Higher Tech, Lower Prices: Are China's Smartphone Firms Getting Smarter?

The unveiling of Apple's updated iPhone 4 on October 4 was modest, but it still caused ripples in China, one of the world's biggest smartphone markets. Only weeks earlier, Chinese consumers were already able to buy an iPhone 5, but those were counterfeits -- as were many Apple stores that have been shuttered across the country recently. While Chinese authorities have been going out of their way to crack down on the latest flood of Apple fakes, the appetite among consumers for anything from the U.S. brand speaks volumes about the quirks of the country’s burgeoning smartphone market. While the non-counterfeit iPhones remain financially out of reach for many Chinese, smartphone use is soaring in the country, helped by telecom providers keen to shift to higher value-added 3G services, and by local manufacturers who are more than happy to help.

But can China's manufacturers stun world markets with a product capable of beating the iPhone? Experts say that's unlikely. As the home-grown powerhouses -- particularly Huawei and ZTE, both of Shenzhen -- expand quickly in China and abroad, their aim is like that of many Chinese companies: to be profitable by maximizing volume rather than raising the quality of their handsets so they can charge much more for them. But playing the volume game can be risky, especially since unit costs can drop rapidly in today's extremely fragmented market, warn observers.

Still, despite such warnings, analysts also predict that the smartphone industry will continue to grow rapidly. While foreign brands, including Apple, hold the lion’s share of the smartphone market in China for now, Huawei, ZTE and China's other relatively young smartphone handset manufacturers are expected to hold more than 50% of market share by as early as 2013. The signs bode well for them globally, too.

According to research firm IDC, the global smartphone market will mushroom to 982 million units by 2015, from an estimated 472 million units this year and 305 million units in 2010. IDC also forecasts that over the next four years, China will nudge its way ahead of other countries to become the world’s biggest market, with a 17.2% market share compared with the U.S.'s 17.1%.

Life at the Low End

Two emerging trends have recently been working in the Chinese firms' favor. "It was in 2010 that [the People's Republic of China] really pulled ahead of Japan [as the second-largest market] with the ramp up of 3G telecoms and [as] the catalyst of the RMB 1,000 [US$150] smartphone,” says Teck Zhung Wong, an IDC regional analyst based in Beijing.

In terms of price points, Huawei, ZTE and the other Chinese phone makers selling handsets for RMB 1,000 do indeed have an advantage over foreign rivals. The iPhone, for example, sells for about RMB 5,000 in China and its marketing targets upper-middle-class professionals. Taiwan's HTC sells its smartphone for between RMB 2,000 and RMB 3,000.

As for 3G, that new wireless technology is still getting a foothold in the country. “China’s mobile phone market is huge, with over 900 million subscribers, but 3G is only 10%," says Ryoji Nakagawa, a professor at Ritsumeikan University in Kyoto, Japan, specializing in the Chinese IT industry and economy. "You do not have to have 3G to use smartphones, but if you really want to use [a smartphone's] functions fully, you do need it."

RedTech Advisors, a Shanghai-based research and advisory company, predicts that the share of 3G subscribers among cell phone users in China will increase to 25% by the end of 2012.

"The increase of 3G penetration and the increase of smartphones will have a multiplier effect in China,” says Nakagawa. “I do not think all 900 million will shift to 3G at once, but there is big market, even just at the high end.”

However, can something that's an asset today become a liability tomorrow? One way Chinese manufacturers are gaining market share so quickly is by designing their products to the specifications of telecom operators rather than with an eye toward breakthrough innovation, like Apple does. This will constrain their ability to compete against Apple and other big foreign rivals, says Tomoo Marukawa, a China industry and economy specialist at Tokyo University’s Institute of Social Sciences.

The Call of 3G

Because the number of 3G subscribers is still relatively small, the country's three mobile operators -- China Mobile, China Unicom and China Telecom -- are desperate to expand the number of subscribers by selling more 3G-compatible smartphones. “Chinese telecom operators are keen to get people to use smartphones in order to expand their 3G subscriber bases,” notes IDC's Wong. At the same time, he adds, "smartphone vendors think smartphones are the new goldmine."

To encourage the switch from 2G, the operators are subsidizing 3G subscribers. China Unicom, for one, uses about 40% of its 3G revenue to underwrite purchases of smartphone handsets, according to Meiqin Fang, research director of K-Island Consulting, a technology, media and telecoms research and consulting company in Beijing. Since last year, vendors, both foreign and Chinese, have vigorously promoted many new models at cut-rate prices, including Huawei and ZTE, which "are very aggressively selling lower end smartphones for around RMB 1,000, with very good features, such as touch screens and high definition,” she says.

China’s smartphone shipments are forecast to exceed 54 million units this year, from 35.3 million units in 2010, according to IHS iSuppli China Electronics Supply Chain Service. Huawei, the world’s second-largest telecoms equipment maker (with annual revenue of around US$29 billion) after Ericsson, and China’s largest, says it expects to ship between 12 million and 15 million smartphones this year, compared with 3.3 million last year. ZTE, China’s second-largest telecoms equipment maker, shipped five million in the first half of the year, with a view to shipping 12 million by the end of 2012, compared with three million last year.

As of the end of June this year, about 44% of China’s smartphones were running on the Android OS, and 36% on rival OS Symbian, says Sandy Shen, research director of consumer services for mobile and wireless technologies at Gartner in Shanghai.

Despite the ascendance of domestic smartphone makers, foreign vendors dominate the Chinese market. China-based research company ZDC says Finland's Nokia was leading the sector with over half of the market share at the end of 2010, followed by Taiwan's HTC and South Korea's Samsung, with less than 10% each. The rest of the market is fragmented, divided up among Motorola, Apple, Blackberry, SonyEricsson and LG, all followed by a smattering of Chinese makers.

The landscape is changing quickly. According to Gartner, Huawei’s market share jumped to 7.3% in the second quarter of this year from 1.2% in the fourth quarter of 2010, while ZTE’s rose to 5.3% from 1%. Meanwhile, Apple rose to 13.3% from 9.5% over the same period, and Nokia dropped to 36.2% from 58.2%.

As suppliers to overseas telecoms operators, Huawei and ZTE have another advantage over other manufacturers. “Their very good relationships with telecom carriers help them tremendously,” says Wong of IDC. In that vein, “they are going to both developed countries and emerging markets. Their strategy is not one or the other, but both. They are going to Africa, Southeast Asia, Europe, the U.S. and Japan.”

So far, however, Huawei and ZTE’s strongest growth has been in their homeland. Most recently, for example, ZTE signed two contracts this year with China Unicom for a total of three million of its flagship Blade V880 smartphone, which costs RMB 1,000, is 3G compatible and whose features include a 3.5-inch touch screen and 600Mhz CPU.

“China Telecom, China Unicom and China Mobile are all getting large-volume procurements [deals] from Huawei and ZTE and other Chinese vendors,” says Fang of K-Island. Meanwhile, Huawei and ZTE are beginning to build their own distribution networks by working with chain stores and national electronics distributors, such as China Telling Telecom in China, she says.

Foreign Favorites

Telecom experts agree that Huawei and ZTE will be among the top five suppliers in China by 2015 at the latest. But they'll clinch that positions by focusing on high volume and low- to mid-end sales, rather than competing directly with Apple, says Fang. “I don't think they will compete head-to-head with Apple because their position in the market is different. Apple is strong in the high end, and even HTC is not competing with Apple. Huawei and ZTE are now trying to move from low end to mid-end.”

But making such a move may not be as straightforward as they would like. One big hurdle is branding. Chinese consumers generally favor foreign mobile phones, and see all Chinese brands as cheap 2G laggards. “They need to change the cheap brand image and differentiate themselves from other Chinese smartphones," which tend to be based on the open-source Android operating system (OS), says Wong of IDC.

Meanwhile, competitors are nipping at their heals. In September, China’s biggest search engine, Baidu, launched its Android-based mobile OS called YI, which offers its own applications and features cloud integration for content storage and back-up. Dell will develop a smartphone with Baidu. E-commerce giant Alibaba also recently launched its own cloud platform, with a smartphone made by OEM partner Tianyu, which includes online payments and e-commerce platforms. In August, Xiaomi Technology unveiled its cloud platform Xiaomi Mobile, which runs its Miui OS on top of Android. “It is too early to know what the impact will be, but one outcome will be the fragmentation of the Android OS [market],” Wong says.

Huawei and ZTE face an even more daunting branding challenge overseas, where most consumers have either never heard of them or never used their products since they are sold to telecoms operators, not retailers, points out Wong. “If Huawei wants to sell its smartphones on its own in the U.S., it has to build up sales channels, but it lacks a presence there. They have to find distribution partners or channels to sell directly to consumers.”

Value vs. Volume

What's more, the low-end, high volume sales strategy may not be sustainable, at least in terms of their bottom lines, says Michael Clendenin, managing director of RedTech Advisors. “If Apple and HTC [were to], for argument’s sake, control a combined 30% market share, they would capture 85% of the profit. Huawei and ZTE may be among the top five in China’s smartphone market, but not in a way that matters," he notes. "They may have a 50% market share but capture only 10% of the profit. They are going to win the volume game but not the value game.”

From Clendenin’s point of view, another reason the low-end, high-value game is risky has to do with the dichotomy between the handset makers' aims and those of telecoms operators bent on ramping up data network usage in order to justify the hefty infrastructure investments they've been making. Price-conscious Chinese are happy to show off the nifty new functionality of their smartphones, but not if that means big monthly bills.

“In China, about 30% to 40% of cell phone users spend only RMB 50 per month. And 60% to 65% of the market is younger than 30 years old. They are not going to be huge data users. The subsidy [that the operators are paying to attract more customers] may not be money well spent,” Clendenin says. Given these pressures, telecom operators will continue insisting on cheaper smartphone models to suit the mass market.

There's also the question of how to design products that will meet global specifications, according to analysts. “Huawei and ZTE will not be able to make smartphones that they can sell anywhere in the world, unlike Apple or Nokia,” notes Marukawa of Tokyo University. For Japan, China and India, Huawei makes smartphones based on carrier-specific requirements, he says. In turn, differentiating itself is essentially impossible.

It's also why the Chinese OEMs are as vulnerable as their Japanese counterparts, which already pursued a strategy similar akin to what Huawei and ZTE are doing today in their failed bids to break into global markets. “If Huawei and ZTE become order takers for world telecoms operators, they will make the same mistakes as Japanese makers,” predicts Marukawa.

Avoiding that fate depends largely on whether they can develop innovative products that appeal to the global marketplace, says Fang of K-Island. So far, the big Chinese telecoms makers have shown little sign of that talent. “It may take a long time for Huawei and ZTE to be able to compete on par with Apple,” she says.

Knowledge@Wharton