Foxconn Noise Highlights Apple’s Need For A China Mobile Deal

Foxconn, one of Apple’s (NASDAQ:AAPL) biggest manufacturing partners, announced Wednesday that it has frozen hiring at its Shenzhen plant in China, sparking intense speculation that this is related to a possible slowdown in demand for the iPhone 5. This added more fuel to rumors that Apple may have started cutting component orders for the iPhone amid intense competition from Samsung (PINK:SSNLF) and other handset makers using Google’s (NASDAQ:GOOG) Android software. While Foxconn sought to play down the rumors by saying that the hiring freeze wasn’t related to any one customer but a higher-than-expected return rate of employees following the Chinese New Year, the uncertainty saw Apple fall more than 2% and below the $450 mark once again in trading Wednesday.

Considering that the iPhone is the single biggest driver for Apple and accounts for about half of the company’s value by our estimates, the intense market nervousness is understandable. A big reason for Apple’s fall of over 35% in the past five months has also been a growing concern that the iPhone demand is waning amid an increasing number of competitive products in the marketplace such as Samsung’s Galaxy S smartphones and Note phablets. This could have an impact on margins as well – something that we have already incorporated in our long-term forecasts. However, we also believe that the iPhone still has a lot of market opportunity left, especially in the emerging markets where Apple is yet to sign subsidy contracts with some carriers.

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Specifically, we see untapped opportunities in China (an in-the-works deal with China Mobile should be the catalyst) and the enterprise contributing heavily to Apple’s growth both in terms of iPhone and iPad sales. Accounting for that as well as the subsequent margin pressures due to rising competition in a maturing market, we maintain our $650 price estimate for Apple’s stock, about 45% ahead of the current market price.

China Key To Sustainable iPhone Demand

With the smartphone market in developed regions such as the U.S. getting more saturated (U.S. smartphone sales grew y-o-y by just 9% in Q2), Apple will be looking to tap the fast-growing emerging markets such as China to grow at historical rates. China, despite being only in the early stages of smartphone adoption, 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 20% currently. Considering the huge 2G subscriber base that the Chinese carriers are looking to upgrade to 3G, the potential for Apple to ride the boom is huge. This was borne out by the opening weekend sales for the iPhone 5 in China last month, which crossed the 2 million mark and made it Apple’s best ever launch in the country.

However, Apple currently sells the iPhone through only the smaller two of the three carriers in the country, China Unicom and China Telecom. A deal with the largest wireless carrier in the world, China Mobile, remains elusive until Apple can work out a subsidy deal with the carrier. How soon that will happen is open to speculation considering the Chinese government’s possible opposition to the huge iPhone subsidies. (see Apple’s China Potential Could Be Limited By A Subsidy Compromise With China Mobile) But considering the increasing seriousness with which Apple has been considering China recently, we believe that a deal is in the offing.

Apple CEO Tim Cook recently said that about 50% of subscribers in the world do not have access to an iPhone currently – a figure that could decrease significantly with the potential addition of China Mobile’s over 700 million subscribers. Such a deal has the potential to instantly double the iPhone’s current addressable market in China and act as the next big boost to Apple’s stock. (see Apple Could Have A $750 Fair Value If China Mobile Deal Works Out)

However, in order to benefit more from the China potential, it may behoove Apple to consider a cheaper iPhone for the emerging markets that does not compromise much on the build quality and margins, in a move similar to the iPad mini. This will also help lower per phone subsidy costs and potentially help bring China Mobile on board. This would also translate well to other developing markets that want Apple’s iPhone but may find the subsidy costs and the retail price tag too high.

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