Apple has a China problem: sharply declining sales in what is a critical market. But now, thanks to a change in regulations by China’s government, the tech giant may have an opportunity to reverse some of its slide.
On Monday, Apple trimmed prices on the iPhone, iPad, and other products it sells in China by up to 6%, according to the state-run Xinhua news agency. The move was triggered by China reducing its value-added tax, a levy similar to sales tax, to 13% from 16%.
Cutting prices usually gives companies a quick revenue jolt as cost-conscious customers who otherwise balk at buying a product reconsider. And Apple desperately needs to regain momentum in China.
Although the U.S. is still Apple’s biggest market, potential growth in China is unlike any other major country except India. That growth is key for Apple, which is grappling with declining overall sales and a share price of $195.53, 16% lower than its 52-week high in October.
In China, Apple generated $18 billion in revenue in the fourth quarter of 2017, accounting for 20% of the company’s total revenue during the period. By the fourth quarter of 2018, Apple’s China sales had fallen to $13.2 billion, or 16% of the total.
At the heart of the problem is Apple’s iPhone. In the fourth quarter of 2018, Apple shipped 11.8 million iPhones in China, a 20% drop from the 14.8 million the company shipped during the same period the previous year, according to market research firm IDC.
Apple mostly blames its trouble in China on weakness in that country’s consumer market and China’s slowing economy. However, Apple CEO Tim Cook and fellow executives remain bullish about the company’s long-term prospects there.
Apple did not respond to a Fortune request for comment about its China business. In January, during the company’s most recent earnings call, Cook said that his company is “proud to participate in the Chinese marketplace” and that he continues to see “great upside” in the country.
But not everyone agrees. In an interview with Fortune, Wedbush analyst Daniel Ives called Apple’s China business “precarious” and said the company faces “significant headwinds.”
“The biggest challenges are lower priced competition, lack of innovation around camera technology on its latest iPhone, and Huawei backlash within the country,” said Ives, referring to Chinese citizens avoiding U.S. goods after the U.S. accused Huawei of using its telecommunications equipment to spy for the Chinese government.
Earlier this year, BMO Capital Markets analyst Tim Long said a combination of strained U.S.-China trade relations and Apple’s high prices compared to China’s cheaper domestic phone makers like Huawei, Oppo, and Vivo “will probably mean more tough quarters ahead” for Apple’s China division.
In fact, those domestic phone makers all grew their shipments in China in the fourth quarter while Apple struggled. For example, Huawei shipped 30 million smartphones during the fourth quarter of 2018, 23% more than the same period a year earlier.
But even after Apple’s price cuts this week, IDC analyst Kiranjeet Kaur said in an interview with CNN on Monday that, “iPhones are still more expensive than the competing ones from those such as Huawei.” Depending on the phone, Apple’s iPhones can be hundreds of dollars more expensive than alternatives.
Broader market factors could also affect Apple’s iPhone sales this year. Mobile phone sales are expected to tumble 9% in China this year, partly because of pricier phones from Apple, Samsung, and other companies, according to CCS Insight.
Tim Cook’s Moment
This isn’t to say that Apple’s China division is dead. According to Wedbush’s Ives, there are between 60 million and 70 million potential iPhone customers in China who are both loyal to the company and are considering upgrading their iPhones. He called it Apple’s “golden opportunity.”
But Apple’s rivals aren’t feeling the same pain in China. Huawei’s Mate X foldable phone, for example, is expected to sell well when it goes on sales later this year, putting pressure on Apple to respond with a flashy alternative.
If nothing else, Ives said, “this is a major prove-me period for Cook,” suggesting the Apple CEO must prove to shareholders that he can overcome the China challenge.
An Eye on Price
Many analysts say Apple has few options to lower prices.
“The company has pricing hubris,” said Ives, adding that it should cut the cost of its more affordable iPhone XR, which sells for the equivalent of $630 in China, by 15% to 20%.
Of course, that would cut into Apple’s profit margins. But the company during its last-reported quarter had a 34% gross margin on its hardware sales. Apple’s gross margin, a measure of the profit the company makes on its hardware sales before operating expenses are factored in, is strong in an industry notorious for high manufacturing costs.
Last year, Ives told Fortune that iPhones account for 65% to 70% of Apple’s profits. In other words, the company could absorb the lower profits resulting from a price cut in China and still make plenty of cash. Meanwhile, attracting more iPhone owners would create a bigger pool of people willing to pay for apps, digital services like iCloud, and other products.
But even when Apple discounts its products, those cuts are typically small compared those offered by many of its competitors. And at least so far, if Apple’s multi-billion dollar profits are a guide, that has worked well.
Of course, Apple must contend with other problems in China, including a slowing economy that could depress sales and a government that, at times, has been hostile to U.S. companies.
But solving all these China problems won’t be easy—even as Cook keeps a brave face. As he told shareholders in a recent letter, “We manage Apple for the long term, and Apple has always used periods of adversity to re-examine our approach, to take advantage of our culture of flexibility, adaptability and creativity, and to emerge better as a result.”