Apple is running into a wall in China

Apple just had a bad quarter.

The Cupertino company giant just reported a 13% drop in earnings for its March quarter - and stock dropped by 8% in after-hours trading.

Remarkably, it is the company's first year-on-year quarterly revenue drop in 13 years. And it's largely down to China.

Sales in Greater China were down 26%. The Wall Street Journal's Eva Dou writes that the area accounts for 58% of Apple's global decline.

There are two factors at play here. First, there is the messiness that is China's economy. The economic downturn in the country is harming sales.

But second: The market is just saturated. The Chinese smartphone market has been a remarkable growth driver for companies as people bought their first devices. But this period of growth is coming to an end.

There is no immediate substitute for China ...

Apple CFO Luca Maestri referenced this on the earnings call as he tried to put the China decline in perspective: "In Mainland China, revenue was down 11%, and the decline was 7% in constant currency terms. Keep in mind that we were up against an extremely difficult year-ago compare when our Mainland China revenue grew 81%."

The vast, vast majority of Apple's revenue comes from the iPhone. The company racked up $50.6 billion in sales in the last quarter; $32.6 billion of these came from the iPhone. The next biggest category, Services, came in at a (relatively) paltry $6 billion.

With the Chinese good times coming to an end, Apple needs to look elsewhere to maintain growth. But there is no natural candidate to drive that. India's 1.2 billion population makes it one possibility, and Apple is seeing growth there: "our iPhone sales [in India] were up 56% from a year ago," says CEO Tim Cook.

Cook talked up India's possibilities on the call, but acknowledged that it won't solve Apple's growth problems in the immediate future, given its less-developed market. Here's Cook - emphasis ours:

I'm encouraged by the results that we're beginning to see there, and believe there's a lot, lot more there. It is already the third largest smartphone market in the world. But because the smartphones that are working there are low end, primarily because of the network and the economics, the market potential has not been as great there. But I view India as where China was maybe seven to ten years ago from that point of view, and I think there's a really great opportunity there.

...So Apple is turning to services

In an acknowledgment of the growing maturity of smartphone markets around the world, Apple is increasingly turning to services as a source of revenue.

It's getting harder and harder to find first-time smartphone buyers to acquire, and once customers have an iPhone, they have it for a while. Subscriptions (like Apple Music) and other payments (like in the App Store and iCloud) let Apple monetise existing customers in new ways:

Here's Cook again, talking about the growth in the service in the March quarter - emphasis ours:

Next I'd like to talk about Services, which was our second largest revenue-generating category during the quarter. Setting aside the amount we received from a patent settlement in the December quarter, the March quarter Services revenue was our highest ever. Services revenue jumped 20% to $6 billion. App Store revenue was up 35% to beat last quarter's all-time record. And Apple Music continues to grow in popularity, with over 13 million paying subscribers today. We feel really great about the early success of Apple's first subscription business, and our Music revenue has now hit an inflection point after many quarters of decline.

The Services business is powered by our huge installed base of active devices, which crossed 1 billion units earlier this year. As we discussed on this call in January, those 1 billion-plus active devices are a source of recurring revenue that is growing independent of the unit shipments we report every three months. In fact, the purchase value of services tied to our installed base was a record $9.9 billion in the March quarter, up 27% over last year, accelerating from the 24% growth rate we reported in the December quarter.

But Services won't necessarily be the panacea to Apple's China woes. Earlier this month, China abruptly shuttered Apple's iBooks Store and iTunes Movies services in the country. China has historically been protective of local businesses, and the move suggests China is looking to defend the interests of homegrown companies - at the expense of Apple if necessary.

"[China is] interested in protecting the content that the Chinese people see, policing its national security and favoring indigenous giants such as Huawei, Alibaba and Tencent," Daniel Rosen from advisory group RHG told The New York Times. China "is strongly disinclined to accept the dominance of foreign players on the Internet, not least those from the United States."

Apple says it hopes "to make books and movies available to our customers in China as soon as possible." But if the country decides to broaden this crackdown on Apple service, it could restrict the Californian company's ability to effectively monetise its userbase in the country.