China Gatecrashes Smartphone Market With Cheap Clones…

The smartphone market has had five years of turbocharged growth, but success will increasingly be determined on selling price rather than device branding as the key hardware technologies become commoditised. Last week, Apple’s share price decline from its September peak reached over 35% on underwhelming revenue and margin guidance, while Samsung also expressed caution on average selling prices for its smartphones.  As developed markets reach 50% plus penetration rates (over 60% in the UK and Spain), the incremental buyer will come from an emerging economy and be inherently more price sensitive. A key technology trend which will pressure margins is the launch of cheap ‘system on a chip’ processor designs from vendors including Qualcomm and MediaTek, which level the playing field for aggressive Chinese entrants like Huawei and ZTE. Meantime, the 4G networks being rolled out globally have been designed primarily for data rather than voice and use the same TCP/IP protocols that underpin the internet, so that the new generation of 4G/LTE (long term evolution) phones are optimized for streaming video and even multiplayer online games.

Value investing in technology can be dangerous, given ever faster product cycles and tumbling barriers to entry. When RIM’s share price hit over $60 in early 2011, it had PER, P/B price/sales ratios very similar to Apple recently, just as margins and revenue dropped as it followed Nokia in missing a rapid market shift and the stock slumped 90% over the subsequent 18mth period. The fast accelerating growth in Android focused mobile apps reduces Apple’s ‘user experience’ competitive advantage, but will benefit Chinese handset manufacturers as much as Samsung, as they are device agnostic.

The rise of the ultra-cheap smartphones from upstart vendors like China Wireless which run on Google’s Android OS and use off the shelf chip designs is going to transform the industry over the next couple of years, which will see the sort of price and margin pressure experienced in LCD/LED TVs, where sustaining a sustained brand premium has proved impossible amid endless discounting. Apple faces a tricky decision in how far it risks diluting its brand premium by introducing a lower cost ‘iPhone Lite’. Samsung’s overall growth in Q4 was driven by the handset business, which accounted for well over half the group’s operating profit for the year. Sales in the division rose 58% in the final quarter y/y and profits 89%, driven partly by strong uptake of the Galaxy series devices. The total smartphone market reached about $240bn in 2012, up 34% y/y, and smartphones now comprise of 83% of the global market by revenue (or 40% by unit volume). Apple’s share of global handset revenue is 29%, but only 7% of global handset units as Apple charges $618 per phone vs. the industry average of $149, given most basic mobile phones are priced below $50.

However, the company highlighted an uncertain outlook by breaking from its usual practice of giving a target figure for capital expenditure this year, but indicated that it would be similar to last year’s $21.5bn. The key line from the statement was that: “In the first quarter, demand for smartphones in developed countries is expected to decelerate.” That slowdown was inevitable given the typical pattern of penetration rates for new technology. Most independent analysts estimate that LTE smartphones with wholesale ASPs under $200 will account for the bulk of smartphone shipments within four years.

The market has plenty of unit sales growth potential as feature phones get upgraded; smartphone shipments will account for 50% of all handset shipments by 2014 and become the largest handset segment in the world, according to the latest market forecasts by market intelligence firm ABI. By 2018, smartphones will account for 69% of all handset shipments, and LTE handsets half of that smartphone total. It’s feasible that at the premium end of the market, Apple will be chasing Samsung’s technology leadership in 2013 through the foreseeable future. Since 2010 Samsung has grown its smartphone market share from 8% to over 30% in 2012; meanwhile Apple’s market share is expected to peak in 2013 at 22%; remaining flat through 2018. However, both companies face growing pressure from new entrants competing on price, as well as Nokia and RIM’s efforts to restore their lost market share (with a combination of the latter with Lenova an intriguing possibility).