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Two new wireless industry measures being pushed by China’s government could hamper the growth of Apple’s (NASDAQ:AAPL) iPhone in that country, according to UBS analyst Steven Milunovich. In a note obtained by Barron’s, Milunovich cited the work of his fellow analysts at UBS who study the Chinese telecommunications market. The analysts noted that the Chinese government is “urging the three telcos to reduce their sales and marketing costs.” China’s three largest telecommunications companies are China Mobile (NYSE:CHL), China Unicom (NYSE:CHU), and China Telecom (NYSE:CHA).
As noted by Milunovich, the government’s push to reduce sales and marketing costs will likely affect the three carriers’ abilities to offer the subsidies that reduce the upfront cost of mobile phones in a market where various taxes make many higher-end devices otherwise unaffordable for most consumers. As a maker of relatively expensive premium smartphones, Apple is especially vulnerable to any reduction in subsidies.
“The State-owned Assets Supervision and Administration Commission (SASAC) is considering a plan for all three telcos to reduce marketing costs by 20% or Rmb35-40bn, out of which handset subsidies likely amount to more than one-third,” wrote Milunovich in a note seen by Barron’s. “Some 50-60% of all phone sales in China are subsidized, and handset distributors suggest sales could be reduced. We estimate the high-end market (>$500 w/VAT) is roughly 20% of sales, of which Apple had a 33% share in C13.” It should be noted that “Rmb35-40bn” is equivalent to $5.6 billion to $6.4 billion at the current exchange rate. “We think Apple sold about 25.5mn phones in China in C13 or 17% of its unit sales. China represented roughly 40% of unit growth prior to signing China Mobile,” noted Milunovich.
Apple’s Luca Maestri similarly highlighted the increasing importance of China to Apple’s overall iPhone sales in the company’s recent quarterly earnings call. “The addition of China Mobile coupled with great response to our more affordably priced iPhone 4S led to an all time quarterly record for iPhone sales in Greater China,” said Maestri, according to a transcript provided by Seeking Alpha. “We look forward to broadening our relationship with China Mobile as they expand points of sale and continue to build out their 4G network.”
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As pointed out by Maestri, Apple’s partnership with China Mobile — the world’s largest carrier — and the continuing expansion of China’s nascent 4G network are two of the primary reasons why the iPhone has achieved record sales in the country. China Mobile CEO Li Yue recently confirmed the link between 4G availability and the iPhone when he revealed that iPhone users accounted for nearly half of the 2.8 million 4G subscribers that the carrier had in the first quarter of 2014, reports Radio Television Hong Kong.
According to Strategy Analytics executive director Neil Mawston, China is predicted to become the world’s largest mobile phone market by revenue this year with sales numbers that are expected to reach 430 million units. Mawston noted that China’s growth is largely due to the country’s “rapid shift to 3G and 4G smartphones,” including Apple’s iPhone.
Unfortunately, another measure being pushed by China’s government may also impede the growth of the country’s 4G network. “SASAC also plans to form a tower-building company (towerco) to build new and manage existing mobile base stations. Press reports indicate SASOC will have the towerco established before July and will acquire all existing base stations by the end of 2015,” wrote Milunovich in a note obtained by Barron’s. “The roll-out of an incremental 300,000 TD-LTE base stations this year could be delayed. A slower roll-out of LTE/TD-LTE towers might impact iPhone unit growth or adversely impact mix with consumers opting for older models.”
Despite the implementation of two government initiatives that could negatively impact the growth of the iPhone, there are several bright spots to consider. Milunovich noted that “Elasticity of the high-end user remains untested though any subsidy cuts could slow recent momentum.”
In other words, it is still unclear how much the subsidy reductions would actually affect sales of Apple’s iPhone, which is targeted at a relatively affluent segment of China’s market. Milunovich maintained an “Outperform” rating and a $700 price target on Apple shares.
Finally, as noted by Strategy Analytics’ Neil Mawston, although China will soon surpass the U.S. as the largest mobile phone market by revenue, the U.S. still remains the most valuable country by profit. According to March quarter data from comScore, Apple maintained a comfortable lead over its rivals in the U.S. market with a 41.4 percent share. This lead is even more impressive when considering that Apple also took 65 percent of the total handset industry’s profits during the March quarter, according to Canaccord Genuity. For this reason, regardless of the short-term impact of the changes to China’s wireless industry, Apple will likely maintain its overall profit lead in the overall market.
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