China could shake Apple’s earnings to the core: Here’s why

Apple could face further woes in China when it reports third-quarter earnings on Tuesday thanks to its iPhone market share in China slipping to 2014 levels, anti-U.S. sentiment and reports of weaker footfall in its stores.

The California-based tech giant has already been caught in the diplomatic crossfire between the West and China. Over the weekend, demonstrators picketed Apple stores and resellers across China protesting against the recent ruling in the Hague that Beijing had no legal basis to claim a large part of the South China Sea.

Chinese officials denounced the protests, with state-backed Xinhua news agency writing that it was "not the right way to express patriotism". Analysts said the protests were small-scale and unlikely to damage the good brand equity Apple has built.

"I don't see this event having a short term or long-term impact," Nicole Peng, research director for the Asia Pacific region at Canalys, told CNBC by phone on Monday.

"This is a brand that many Chinese customers know and have used."

Slowing iPhone sales

While the political turmoil might have a limited impact on Apple's China sales, the iPhone's flagging momentum in the world's second largest economy is a bigger worry for investors.

Unlikely Apple will leapfrog Samsung: Pro

Data released over the weekend from Counterpoint Research showed Apple's market share in China at 9 percent in June, down from 13.2 percent in the same month last year, and below the 9.9 percent recorded in June 2014.

Competition in China's smartphone market has intensified from domestic players. Oppo for example now has a 22.9 percent market share while Huawei commands 17.4 percent. Another upstart Vivo has a 12 percent market share. On top of this, demand is slowing. The UBS China telecom team recently noted that slowing handset sales in the June quarter and relatively weak 4G subscriber additions.

In China, Apple is too slow to market with innovations, and this is why its falling behind, analysts said.

"If you look at the Chinese players, the amount of innovation they are bringing with a faster time to market is phenomenal," Neil Shah, research director for devices and ecosystems at Counterpoint Research, told CNBC by phone.

"If Apple can't innovate faster in hardware and bring all the features every year or six months like these guys are doing, it will fall behind. By the time Apple has a dual camera, it's almost a year old, which is what most mature smartphone users are realizing."

Apple is widely-tipped to release the iPhone 7 this year which could have a dual camera, as well as a host of other new incremental features. This is something that other handsets from Chinese companies have had before however.

Ready for an iPhone 8?

There are signs that Apple might be speeding up its upgrade cycle. Instead of bringing out an iPhone 7 "S" variant in 2017, the company might be jumping to an iPhone 8. It has already released the small-screen iPhone SE, which is aimed at addressing the lower price point as well. But with the Chinese high-end market maturing, Apple is likely to face falling sales unless it can bring out a device to compete with the likes of Oppo and Vivo.

"Everyone wants a bigger screen size in China, they are looking for something with similar or better features for $400 and $500 like Oppo and Vivo," Shah said.

Software and services

Revenue in greater China in Apple's fiscal second quarter fell 26 percent year-on-year. In its next quarterly earnings release, this figure could show a 20 percent year-on-year fall, according to analysis done by Baidu, which used data gleaned from its mapping and search software to forecast results.

iPhone sales make up the majority of Apple's revenues and this is why they are such a big focus for investors. UBS said in a note on Monday that it did not expect a significant uptick in unit shipments in the 2017 fiscal year, but strong growth could come in 2018.

Pro: The business climate is worsening in China

"We expect flat to slightly up unit shipments in F17. A lack of differentiation in the iPhone 7 may cause the upgrade cycle to lengthen," UBS analysts wrote.

"We now expect iPhone unit growth of about 2 percent in F17 with upgrade growth offsetting a decline in new users. Strong sales in F15 stole from F16 but upgrades should hit in F18."

To try and counter the slowing device sales, Apple has been focusing on boosting its software and services such as Apple Music or App Store. Services revenue rose 20 percent year-on-year in the fiscal second quarter with total revenues eclipsing those for the Mac and iPad.

But in China, monetizing these are a challenge. In April, China shut down iTunes Movies and iBooks after just six months and it faces tough competition from the local technology giants. In the music space, the likes of Alibaba and Baidu have their own services in China, while in payments, Alibaba and Tencent already dominate the market.