Apple’s China Potential Could Be Limited By A Subsidy Compromise With China Mobile

by Trefis Team
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We all know how important China is to Apple’s (NASDAQ:AAPL) future growth. Despite being only in the early stages of smartphone adoption, the country has already pulled ahead of the U.S. as the world’s largest smartphone market by volume. This is an incredible statistic given that 3G penetration in China stands at only about 19% currently. It is therefore disappointing that Apple is yet to reach an agreement to sell the iPhone through China Mobile (NYSE:CHL), the country’s as well as the world’s largest wireless carrier. What could be even more frustrating for Apple’s investors is to hear China Mobile CEO Li Yue’s recent comments on the issue.

Speaking at a developer conference in Guangzhou, Li Yue said that both companies need to negotiate details of a possible ‘benefit sharing’ model before the iPhone could become available on China Mobile’s network. What this means is that China Mobile is trying to get a bigger share of the profits by negotiating lower subsidies with Apple. This is in line with the findings of Deutsche Bank who, after a recent meeting with China Mobile’s management, found that the Chinese government, which has a controlling stake in the carrier, is ‘not supportive’ of an Apple deal due to the ‘heavy subsidy burden’ that carrying the iPhone would entail. ((China Mobile, Apple license deal unlikely soon:Deutsche Bank, MarketWatch, October 4th, 2012))

See our complete analysis for Apple here

This revelation comes just months after the iPhone 5 was launched with a Qualcomm LTE chipset that also had support for China Mobile’s proprietary 3G network. Until now, it had seemed that the only roadblock to a China Mobile deal was the lack of a chipset that was compatible China Mobile’s home-grown TD-SCDMA network. With this chipset, it seemed that Apple could finally release an iPhone on China Mobile after making a few minor tweaks. However, China Mobile’s comments imply that the stalemate between Apple and China Mobile could extend longer than many anticipated. Considering China Mobile’s clout and rising pressure on Apple due to Android’s growing popularity in China and Nokia’s recent Lumia 920 deal with the carrier, we might even see Apple compromise on the subsidy issue.

Apple’s China opportunity

However, despite not having a China Mobile deal, Apple hasn’t performed too badly in China so far. Revenues from greater China, which includes mainland China, Hong Kong and Taiwan, in the September quarter grew 26% year-over-year and accounted for 15% of Apple’s revenues for the fiscal year. This brought Apple’s FY2012 revenues from the region to about $24 billion, about 80% growth over FY 2011.

While Apple has managed to achieve this through iPhone deals with China Unicom (NYSE:CHU) and China Telecom (NYSE:CHA), it will need the support of the world’s largest wireless carrier to reach a bulk of the Chinese populace. China Mobile, with close to 700 million mobile subscribers, controls almost 65% of the Chinese wireless market.

The current 3G situation in China is however not as heavily loaded in favor of China Mobile as in 2G due to most handsets’ incompatibility with its proprietary 3G network. (see China Mobile Needs To Step Up As 3G Growth Slows) However, the carrier’s huge subscriber base gives Apple an opportunity to double the iPhone’s addressable market in China. Moreover, it enjoys a superior brand image among the Chinese that has helped it add more than 15 million iPhone users, as of February 2012, despite not offering a subsidized iPhone offering. In fact, we estimate that a deal with China Mobile alone could cause Apple’s stock value to surge past $800. (see Apple Can Ride China Potential Past $800 With China Mobile’s Support)

Impact on Apple from subsidy compromise

It is probably this clout that has put China Mobile in a position to negotiate favorable terms to the deal. If Apple were to compromise on China Mobile’s subsidies, we could see Apple bearing a part of the subsidy burden and decreasing the impact of the higher prices on iPhone’s growth. We could also see Apple deciding to let customers pay prices higher than comparable unsubsidized iPhones on competing carriers, China Unicom and China Telecom, and avoiding margin pressures. However, China Mobile may balk at the latter idea since it puts it at the risk of losing potential 3G customers to rivals.

Either way, it seems penetrating China further will mean Apple having to compromise on either margins or iPhone sales. Both of these scenarios put a cap on the potential that Apple could have unlocked from China. You can move the trend lines in the graphs presented here to analyze different scenarios and come up with your own price estimate for Apple in each case.

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