Is Apple's China Mobile Deal Overhyped?

In the last few weeks, it's become common knowledge that Apple (NASDAQ: AAPL  ) is finally on the verge of making the iPhone available through China Mobile (NYSE: CHL  ) . Investors have been looking forward to this deal for years, as China Mobile is the largest wireless carrier in the world, with more than 750 million subscribers!

China Mobile will soon start selling Apple's new iPhone 5s. Photo: Apple.

However, at least one analyst -- Scott Craig of Merrill Lynch -- thinks that the Apple-China Mobile partnership isn't such a big deal. In fact, he thinks the incremental opportunity for iPhone sales may be fewer than 10 million units annually.

Craig may be on to something: Some Apple bulls are overlooking the fact that there are already a lot of iPhones running on China Mobile's network. However, a short-term spike in iPhone sales is still likely, as current iPhone users on China Mobile will be able to upgrade from 2G to 4G speeds overnight. Moreover, China Mobile represents a significant long-term opportunity for Apple, as it can become a first mover for LTE-equipped smartphones in the Chinese market.

Factors to consider
The iPhone is expected to arrive on China Mobile's network next week, at the same time that the carrier starts 4G service under the TD-LTE standard. One of the biggest stumbling blocks to an Apple-China Mobile deal in the past was the incompatibility of China Mobile's 3G network with most other wireless networks. Apple never built an iPhone that worked on China Mobile's 3G network.

The upgrade to 4G will drastically increase the iPhone's appeal for China Mobile subscribers. There may be as many as 42 million people already using unlocked iPhones on China Mobile, but they are restricted to slow 2G data speeds. However, the 4G network won't be turned on everywhere at once: The initial rollout will be limited to Beijing, Guangzhou, and Chongqing. (The city of Shanghai is building its own 4G network that will be ready at a later date.)

These megacities account for tens of millions of China Mobile subscribers, and are relatively wealthy compared to the rest of the country. Still, only a small fraction of China Mobile's subscriber base will have 4G service anytime soon. For most people, buying an iPhone through China Mobile will still mean suffering through 2G data speeds.

Handicapping iPhone sales
Most of Apple's China Mobile iPhone sales will go to two different groups. First, there are perhaps 42 million people already using iPhones on China Mobile's 2G network. Those who are in the initial TD-LTE rollout cities are likely to upgrade to the new iPhones as soon as possible, in order to get faster data speeds.

Second, there are wealthy Chinese consumers who are already on China Mobile's 3G network and will want to move to 4G as soon as it is available. Since those subscribers are by definition using other platforms today (primarily Android), Apple may only get a small percentage of those users. Still, the absolute numbers could be significant (China Mobile currently has about 176 million 3G subscribers).

Summing this up, several tech analysts have suggested that Apple could potentially sell 20 million-25 million iPhones in the first year of an agreement with China Mobile. That number seems fairly reasonable given the scope of the initial 4G rollout.

However, as the Merrill Lynch analysts are quick to point out, not all of these sales will be incremental. Indeed, if there are really 42 million iPhones running on China Mobile's network today, it suggests that China Mobile users have already been activating iPhones at a rate of at least 10 million-15 million annually.

Some of these may be used iPhones that were resold to China, but others were bought factory unlocked in China, or were purchased in other countries and then shipped to China. By offering the iPhone directly, China Mobile will cannibalize these other sales channels. As a result, even if China Mobile activates 20-million-plus iPhones in the next year, the net increase in Apple's global iPhone sales could still be 10 million or less.

The real opportunity
Thus, while there may be an initial spike in demand for the new iPhones from China Mobile users looking to upgrade, beyond that, many of the phones sold through China Mobile will just cannibalize gray market sales. The real opportunity for Apple with China Mobile is longer-term in nature, and the Merrill Lynch team overlooks this growth driver.

First, China's economy is growing rapidly. As a result, premium smartphones like the iPhone will become affordable to an increasing cross-section of Chinese consumers over the next decade.

Second, the LTE-enabled iPhone 5c is likely to see a big price drop next year, making it more appealing to members of China's middle class. The iPhone 4S -- which sits just below the 5c in Apple's current pricing scheme -- is almost $200 cheaper in China today. (The iPhone 4 is in turn more than $100 cheaper than the 4S.)

The iPhone 5c could become a popular midrange phone if Apple cuts its price next year. Photo: Apple.

While Apple will never join the race to build smartphones priced at less than $200 unlocked, a cheaper 5c on China Mobile could be a powerful weapon, particularly if paired with a significant carrier subsidy. An iPhone 5c price drop is likely to occur when Apple unveils its next-generation iPhone in 2014.

Lastly, next year's expected "iPhone 6" is likely to sport a larger screen, according to numerous media reports. Large-screen phones (many of which have 5- or even 6"-inch screens) have become quite popular in China recently. Apple's entry into this market segment could make the iPhone more popular with China Mobile customers looking to upgrade from 3G Android phones.

Foolish bottom line
Scott Craig and his team at Merrill Lynch are correctly cautioning investors that many of the iPhones that will be sold on China Mobile in the next year would have been sold anyway, through gray market channels. There will probably be a brief surge in sales to iPhone loyalists looking to upgrade to 4G speeds, but after that, growth may recede.

Nevertheless, the long-term opportunity at China Mobile is massive. Over time, Apple will probably broaden the iPhone product line, while the iPhone 5c will become the entry-level phone many Apple watchers expected from day one. Meanwhile, the growth of China's middle class will move many China Mobile subscribers into Apple's addressable market. This will provide years of solid growth for the iPhone in China.

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Read/Post Comments (18) | Recommend This Article (13)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On December 11, 2013, at 1:37 PM, DanManners wrote:

    Wait until you see the numbers. The growth will be immediate as many will upgrade to 4g phones and Apple will be one of those phones. To have 40million black mkt phones shows how much Apple is loved.

  • Report this Comment On December 11, 2013, at 1:39 PM, DanManners wrote:

    B of A said it but many said Apple would sell more. Why do we only trust B of A?

  • Report this Comment On December 11, 2013, at 1:48 PM, drax7 wrote:

    This article is full of negatives for apple. Cook should resign after reading this and shut the firm .

  • Report this Comment On December 11, 2013, at 2:41 PM, Mathman6577 wrote:

    10 -15 million units seems too low (most analysts say at least 17 - 20 million or more). Didn't Merrill Lynch need to be bailed out ? (Apple didn't).

    10 million units x $700 = $7B (15 million units = $10.5B. If Apple sold only iPhones and only to China Mobile customers it would still rank higher than #363rd on the Fortune 500 list.

  • Report this Comment On December 11, 2013, at 3:13 PM, GaryDMN wrote:

    Consider Japan, long thought to be the hardest place on earth to sell American electronics, where the iPhone absolutely rocks now. The iPad outsells all Android tablets in China by a long shot, even it costs much, much more to buy. Apple is the number one electronics BRAND in the world and they are gaining ground and loyal users every month. Apple is a growth company, but it not being valued as such. They will be the first company in the world with a billion paying customers, sooner than most people think.

  • Report this Comment On December 11, 2013, at 4:14 PM, TMFGemHunter wrote:

    @DanManners: I don't think you quite understood the point. Apple may sell 20-30 million iPhones on China Mobile in 2014, but they aren't all incremental sales. Apple is already selling 10-15 million iPhones that go to China Mobile customers today. So the real increase in sales might be around 10 million.

    That doesn't even count the fact that China Mobile's move to 4G could help win some iPhone users back from China Unicom and China Telecom. The gains at China Mobile will be partially offset by losses at the other carriers.

    @GaryDMN: Not sure where you're getting your tablet market share numbers. Most recent data I saw was 28% for iPad and falling. I would guess it bounces back a bit this quarter with the new iPads but it will probably resume its downward slide. It's no knock on the iPad, but most Chinese consumers cannot afford one, whereas there are plenty of $99 white box Android tablets to be found.

    BTW, just to be clear, I own Apple shares and it's actually my largest investment. I'm very bullish on Apple. This article is not meant to imply that there's a problem with the company. People just shouldn't have unrealistic expectations -- that's what got Apple investors burned last fall.

    Adam

  • Report this Comment On December 11, 2013, at 5:47 PM, billroselius wrote:

    i believe that the iPhone has more customer appeal than the Android phone even if it is more expensive. For the same reason people want products with brand appeal such as coach bags or Lexus cars (or similar high value items).

    i believe all smartphone usage will increase dramatically in the next few years. (See other TMF articles). The introduction of Near Field Communications (NFC) will bring more users to smart phones. The fashion conscious users will want to pull out their luxury iPhones to do their transactions. A good barometer will be what percentage of gold iPhones are sold in China.

  • Report this Comment On December 11, 2013, at 6:03 PM, RM97665 wrote:

    @TMFGemHunter ... good point about the incremental sales. However, if there are 42 million people are willing to buy an unlocked iPhone to use at 2G speeds, I would guess that most of these will be upgrading to 4G versions when they come out. This will result in ~42 million new phones being bought just as upgrades alone, and doesn't count the people that would like an iPhone but never bought one because they wanted more than 2G speeds.

  • Report this Comment On December 11, 2013, at 7:23 PM, TMFGemHunter wrote:

    @RM97665: That's a good point. But the vast majority of those iPhones on the CM network today were activated in the last two years. Those people are likely to upgrade over time, but I don't think they will all be rushing to upgrade in the next few months when they have relatively new iPhones that they spent a lot of money on.

    Hey, as a shareholder, I'd love to be proven wrong!

    Adam

  • Report this Comment On December 12, 2013, at 5:18 PM, BeFly wrote:

    No matter how much Apple reduces it's iPhone price, it is very hard to compete in China's cellphone market. There are cellphones such as xiaomi with just as robust OS and SoA that are 1/3 of iPhone's price.

  • Report this Comment On December 12, 2013, at 8:48 PM, TMFGemHunter wrote:

    @BeFly: Thanks for the comment. You are right that Apple can't compete on price alone. Xiaomi and others offer great phones at really low prices. But Apple has shown a pretty good ability to win business in developing countries even at a premium price point -- as long as the premium isn't too steep.

    At $700 or so, the iPhone 5c won't sell much in China. At $400, I think it would do pretty well. There's nothing wrong with Android, but there are a lot of people who prefer Apple's products because of the full hardware-software integration, among other things.

    Adam

  • Report this Comment On December 13, 2013, at 4:57 AM, grahamsway wrote:

    I think maybe Merrill's got it backward. Initial sales could be slow but they should grow in the future.

    I think what's missed is that it looks like China's just getting started moving into 3g. Unicom and Telecom's been doing better than Mobile lately because they concentrated on 3g. Latest stats I've seen have indicated Telecom added 18 million 3g in first half and Unicom added 35 million 3g in first three qtrs.

    It seems that Mobile's strategy was to downplay 3g and go with 4g. That might give them a serious competitive advantage going forward. Assuming they have a decent network, and assuming 4g's noticeably better than 3g, they probably will not only get plenty of their own customers upgrading but a significant share of available Telecom and Unicom who were thinking about going from 2g to 3g and even some who can change carriers that already have 3g.

    If Apple's name is anywhere near as popular in China as the U.S. and if CHL's strategy pays off, the combo may result in some significant numbers over time.

  • Report this Comment On December 13, 2013, at 5:18 AM, KongPL wrote:

    I live in china since 6 years. All my support staff own iPhones. They can't wait to upgrade. There is a lot of free cash/spendable income, and Apple is indeed very popular.

    Wait and see........

  • Report this Comment On December 13, 2013, at 8:15 AM, drax7 wrote:

    I never made a dime following any analyst 's recommendation. Their biases and guesses that pass as intelligence are not worth a dime.

  • Report this Comment On December 13, 2013, at 8:56 AM, sabresoft wrote:

    Drax7: "I never made a dime following any analyst 's recommendation. Their biases and guesses that pass as intelligence are not worth a dime."

    Drax7: "This article is full of negatives for apple. Cook should resign after reading this and shut the firm ."

    Point taken

  • Report this Comment On December 13, 2013, at 9:21 AM, sabresoft wrote:

    While this agreement may not result in immediate explosive growth it is still much better than no agreement at all.

    Also, while markets are relatively static in Europe and North America because smart phone adoption is already high, and there isn't significant population growth in these areas, in China the more affluent middle class is still a growth market as more of China's population is moving from a rural, agrarian economy to an urban, industrial/commerce economy. This opens up a bigger market each year and an opportunity for sales of recycled phones at the bottom end of that market, and although many of those sales will not necessarily benefit Apple directly, future possible upgrades by the new customers will.

  • Report this Comment On December 13, 2013, at 10:07 AM, TMFNewCow wrote:

    Nice article, Adam.

    -- Evan

  • Report this Comment On December 17, 2013, at 12:06 AM, dwilh51183 wrote:

    AAPL IS HEADING TO $850 BY MARCH AFTER CHINA MOBILE DEAL AND HUGE XMAS EARNINGS, FOLLOWED BY HUGE SHORT SQUEEZE…AND THEN OFF TO $1100 PRICE BY MAY. AAPL STILL HAS 40 BILLION LEFT IN BUYBACK SO STOCK IS GOING WAY UP, UP, UP

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