(By Mani) China would be the next leg of growth for Apple, Inc. (NASDAQ:AAPL) and its flagship product iPhone as the demand in its key U.S. market is saturating and half of the smartphone sales are now in Asia. But, the journey would not be easy as it seems.
Smartphone penetration has increased in developed countries such that Apple will be increasingly dependent on developing markets. Asia-Pacific is the most significant opportunity at over half of global smartphone shipments with smartphone penetration of about 30 percent, according to Gartner.
About twothirds of Apple's Asian sales are in China, where the company has demonstrated its ability to sell high-end smartphones. Much of Apple's success stems from affluent consumers' desire to associate with a luxury brand.
iPhones were formally introduced by China Unicom in October 2009, followed by China Telecom in March 2012. The two carriers service one-third of China's total wireless subscriber base and 82 percent of China's 3G subscriber base.
"Apple's iPhone opportunity in China is determined by the size and growth of the high-end smartphone market as well as by Apple's share based on its product and ecosystem attractiveness along with access to a 3G network," UBS analyst Steven Milunovich wrote in a note to clients.
As in other countries, Chinese users tend to have more iOS than Android apps installed and spend more time on those iOS apps, thereby making Apple attractive to carriers and creating barriers to switching for users.
However, similar to most of the emerging economies, Apple's China ambitions may be impeded by lack of carrier availability, the iPhone's high price, and regional network quality issues that diminish the functionality of high-end smartphones.
"Nevertheless, we expect that developing countries could provide half of iPhone sales and the majority of growth in 12-18 months," the analyst said.
Apple's premium pricing and cost of owning an iPhone may limit Apple's customer base to only to the top decile of income earners in China, which has the world's largest number of mobile subscribers. Notably, the company's recent launch of iPad in China met with mixed response.
"Observing iPhone plans at China Unicom and China Telecom, we estimate the annualized total cost of ownership for the iPhone ranges from Rmb4,300-7,600 for a 24-month contract or Rmb3,500-7,000 for a 36-month contract," Milunovich noted.
Apple's sales from China amounted to $5.7 billion for its third quarter ended June, down 28 percent from the second quarter. The sales drop has been attributed to the upcoming launch of iPhone 5.
Chinese customers are also lured by competitive products such as Samsung Galaxy S III model and HTC's One X. Both products are gaining immense popularity among smartphone users globally, including China.
On the positive note, China's potential transition to 4G from 3G would help customers take advantage of the latest high-end smartphone features and bodes well for Apple. Although the global rollout of LTE networks is accelerating, the pace of the transition in China is a big question mark.
Meanwhile, speculations are rife that iPhone may come to China Mobile, world's largest mobile phone operator with more than 650 million subscribers. However, China Mobile might not ink a deal until it receives an LTE 4G license, which could come in 2014.
"We believe the Chinese government wants China Mobile to focus on TD-SCDMA before moving into TD-LTE full steam as most of the TD-SCDMA value chain vendors are Chinese companies while the majority of the 4G participants are foreign firms," the analyst said.
The bottleneck for TD-LTE progress remains spectrum allocation. Also, rolling out a full-coverage LTE network in a large country with high population intensity is difficult.
In addition, handset subsidy costs for the iPhone could pressure China Mobile's margins and earnings. The U.S. carriers, too, have started complaining over the margin impact of subsidized iPhones.
"We think the State-owned Assets Supervision and Administration Commission (SASAC) might not allow China Mobile to spend billions subsidizing a foreign firm. We believe SASAC had approved Unicom and China Telecom's agreements with Apple because it wanted to support these smaller carriers," Milunovich added.
However, competition may spur the need for China Mobile to carry hot devices. With its burgeoning 2G subscriber base, China Mobile's 3G network had been catching up quickly with China Unicom and China Telecom.
Apple could include iOS software that supports TD-SCDMA functionality on the iPhone 5, allowing consumers to purchase the phone independent of formal cooperation with China Mobile. Apple has proved it can sell a sizable number of units without carrier support and full functionality, which could leave China Mobile no choice but to get on board.
"Whenever it happens, we estimate that formal China Mobile support could contribute $13bn to Apple's annualized revenue and roughly $6.00 to annualized EPS," Milunovich noted.
With more than 15 million unofficial iPhone users already on China Mobile's 2G network, the uptake of the iPhone 5 could be strong as these high-end customers switch from 2G to a TD-SCDMA-capable device.
Apple too has been trying to localize its functionalities to garner Chinese attention. Recently, it incorporated increased Mandarin functionality with the release of Mountain Lion and the upcoming iOS 6.0 update in September. Specifically, iOS 6.0 will include close integration of Chinese media download services, such as Baidu's Ting and Youku/Todou.
"Integration with these services should increase user stickiness in the absence of a Chinese version of iTunes or perhaps even obviate the need to have iTunes in China," Milunovich added.