Apple CEO Tim Cook (second from right), Telangana CM K. Chandrashekar Rao (right) and IT minister K.T. Rama Rao (third from right) at the inauguration ceremony of the Apple Development Centre in Hyderabad.
Apple CEO Tim Cook (second from right), Telangana CM K. Chandrashekar Rao (right) and IT minister K.T. Rama Rao (third from right) at the inauguration ceremony of the Apple Development Centre in Hyderabad.

What’s cooking in Apple’s India business?

Apple CEO Tim Cook's recent learning mission to India may open up new possibilities for the world's most valuable company. But here's the nub: it may not quite follow the script drawn up by the Indian government

By the time you read this, Tim Cook, chief executive of Apple Inc., the world’s most valuable company, would be back at his home in California. He’d just have concluded a visit to India where every move of his was tracked not just by the media, but by arch Korean rival Samsung who had deployed people to keep track of his every move so that it may be reported to its headquarters in Seoul. Why?

Various versions of the story exist. The one that excites everybody the most is that India is the next bastion Apple needs to conquer. But for Cook, this will be anything but a cakewalk, especially since the world’s biggest smartphone maker by profit remains a bit player so far—at the bottom of the top 10 companies, to be precise. And the dilemmas he faces are incredibly tough ones. Consider these:

—Apple is sitting on $233 billion in cash. So, without a doubt, every government in the world will want a piece of it.

—As things are, by the end of this year, China will emerge as the most potent player in Apple’s longer-term scheme of things. The country is poised to replace the US as its biggest market. But China has demonstrated more than once that it is eminently capable of holding the gun to Apple’s head to suit its needs. Some of Apple’s recent wobbles in China (in the first quarter of 2016, Apple posted a 13% drop in revenue. Falling sales in Greater China, which includes Hong Kong and Taiwan, were responsible for 58% of that decline) aren’t just about not having enough winners in its product portfolio or indeed, the same product saturation that’s affecting key smartphone markets across the world. Apple is running into unexpected political headwinds in China. And unless it loosens its purse, it could find itself denied market access, just as it did with the delayed launch of the iPhone 6 for seemingly inexplicable reasons, according to Stratechery’s Ben Thompson, a leading technology writer based in Taipei.

—As for the India story, Apple’s current revenues are in the region of $1 billion, says an analyst who declined to be named. For a company that generated $233 billion in revenue in fiscal 2015, $1 billion is chump change. So why was Cook expending time in India?

—Then he’s got to deal with an Indian government that insists Apple manufactures iPhones in India to fit into its Make in India strategy. So far, Apple has remained non-committal—perhaps for good reason.

—Assuming Apple agrees to make in India, the Chinese will get into the picture in the form of Foxconn. The Taiwanese contract manufacturer is Apple’s manufacturing partner in China. And Foxconn’s track record in India has been anything but exemplary.

—Apple wants to sell refurbished phones because it has a carefully thought through strategy. But the Indian government won’t let it do that.

Add to all of this the fact that Apple is no longer a computer or handset manufacturer. It is transitioning into something else altogether—the contours of which are still unclear. The territory Cook is navigating on is a compelling one—and very different from what he inherited from Steve Jobs.

The fundamental difference is that what Jobs followed was a Deliberate Strategy. He tried to fundamentally redefine an existing category, every time he launched a new product. Cook, though, is dealing with an Emergent Strategy. That means, not just pushing the boundaries of Jobs’s original strategy, but breaking out of the predominantly hardware mindset that defined Apple in the Jobs era and place a greater premium on crafting a culture around services and software. That is unchartered territory.

How Cook steers through these waters will be one of the most compelling corporate journeys we will witnesses in our lifetimes.

Let’s take it one thing at a time.

Manufacturing is passé

Until now, a good part of the discourse around Cook’s visit to India has been that Apple ought to set up manufacturing facilities. Bad idea. To understand why, take a look at the chart below, computed by Business Insider.

Global smartphone shipments are getting close to saturation. Apple went one step ahead and argued that when people buy its product, they buy an experience. Selling an experience translated into an astounding set of numbers. Apple averages the highest sales per square foot among US retailers, at $5,009. Any retailer would give an arm and a leg to get to these kind of numbers.

No other technology company has thought along these lines. Instead, all they are engaged in is tweaking their products into better creatures. But as the chart indicates, the peak is on hand and few know what to do next.

Experiences don’t come cheap

Dig one layer deeper. Prasanto Roy, a veteran technology writer based in Delhi, points to an interesting set of numbers put out by CyberMedia Research (CMR).

The report states that in India, 96.4 million smartphones were shipped last year. Of these, 3.3 million (or 3.4%) were premium smartphones (costing over 30,000)—most of which came from Apple and Samsung, with Samsung leading in both segments. CMR reckons these numbers could go up to 5 million by the end of 2016.

Does Apple want to wrestle a lead? Short answer. No.

Apple has taken a clear stance that it is a premium brand and wants to stay there. “Ninety percent of global handset profits are taken away by Apple… So why would it want to play at the 5,000 point?" suggests the analyst cited earlier.

From Apple’s perspective, a strategic way to get around this stated position would be to introduce refurbished handsets at a lower price. But in India, it faces two unexpected hurdles.

1. The Indian mindset: “Second hand" is how the common man calls it. In the upper echelons, they call it “dumping of toxic waste into Third World countries".

“Nothing could be further from the truth," argues Roy. “It is accepted practice. Even in the most advanced countries, refurbished phones that carry a company warranty and a new IMEI number are considered kosher. It’s a perfectly acceptable and legitimate strategy."

He asks, if you don’t think twice about buying a reused Mercedes or BMW from an authorized dealer, why should you about buying a high-end device from an Apple Store and save some money and get the same experience?

Gartner lends credence to Roy’s arguments with data from Western nations. The tech research firm says: “With consumers in mature markets upgrading their smartphones every 18-20 months, the inevitable question is what happens to the old device? While only 7% of smartphones end up in official recycling programmes, 64% get a second lease of life with 23% being handed down to other users and 41% being traded in or sold privately.

“In North America and Western Europe, the market for refurbished phones is forecast to be worth around $3 billion in 2015 and growing to $5 billion in 2017. Many users are attracted to used high-end devices that they would not have been able to purchase at the original selling price," notes Gartner.

2. Lobbying: Then there are lobbies at work led by Samsung, Karbonn, Micromax and Intex to keep the pressure on the Narendra Modi government not to allow Apple to import refurbished phones into India. If Apple’s proposal goes through, by 2017 it could very well be selling 10 million handsets each year, reports Bloomberg. “Even if the refurbished iPhones are priced a bit more than 10,000 ($150), that will hurt our sales because Indians may choose Apple for its snob value," Sudhir Hasija, chairman of Karbonn Mobiles, told Bloomberg.

Not just that, in the shorter run, it may allow Apple some more headroom in India. For instance, in many countries, Apple has been able to achieve the numbers it has because it could tie up with cellular operators who subsidized the cost of the handset. In India, the policy did not allow that. If the proposal to refurbish goes through, Apple can offer newer models at lower prices as opposed to offering disasters like the iPhone SE—ostensibly built for the price conscious customer, but still out of their reach.

Manufacturing is outright silly

It is nothing but a mug’s game. Consider these numbers:

In the last quarter, Bloomberg reports that Hon Hai Precision Industry Co. Ltd, Foxconn’s parent company, saw quarterly profits fall 9.2% and operating profits shrink from 3.81% a year earlier to 3.69%. Foxconn is a contract manufacturer for many technology companies including Apple and has 12 plants in China. Its affiliate FIH Mobile, which assembles devices for Xiaomi Corp. and Sony Corp., warned that income for the first half of the year could plunge by as much as 92% from a year ago.

But this isn’t a new story. This is how it has always been. Take a look at this chart that Bloomberg put together on the difference in net profit margins between Apple and Hon Hai. The latter makes just a little more than grocery stores.

The thing about Apple is, all of the products are designed (read, the high-end, intellectual work) at its headquarters in Cupertino, California. Sporadic media reports have emanated that Foxconn’s human resource practices are among the worst in the world. There has been a history of suicides in the company on account of its bad working conditions.

Foxconn’s argument is that to make even the kind of monies it does, it has to deploy labour in its factories in 12-hour shifts, six days a week. This is the kind of thing that can work in China. But can Foxconn get away with that in India?

In India, the company started operations in Tamil Nadu in 2006. By 2014, on account of differences between the management and the unions, it shut down the unit. It affected 22,000 people. Last year, the company announced it will set up 12 factories across India and create one million jobs.

As things were in 2012, Apple had managed to squeeze Foxconn to work with it at an operating margin of 1.5%. This, even as Foxconn continues to accede to Apple’s demands for technical changes and higher orders. If relationships of these kinds that Apple have forged with Foxconn are to be broken, it will come at a huge price—financial and human.

Various subsidies have been offered to Foxconn to set up manufacturing in India. Implicit to these subsidies are two questions.

1. A senior bureaucrat who did not want to be named spoke of the time he was assigned with the task of wooing Foxconn to his state capital. The chief minister asked him to “get the company in at any cost". He followed instructions, took charge and stayed in touch with the top management at Foxconn. On their part, they had a set of dos and don’ts in terms of protocol to be followed when Terry Gou, Foxconn’s chairman and CEO, was in town. This included a diktat that the visit be kept strictly hush hush.

When Gou’s private jet landed though, he was accompanied by a contingent of 60 Chinese media personnel. They reneged on every promise they made in their list of to-dos before Gou’s visit. So much so, that he kept the chief minister waiting until 9pm and he finally did not turn up.

When the bureaucrat checked with his counterparts in other parts of the world, it turned out Foxconn has a history of not living up to its promises. What it puts on paper is one thing—whether it delivers on that is something else altogether. Brazil being a case in point.

When looked at from that perspective, the Maharashtra government’s decision to offer the kind of subsidies it has to Foxconn sounds ridiculous. Business Standard reports that Maharashtra has offered 2,000 sq. ft of office space on rent in the plush Cuffe Parade area in Mumbai and 150,000 sq. ft in the Mahape industrial area, Navi Mumbai, on lease for the production of Xiaomi and Reliance Jio’s Lyf smartphones. For the Cuffe Parade office, the state government agreed to bear the rent.

Other sops include a subsidy on fixed capital investment without any limit on the amount and an additional 20% capital subsidy above the central government subsidies. This apart, Foxconn will get 100% exemption from stamp duty during the investment period, cash subsidy of 50% (or up to $10 million a year) on research and development costs, and exemption from local body taxes such as property, land and entry tax. So far, nothing has come out of it and the Devendra Fadnavis-led government is beginning to feel the jitters. Given a history and work ethic like these, the real question to ask, the bureaucrat says is, do we really need companies like Foxconn and the jobs it offers in India?

2. The second question that bothers him is: How does Foxconn make money? Like it has been articulated above, the company operates on wafer-thin margins. If you consider the fact that Apple currently makes a bulk of its revenue from hardware, it has an operating profit margin in the region of 30%. Every other hardware manufacturer makes operating profits a little over 10%. Dell and BlackBerry operate in single digits and are gasping for life.

So, if a company like Foxconn can work at margins of 1.5% and still flourish, it has to have the tacit support of the state. Given its record, and Apple’s history with the company, does it make sense then to offer sops to Foxconn? Can it be sustained?

It wouldn’t be outlandish then to suggest that the Indian government hasn’t understood the nuances of Apple’s longer-term strategy and the significance of Cook’s visit to India.

Apple is vulnerable in China

Just before Cook set foot in India, he visited China—his eighth visit to the country, as against his first to India. On that visit, he announced a $1 billion investment in Chinese taxi ride-hailing service Didi Chuxing to “help the company better understand the critical Chinese market".

“We are making the investment for a number of strategic reasons," Cook told Reuters. “Of course we believe it will deliver a strong return for our invested capital over time as well." It is another matter that the company, with an 87% market share in China and valued at $25 billion, has been losing billions every year.

While most investors reckon this is one of the surest signs of Apple’s interest in getting into self-driving electric cars, fact is this investment does not give Apple even a semblance of control in Didi. More on self-driving cars and other investments later. What is interesting here is the nature of the investment. As a thumb rule, Apple prefers to buy smaller companies and absorb their technologies into its products. Then why did it invest in Didi, wonders Stratechery’s Ben Thompson in his newsletter. He has a few theories.

1. The Chinese App Store is massive for Apple. In 2015, it generated $3.4 billion in revenues for Apple, next only to its home market in the US. That number, Thompson estimates, will breach $4.5 billion in 2016 and will catapult China as the most important market when it comes to Apple’s services-as-growth opportunity.

2. Earlier in April, China blocked access to the iBooks and iTunes music stores. Perhaps, it was just to prove a point to the company that the government has the muscle to barricade growth.

3. This was not the first time. Earlier when the iPhone 6 was launched, for inexplicable reasons, while Chinese customers were clamouring for the device, it was unavailable. In fact, the Chinese government went on a public relations offensive and a fiercely nationalist newspaper, the Global Times, published an editorial on what it thought of people who owned the iPhone 6: “Most people do it for vanity so that they can show off…whomever has an iPhone 6 deserves to be looked upon with despise."

When all of these are extrapolated, is it possible, Thompson wonders, that Apple was compelled to invest in Didi? (It is worth noting that the Chinese government is an investor in the hugely loss-making entity.)

Apple has had an amazing run in China, but there are some very real challenges emerging on the horizon—no different from what many other US technology firms have faced while dealing with the government. Apple needs to hedge its bets and India by virtue of its sheer size is a good place to begin. To do that, Apple needs to first create a larger ecosystem in India. But, it is unwilling to get into the mug’s game and play in the 5,000 ecosystem.

Is India Apple’s hedge?

The analyst cited earlier, who has seen Apple from close quarters, says that in other parts of the world, “50% of Apple’s revenue come from selling iPhones. And telecom companies are its partners. So if they buy two million handsets from Apple, the onus is on them to sell it." Apple creates the ambience and it is able to do it right by setting up stores to create shock and awe in a consumer’s mind. That makes the telecom operator’s job easier.

But in India it doesn’t work that way. “Telecom companies are more interested in selling data, which is where they make their money from," says the analyst. “So Apple has to create an absolutely new market. It has to do a lot of things right on the ground. And it is not going to be easy. Now that it has permissions to set up Apple Stores, it will bring in design partners, fixtures and experience that will be the same as it will be in any other part of the world. But it has a long way to go before it catches up." The most obvious way to play catch-up is to begin someplace—and that someplace is by introducing refurbished, certified phones. With a larger handset base, Apple can start to think of building a larger services ecosystem.

In any case, Cook knows there is only so far Apple can go selling handsets. Apple’s long-term strategy is clear. It is morphing into a services company, as the chart shows.

What do we mean by Apple services? Okay. So there’s a camera there. What do you do when you run out of space to store pictures? You buy space on Apple’s iCloud. That’s a service.

You like to listen to music, watch movies and television shows, listen to audio books, and need a piece of software as well to manage all of it on your Apple device? Subscribe to iTunes.

Then you need to work as well for which you need software to write on, create spreadsheets, make presentations and what not. All of it comes bundled when you subscribe to iCloud. And all of it stays synchronized across all your Apple devices.

Apple charges a small fee for each service. Like the chart above illustrates, in the last quarter, Apple Services got the company $6 billion in revenue. That’s pretty much the kind of money Time Warner, the American media and entertainment conglomerate, earns in a year. HBO makes marginally more than that and Netflix is right now in the region of $4.7 billion.

With the kind of monies Apple has at its disposal—$233 billion in cash—it can buy all of these companies at one go. But one of these it will buy. Because Apple, at the risk of sounding repetitive, is transitioning into a services company. For that, it needs to come up with quality content, software and applications—and that includes a driverless car.

Projects of these kind don’t require manufacturing expertise. They need design, high-end coding and software skills—all of which India possesses. More pertinently, it provides a higher return on investment to both the people on the projects and India.

A glimpse of what Cook wanted to get a sense of was evident from the heads of four companies he met, all of whom also develop apps for Apple. These include UrbanClap, a service aggregator; Cynapse, a high technology platform that seeks to integrate productivity, collaboration and information management between knowledge workers; Invention Labs, a company that builds apps to help differently abled children learn; and Sweet Couch, an app that tries to mimic the window shopping experience.

They couldn’t be more different from each other. But what they did offer Cook was a glimpse into what is possible from India. To that extent, India was a learning experience.

That said, Thompson points out, Apple has a long way to go to develop the services ecosystem. “Services, though, have a very different business model. First, there is precious little evidence that consumers are willing to pay more than a nominal amount for services (if that!), which means the most profitable services make money through volume. Secondly, services are effectively free on a marginal basis; the real costs are fixed, which means that services business have a strong economic imperative to reach as many people as possible.

“These differences get at the very fundamental reasons why Apple struggles with services: it’s not that the company is incompetent, but rather that the company is brilliant—brilliant at making devices, which require completely different business structures and incentives," adds Thompson.

What Apple does next is anybody’s guess. It certainly has the cash to spend.

Speculation on what it goes out to acquire first now includes:

a) Time Warner or HBO because Apple needs a steady service of content for Apple TV and iTunes.

b) Netflix. Instead of launching its own streaming TV service, why not just acquire the market leader?

c) Twitter seemed unstoppable once upon a time. But it could do with a saviour right now and Apple can use this microblogging platform to beef up Apple Music and Apple TV.

d) An electric car that Apple is reportedly chasing. Elon Musk and Cook have met. And what better acquisition than Tesla?

“All of these sound ridiculous right now," says Roy. “But 10 years ago, if you’d told me most of Apple’s revenues would come from a phone, I’d have told you it sounds ridiculous."

The author is co-founder and director, Founding Fuel.

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