Consumers clearly love smartphones. The global market is growing fast with 380m sold in Q4, up 31% versus 2013. But manufacturers might be forgiven for not being so sure.
As the chart above shows, major change is underway in the market. The concept of ‘affordable luxury’ is disappearing as the market polarises between affordability and luxury.
- Samsung’s market share has dived from 35% in Q3 2013 to just 20% in Q4 (blue line)
- The share taken by low-cost Chinese suppliers has more than doubled to 17% (red)
As a result, pricing for Android-type phones has collapsed to $254, whilst Xiaomi sells its phones for just $220, as the chart from the Wall Street Journal highlights.
The smartphone market is thus just one example of the way China is exporting deflation to the rest of the world. It is also an excellent example of the way that the highly profitable middle ground of ‘affordable luxury’ is disappearing.
The reason is the Great Unwinding of policymaker stimulus. It created a ‘wealth effect’ by boosting property and stock markets. And it fooled many companies and investors into believing the major emerging markets had suddenly become middle class.
But as the WSJ notes, the top 10% of the world’s population controls 87% of its wealth. Thus you only need to have an income of $34k to be in the richest 1% of the global population. In India, probably the country with the most growth potential, average incomes are just $600/year.
For the moment, therefore, Apple is sitting pretty. It now makes 90% of all profits in the mobile market. But this will not continue for long:
- Major companies such as Samsung and Microsoft will continue to battle China for market-share
- And the Chinese manufacturers such as Xiaomi and Lenovo will continue to battle them and each other
- Prices will continue to fall as a result, and suppliers will be squeezed harder and harder to support the price-cutting strategies
- Before too long, Apple will also have to cut prices too, as the novelty of the latest iPhone wears off
This is why Apple is using its windfall profits today to reposition itself as a supplier of services, not hardware. As the New York Times notes:
“Actual hardware is less and less important these days, and the services more and more important, so Apple will have to get services like maps and messaging right — as well as more complicated services like HealthKit and HomeKit, its frameworks for collecting health and fitness data and connecting to smart home devices”.
Companies who hope to make money out of supplying Apple need to make the same shift. If they don’t, they will find themselves in Samsung’s position, with profits plunging along with market share.
The picture on the right is the Xiaomi Mi4 smartphone.
The 16GB version sells in China at Rmb 1999 ($326), and the 64GB version at Rmb 2499. By comparison, Apple’s iPhone 6 sells for Rmb 5288.
Unsurprisingly, Xiaomi is moving up the world sales league very fast. In Q2, it jumped to 5.1% market share, from just 1.8% in Q2 2013. In Q3, it reached 5.6% and seems likely to move higher as it begins to launch in India next month.
Nor is Xiaomi the only Chinese smartphone company enjoying success in the global market. Analysts Strategy Analytics report that Chinese companies gained a 38% share in Q3 – more than Samsung (24.7%) and Apple (12.3%) combined.
Of course there will always be people who want, and can afford, cool phones such as Apple’s. But will there always be people who want mid-market phones like Samsung’s?
Probably not, if one looks at what is happening to Samsung’s market share and profits:
- Its market share was down by nearly a third in Q3 to just 25%, versus its 35% in Q3 last year
- Its profits halved in Q3, as its smartphone margin halved to 7% from 15% over the past 10 quarters
And whilst Xiaomi is piling on the marketing pressure, China’s Lenovo is busy consolidating the market – with Motorola its latest acquisition. Generally speaking, companies find it very difficult to fight back if market share crashes like this. Cash begins to drain out of the company, and already Samsung executives have taken a 25% cut in H1 bonuses.
THE AFFORDABLE LUXURY MARKET IS DISAPPEARING
The problem is simple. Samsung’s success was based on selling an affordable version of Apple’s luxury models. But now, Xiaomi’s very different business model means it can do this profitably at half Samsung’s price. Its marketing, for example, uses social media instead of expensive traditional advertising. Overnight, therefore, Samsung’s niche in the smartphone market is disappearing.
And the problem is not just confined to smartphones. A new report for Korea’s Institute for Industrial Economics and Trade forecasts that although Korea has strengths in certain high-end markets (like autos and memory chips):
“Korea is expected to lose out to China in the manufacturing of mobile phones, display screens, ships, machines, petrochemicals, steel and textiles.”
Essentially, therefore. its export-led success of the past decades has ended:
- It used to sell high margin petrochemicals and other products to China
- China would then undertake low-margin assembly work for export markets in the West
- But now China is moving up the value chain – as described last week – whilst Western markets are slowing fast
This paradigm shift has enormous implications across the entire Asian region.
For 20 years, companies across North and South East Asia have built successful businesses based on exports to China. In petrochemicals, for example, many firms expect to sell half their production to China.
Now, all those exports are no longer needed. And even worse, Chinese companies are now starting to supply a very wide range of products – from smartphones to PVC and PTA – into their own domestic markets, and more cheaply.
The conclusion is clear. China’s move up the value chain is for real. And the speed of its advance gives little time for companies outside China to change their business model. Probably all they can do is to rush to the government for protection, and argue for duty barriers to be erected in order to preserve as many jobs as possible.
Samsung’s agony is thus just one high-profile example of the Cycle of Deflation in action
China’s exports are growing again. But not because SuperCycle levels of demand have returned in the West.
Instead, its companies are using their low-cost manufacturing model to take on and beat Asian and Western giants. Developments in the global smartphone market highlight the rapidity of the change underway
They confirm China’s economy is moving in exactly the direction set out in the blog’s February Research Note:
“Export Demand. China’s main export focus will no longer be the cheap textiles and plastic products of the past. Instead it will create jobs via an aggressive drive to sell affordable cars, smartphones and relatively high-value chemicals into emerging and Western markets, based on the major new capacity installed in recent years”
Q2 data for global smartphone sales from Strategy Analytics highlights the change now underway:
- Total market share for China’s Huawei, Lenovo and Xiaomi has jumped to 17% from 11% in Q2 2013
- Xiaomi has more than doubled its share to 5% from 2%, and become the world’s 5th largest supplier
- The big loser is Samsung, down to 25% from 33%
- Even Apple is slipping, down to 11% from 12%
Smartphones are big business, of course, with handset sales rising 27% to reach 295m in Q2. But the Chinese suppliers, particularly Xiaomi, appear to have a clear strategy to dominate the market.
Xiaomi only launched its first smartphone in China 3 years ago, in August 2011. But it now has 21% market share, versus only 16% for Apple, and just behind Samsung’s 23%. The reason is price – its new RedMi model sells for Rmb 799 ($125) versus Rmb 5000 for the iPhone 5S.
Their main focus today is on Samsung. Its problem, like many companies, is that it has been focused on the middle market, where people were prepared to pay extra for cool features. But now, as with the auto market, “design to cost” is the key parameter for today’s more cash-strapped consumers.
Thus Samsung’s new Galaxy 5S is aiming at the wrong market by adding pricey features—such as an improved camera, a fingerprint scanner and a heartrate sensor. As the Wall Street Journal notes, this strategy is causing its margins to be squeezed as its costs increase.
Xiaomi’s performance couldn’t be more different, as Strategy Analytics describe:
“Xiaomi was the star performer in the quarter, capturing a record 5% marketshare and rising into 5th place in the global smartphone rankings for the first time ever. Xiaomi’s Android smartphone models are wildly popular in the Chinese market and it shifts millions of them every quarter through its extensive online and operator channels. Xiaomi’s next step is to target the international market in Asia and Europe.”
Bloomberg report that Xiaomi is now the leading smartphone vendor in China, giving it an excellent springboard for overseas expansion. In India, local supplier Micromax is following the same low-cost strategy and is now the leading mobile phone supplier:
“Earnings and shipments at Samsung are shrinking as consumers increasingly look past its Galaxy devices to local makers selling inexpensive phones. Xiaomi keeps prices down by selling through its website and tapping social media to create Apple Inc.-like buzz, while Micromax offers models with longer battery life and dual-SIM capacity in a market where wireless carriers don’t subsidize phones.”
Thus Xiaomi is targeting sales of 100m next year, up from 15m in Q2 this year. This seems very possible, with its Mi3 device selling for a starting price of $230. And as Bloomberg add:
“Similarly, Micromax aims to sell feature-filled phones cheaper than comparable models from rivals. In April, it introduced its Canvas Doodle3 with a 6-inch screen, magnetic flip-cover, 1.3GHz dual-core MediaTek processor, Android 4.2.2 Jelly Bean operating system, 5-megapixel camera, and six-month movie subscription — all for 8,500 rupees ($140).”
The problem for established companies, as Samsung is finding, is that they are now following, rather than leading the market. And this creates a vicious circle, as Samsung’s SVP for mobile strategic planning confirmed last week:
“We will more aggressively respond to the low- to mid-end smartphone market in China, which is growing rapidly now. There is a concern that it may put further margin pressure on the profitability in the short-term, but we will expand our shipment to secure profit.”
The middle market, able to pay for cool features, is disappearing before our eyes. The successful companies of the future in smartphones, autos and other major industries will be those able to offer low-cost products.
“Forget the Crimea annexation or a U.S.-Russia standoff. The biggest international threat to U.S. economic growth is the slowdown in China, say economists polled by The Wall Street Journal (WSJ).”
That was last week’s headline in the WSJ. These, of course, are the same economists who have been busy telling us for years that China was set for further decades of rapid growth, and would overtake the US as the world’s largest economy.
Of course, this is the low-risk way to behave. Stick with the consensus, and then claim “nobody could have foreseen that such-and-such happened to destroy the dream”. At the same time, ignore the people who have the courage of their own convictions, and who bother to do their own research – such as the blog’s Research Note last month
We saw this happen during the subprime crisis, where the concerns of the blog and others were routinely ignored as the disaster of Q4 2008 developed. Now it is happening again, as people search for excuses to explain why their previous strongly-expressed views turned out to be wrong.
Another example, again relating to China, highlights the same picture. How many times have you read in the past few years about China’s millions of “middle-class consumers”, supposedly all lining up to create a perpetual growth machine for any company with products to sell?
We pointed out in chapter 4 of Boom, Gloom and the New Normal that this was a complete myth, and forecast that ”The term ‘middle-class’ when used in emerging economies will be recognised as having no relevance to Western income levels.”
Now this forecast is coming true, but not before far too many companies have been taken in by the hype and invested vast sums as a result. Thus the WSJ also reported that:
“Total smartphone shipments in China fell 4% in Q4 2013. This could signal harder times for both domestic and foreign smartphone companies looking to China for growth.”
Indeed it could. And hard times for all those companies who have set up to supply them with raw materials.
The truth is that the market only developed due to the lending bubble. People earning just a few dollars a day, the position of most Chinese, could otherwise never have afforded to pay even $100 for a low-end smartphone, let alone $750 for an Apple model. Not everyone was fooled of course. As one long-standing Asian reader wrote to the blog:
“This was something waiting to happen. The penetration rate of smart phones has been one of the highest for any product the world over (thanks to easy & cheap money) and has outpaced the speed of innovation. With smart phone improvements becoming more marginal the rush to upgrade is diminishing.”
Sadly, even within companies, such sensible arguments have been routinely ignored. Instead, the bonuses and promotions have often gone to those pushing forward ever-grander projects, whilst credulous investors believed growth would never end, and pushed the share price ever-higher.
Just for the record, therefore, this is what the blog wrote in January 2013. Because, yes, it was perfectly possible for anyone to see what was coming, if they wanted to know:
“One of the great myths of recent years has been that China – whose population mainly earns less than $10/day – has somehow become ‘middle class’.
“It is certainly true that some of China’s 1.3bn population have done well since the economy reopened to the world after Mao. And equally true that the house price bubble created the illusion of wealth in the major cities, even though incomes remain relatively low on a global scale. But Apple’s problems with its iPhone sales highlight how reality is starting to puncture the myth:
- The iPhone 4 was launched in September 2010 at a price of $750
- In January 2010, analysts Morgan Stanley had forecast a “potential for Apple to sell 4-5 million units annually (in) an attractive addressable market of 50 million consumers”
- In July 2011, Apple said its China stores “have more than 40,000 visitors per day – four times average traffic in the US stores”
- But last week it emerged the iPhone is now in only 6th place in China’s smartphone market
“The reason is affordability. As Bloomberg comment, “the lack of low-cost products limits the iPhone-maker in emerging markets“. Apple’s market share was apparently down to 15% in Q3 2012 “as it struggled to lure consumers earning an average of $577/month”.
Apple’s problem highlights the dilemma facing a vast number of companies, as they slowly realise their business strategy for China has been misguided. There never were 50m ‘middle class’ consumers in China. Instead, as the blog has noted several times, there were 50 million who earned more than $20/day ($7300/year).
“This is not quite the same thing.”
Benchmark product price movements since January 2013 are below, with ICIS pricing comments:
PTA China, down 25%. “The downstream polyester sectors remained slow, struggling to consume the huge supply overhang in the key China markets”
Benzene, Europe, down 7%. “With renewed macroeconomic concerns regarding China, there is no real sense that demand from key end-use markets is supporting any continued bullishness on benzene.”
Brent crude oil, down 4%
Naphtha Europe, down 2%. “Traders expect increased future US gasoline demand for naphtha as a blendstock,”
US$: yen, up 15%
HDPE US export, up 21%. “Global demand remained weak, particularly in China, where the post-Lunar New Year bump has failed to materialise”
S&P 500 stock market index, up 26%
Monday night update. A blog reader has kindly forwarded another WSJ article today, which highlights exactly the same smartphone need for ‘affordability’ in Indonesia. “Cheaper, less fancy smart phones are hot sellers in Indonesia, as lower-income buyers choose affordability over top-of-the-line features”.
Apple will report great sales this weekend from its iPhone launch in China. But these cannot disguise its major problem in selling its high-priced iPhones there. Its difficulties highlight the dangers for those who believe that China has now become a ‘middle-class’ country with most of the population having incomes close to Western levels.
Back in 2010, the analysts were forecasting iPhone 4 sales of 4 – 5 million annually in an addressable market of 50 million. And in January this year, current CEO Tim Cook was confidently forecasting that China would become Apple’s biggest market. But since then, the trends have gone in the wrong direction:
- Android phones dominate the market with 88% share: Samsung is the market leader with 18% share
- Apple has just a 5% share and is number 7 in the market
- Apple’s Q2 sales in China and Taiwan were 14% lower than in 2012
The reason is simple – the iPhone is too expensive for the market. Chinese buyers focus on brands selling below $100, with even Xiaomi’s top range new model selling at just Rmb 1999 ($325). Apple’s new ‘low-cost’ 5C iPhone is nearly double this price at $733 on Apple’s China website. And Apple simply can’t afford to cut prices to gain market share, as this would quickly cannibalise global iPhone sales – currently 50% of total revenue.
The chart above from the FT Data blog highlights the key issue. It shows that wealthy developed countries have much higher smartphone revenues per user. Japan and the US both saw revenue around $50/user in Q2, whereas China’s revenues were below $10/user.
Equally important as the FT comments, is that “future growth opportunities lie at the cheaper end of the market“. Smartphones selling for less than $200 are expected have nearly 2/3rds of the global market by 2016. This is quite a turnaround from a few years ago, when the market was dominated by those selling for more than $400.
Apple is selling a profitable niche product. But Samsung’s success in China’s smartphone market provides an excellent example of the reason why affordability has become the critical issue as we transition to the New Normal.
TUESDAY UPDATE. Apple has announced it sold 2m of the new phones in China over the weekend. This is exactly the same number as it sold last December in the first weekend of the new iPhone 5 launch, when it was already number 6 in the market.
One of the great myths of recent years has been that China – whose population mainly earns less than $10/day – has somehow become ‘middle class’.
It is certainly true that some of China’s 1.3bn population have done well since the economy reopened to the world after Mao.
And equally true that the house price bubble created the illusion of wealth in the major cities, even though incomes remain relatively low on a global scale.
But Apple’s problems with its iPhone sales highlight how reality is starting to puncture the myth:
• The iPhone 4 was launched in September 2010 at a price of $750
• In January 2010, analysts Morgan Stanley had forecast a “potential for Apple to sell 4-5 million units annually (in) an attractive addressable market of 50 million consumers”
• In July 2011, Apple said its China stores “have more than 40,000 visitors per day – four times average traffic in the US stores”
• But last week it emerged the iPhone is now in only 6th place in China’s smartphone market
The reason is affordability. As Bloomberg comment, “the lack of low-cost products limits the iPhone-maker in emerging markets“. Apple’s market share was apparently down to 15% in Q3 2012 “as it struggled to lure consumers earning an average of $577/month”.
Apple’s problem highlights the dilemma facing a vast number of companies, as they slowly realise their business strategy for China has been misguided. There never were 50m ‘middle class’ consumers in China. Instead, as the blog has noted several times, there were 50 million who earned more than $20/day ($7600/year). This is not quite the same thing.
The real market in China is for low-cost products. Thus Apple is being outsold by local competitors offering smartphones that cost less than $100. And these phones have features required in China – such as separate SIM facilities for business and personal use – but not available with the iPhone. Apple will thus find it difficult to recover from its mistake, even though it is now apparently planning to launch a model costing between $99 – $149 later this year.
As former CEO John Sculley notes “Apple needs to adapt to where the growth is. It’s got to learn how to sell products that are priced for the price point that the emerging middle class in Asia, for example, can afford.”