Apple Can't Hedge Its Biggest Risk in China

Apple's store in Beijing. Source: Flickr user Chinnian

For Apple (AAPL -1.92%), last quarter's growth could be summed up by one word: China. Last quarter China accounted for 58% of Apple's total revenue growth on a year-over-year basis and led Apple to its best quarterly revenue haul ever: $74.6 billion. Apple found a receptive audience in the Middle Kingdom for its iPhone 6 and iPhone 6 Plus iterations.

Specifically, by growing 70% year-over-year China remained Apple's third-largest revenue source but significantly narrowed the difference between Apple's second-largest operating segment -- Europe. For perspective, here's a visual year-over-year comparison of Apple's first quarter by operating segment.

Source: Apple's 10Q. Revenue figures in millions

China continues to be increasingly important to Apple's growth story. Unfortunately, China has its own set of rules as a communistic/capitalistic hybrid system -- and in many cases true capitalism takes a backseat to state demands.

For an example, after achieving a search share of nearly 40% in China during 2009, Google moved to autonomous Hong Kong and reversed its policy of censoring results after cyber-attacks from a group with close ties to China's military. Through state-sponsored assistance, Google's share of the Chinese search market has since declined to less than 3%. After being banned from China in 2009, Facebook's CEO Mark Zuckerberg continues his charm offensive by playing up his Mandarin skills.

The biggest risk to Apple in China is a state-sponsored ban; whether it's a hard ban or--most likely -a de facto one by onerous conditions Apple would be hard-pressed to meet, Apple investors should watch Beijing's moves carefully. 

China's proposed rule could hurt Apple
In an exclusive interview with Reuters, President Barack Obama expressed concerns about Beijing's new law that -- according to President Obama [emphasis added] -- "would essentially force all foreign companies, including U.S. companies, to turn over to the Chinese government mechanisms where they can snoop and keep track of all the users of those services." In the event they comply -- which appears highly unlikely considering these companies are now rebuffing the U.S. government's less-encompassing mechanisms -- Beijing would gain substantive surveillance powers.

More interesting, however, is the timing of this rule. Although Beijing blamed recent terrorism and the Edward Snowden revelations, this law seems to have originated during Apple's blowout quarter. Beijing opens itself up to allegations that it is less concerned with terrorism and more concerned with giving Chinese companies an unfair advantage.

Critics can point to Beijing's promotion of Weibo versus banned Twitter, RenRen over banned Facebook, and Baidu over Google as examples of China-approved substitutes that have sprung up to replace American companies. These new terrorism rules seem aimed at Apple's closed ecosystem, and now Beijing has a home-grown competitor: Xiaomi. Even if China doesn't outright ban Apple from the country, it can undermine Cupertino in favor of local handset makers.

Apple would be faced with two poor decisions
Apple finds itself in a tough situation if the rule is codified into law. On one hand, Apple faces the potential loss of a market growing in importance. On the other, Apple would experience a PR disaster if it acquiesced to Beijing's demands and allowed the country the ability to spy on every Apple consumer. 

It will be interesting to see how Apple and Microsoft respond to this threat. In many cases it seems tech CEOs are willing to be more critical of our country than China -- Google's Sergey Brin stated after leaving Mainland China that he's an "admirer" of China's progress of opposing censorship. Zuckerberg called the U.S. government a "threat" to the Internet over its surveillance policies -- in English, of course. Meanwhile, the company continues to work toward overturning its ban in Mainland China.

In the end, if these companies are willing to speak out forcefully against the U.S. government's perceived spying but turn a blind eye to Beijing, you have to ask are they really committed to user privacy and a free Internet or only when it benefits shareholders?