far fewer points of sale (stores) in China than it needs.

When the China Mobile deal happens and Apple builds more stores, watch out. China is likely to become Apple’s biggest handset market, far exceeding even the United States.

Overall revenue for China was $7.9 billion, three times higher than last year.

Another crazy milestone: Asia-Pacific revenue for the quarter was actually higher than European revenue for the first time ever. The relative importance of Asia over Europe is likely to continue indefinitely.

And Then There’s the iPad Problem

Apple also shattered its own record for iPad sales. The company sold 11.8 million iPads in the quarter, which is 151 percent higher than the previous year. What’s interesting about this, however, is that Apple failed to meet Wall Street expectations of 13 million units.

The reason for this disappointment? Again: China.

Apple told investors that the shortfall was the result of supply issues, which the company was vague about. But “supply issues” is code for Asian, mostly Chinese, component manufacturers struggling to keep up with Apple unit numbers or meet Apple’s demands for component pricing, or both.

That’s not the only challenge Apple faces in China.

The company is still embroiled in a trademark dispute with a two-bit, barely viable company called Shenzhen Proview Technology, which claims to own the “iPad” trademark in China.

Possibly as a result of this unresolved and major issue, China was not on the list of next countries to get the new iPad. Even relatively minor markets like Saint Maarten and Venezuela made the list, but not China.

Earlier this week, the deputy director for China’s National Copyright Administration said publicly that the Chinese government considers Shenzhen Proview Technology the rightful owner of the “iPad” trademark.

Because the courts are not independent in China, this could have been the judge’s cue to rule against Apple or force the company into a settlement unfavorable to Apple.

The whole issue could significantly delay the introduction of the new iPad in China and reduce iPad sales for the next quarterly earnings report.

Apple Knows How to Succeed In China

Apple’s overall sales success in China stands in sharp contrast to the experience of many other American or European companies.

Everyone thinks the Chinese market is gigantic for multinational companies. And it should be. China’s population is about 1.4 billion people.

Yet very few companies are getting a huge percentage of their business from the Chinese market. For example, only 7% of Coca Cola’s sales are in China. Only 4% of McDonalds’ sales are in China. Apple is apparently among a very small number of foreign companies who know how to succeed in China.

Apple is also driving another curious trend in China: Investment in its suppliers. Because Chinese citizens are not allowed to invest in foreign companies like Apple, they have to invest in suppliers to Apple instead. This gives Apple extra leverage over these companies for ever lower prices, because if they stop working with Apple, a lot of their Chinese investors would pull out.

One of the many milestones Apple reached in the just-reported quarter was the size of its pile of cash. The company is now sitting on $110 billion.

A new report published this week says such “cash hoarding” is connected to Apple’s offshoring of manufacturing to China and doesn’t really benefit Apple.

The report, issued by University of Manchester’s Centre for Research on Socio-Cultural Change (CRESC), estimated that the total cost of building an iPhone 4G was $178.45 per phone, which Apple sells for about $630. The cost of building the same phone in the United States would be $337.01, according to the report. That would still give Apple a gross margin of 46.5%.

The difference, according to CRESC, is that instead of top Apple executives and top investors keeping all the rewards for Apple’s business, a lot more of it would be spread around in the US economy. The hundreds of thousands of jobs created at American wages, which are much higher than in China, would have a social impact. With the current process, there is no social benefit in the United States or China, as factory workers there barely make any money.

But it’s unlikely that Apple will listen to such nonsense. In fact, one of the reasons Apple reported such high per-share profits was the unexpectedly low cost of its super-efficient supply chain. Commodity costs were lower than expected.

The bottom line is that China is suddenly Apple’s second most important market, and the manufacturing key to Apple’s enormous profitability.

China will probably become even more important to Apple in the years ahead, as the Chinese economy grows and more Chinese phone buyers are able to afford expensive Apple products.

In the meantime, Apple’s report will fuel a new rise in Apple’s stock price and valuation. And it’s all because of China.