Smartphone sales downturn highlights financial market risks

Smartphone May16

There was no great surprise in the news that global smartphone sales fell for the first time ever in Q1.  As I suggested in February, when reviewing Q4 data:

It seems almost inevitable that global growth will now follow China and go negative”.

As the chart shows, Strategy Analytics data suggests that sales fell 3% in Q1, making it the first time that smartphone sales have shrunk on an annualised basis since sales began in 1996.  Equally important is that competitive pressures are rising, particularly in the world’s largest market, China.  As Bloomberg note:

Smartphones are no longer novelties in China, and most domestic brands target the mid- and low-price ranges, where buyers don’t upgrade as frequently as those for high-end Apple and Samsung phones.”

Apple was worst hit by the downturn, particularly in China.  This used to be its fastest-growing market, but sales plunged 26% in Q1, as China Daily reported:

Full-fledged local brands such as Huawei and Xiaomi are pushing high-end smartphones, targeting customers seeking quality products that are priced a few hundred bucks cheaper.

What puzzles me is the behaviour of financial markets over the past 3 months, given that the downturn was almost inevitable as the headlines from my last 3 quarterly posts suggest:

Why then, one wonders, did Apple’s share price rally by 17%, from $94 to $110, between 12 February and 1 April against this background?  Apple’s shares have, of course, since collapsed back to $93 last night.

Clearly nobody really cared about the fundamentals of supply/demand.  Instead, just as in China with its commodities rally over the same period, prices were pushed higher by another sudden surge in liquidity.

One factor was the US Federal Reserve’s sudden realisation that the US economy was far weaker that it had realised. Another was the Q1 lending bubble set off by China’s provinces as they battled to retain jobs by rescuing zombie companies.  But now, there are growing signs that reality is breaking through again, as I suggested last month:

“Q1 saw a short-lived ‘Triumph of Illusion’, which may well now be followed in Q2 by a painful ‘Return to Reality’.  This will confirm that the likely key lesson of the Illusion years is that ‘it is better to travel in hope, than to arrive’.”

Smartphones head for price war as China sales fall 4% in Q4

Smartphone Feb16We all now carry around a mini-computer in our pockets – one with more power than those which controlled Apollo 11 when Neil Amstrong first walked on the moon in 1969.  In certain parts of the world, there are now more smartphones than toilets, according to Time magazine.

This is raising the spectre of market saturation in the world’s largest market:

  • In China, for example, there were 1.3bn users last year – virtually everyone now owns a smartphone
  • The length of the upgrade cycle there is rising from the previous 13 months, and sales actually fell 4% in Q4
  • Apple’s share price has fallen by a quarter in just 2 weeks, since reporting “signs of economic softness there”
  • ARM, the smartphone chip supplier, has seen its share dive 15% in the past 3 days

The chart above, based on Strategy Analytics data, highlights the problems ahead.  The market had a record year in 2015, selling 1.44bn handsets.  But growth rates have collapsed from 41% at the end of 2013 to 31% in 2014 and just 6% in Q4 2015.  It seems almost inevitable that global growth will now follow China and go negative.

This will impact all the major suppliers.  Apple has claimed 90%+ of total smartphone income in recent years, and it has a devoted fan base.  But even the late Steve Jobs would probably now struggle to come up with “the next new thing” that would excite consumers to rush out and upgrade.

The problem is that the market has run out of potential demand.  As I noted in November, there are 4.1bn people in the world who can’t afford a smartphone today.  They are the people who have incomes of less than $5/day:

  • 1.4bn earn $3-$5/day; 1.6bn earn $1-$3/day and 1bn earn less than $1/day
  • Most of the other 3.1bn people in the world already own a smartphone

But the world’s 1000 smartphone suppliers won’t give up easily.  Almost inevitably, therefore, we are heading for a major price war, as it is already possible to assemble smartphones for as little as $20.

As the chart shows, the 3 major Chinese players – Huawei, Lenovo and Xiaomi – now have had a global market share of 17.5%.  And Samsung with its 20% share (down from 35% in Q3 2013), is clearly in their line of fire.  But Apple is bound to be hit as well.

The smartphone market is also probably acting as a leading indicator for many other industries.  It highlights how China’s slowdown means there is a vast amount of spare capacity in the world, which won’t ever be needed again.

This also means that deflation is inevitable as price wars intensify.

Price war hits smartphone market as China’s growth goes negative

Smartphone May15
The smartphone market has been one of the ‘jewels in the crown” of the consumer electronics market.  Yet today, it is rushing headlong into the world of the New Normal.  We can all learn a lot about the outlook for the global economy from watching its development.

Until recently, the history was of astonishing growth, with the market growing 39% in 2013, for example:

  • Samsung was the unquestioned market leader, as the chart shows, with 1/3rd of the market (blue line)
  • Apple was a strong No 2, and highly profitable, with its niche market strategy (green)
  • China was in 3rd position, with no clear value proposition and several players all struggling for scale (red)

But then in 2014, things began to change quite dramatically.  Samsung suddenly found its middle market position being squeezed from both ends.  From the top end it was hit by Apple, who finally entered the Chinese market in a major way and pushed its global market share to 20%.  And it was hit from the bottom end by companies such as Xiaomi, Lenovo and Huawei selling very similar phones at much lower prices.

Suddenly, Samsung’s value proposition of having a larger screen than Apple, combined with ‘affordable luxury’ pricing, didn’t work so well.  Major internal debate is now underway over future strategy.  And it seems unlikely the current concept of offering different models for every minor segment, supported by a vast advertising budget, can continue.

In turn, the Korean, Taiwanese and Japanese companies who supply it with components are facing harder times.  Sharp of Japan, for example, last week announced a $1.9bn loss and plans to sack one-tenth of its workforce.  Korean companies have suffered too, with touchscreen panel manufacturer Iljin Dispay seeing profits fall 62%.

One might have thought that low-end Chinese companies would still be doing well.  But they are being hit by the slowdown in their home market, where sales fell by 6% in Q1.  In turn, this is forcing a major shift in their strategy.

Lenovo seems to be playing the role of industry consolidator, with the acquisition of Motorola its latest move.  But its profits rose just 1% last year, despite a 20% increase in revenue, causing it to cut costs further by moving more sales online – mirroring Xiaomi’s successful strategy.

In turn, Xiaomi is targeting growth outside China, launching a $205 phone for the Indian market and building sales across SEA.  In an interesting move, it is also going up-market to compete with Apple with the $483 Mi Note model.  It also aims to offer smart wristbands as well as air purifiers via a new online US store later this year.

It is keeping its low price strategy, however, which has given it market leadership in China with a 14% share, ahead of Huawei and Apple at 11%.  As the head of Xiaomi Technology said recently:

We’ve continued to revise our pricing strategy, which is now closest to our production cost“.

These dynamics, of course, are the New Normal in action.  Slowing growth, falling prices, intense competition – all played out on a global stage as the impact of China’s new economic policies spreads around the world.  In Korea, for example, the Korea Development Institute warned in February:

Korea faces a similar predicament to Japan in the early 1990s, due in large part to the catch-up of latecomers like China“.

Apple, of course, is still riding high today.  But clearly it is only a mater of time before its highly profitable niche marketing strategy comes under full-frontal attack from Korea and China.  Its future lies in making a successful shift to applications and services, as I noted when reviewing 2014 results in March.

It is not the hardware of the Apple Watch that will secure Apple’s future, or even its sleek design.  Instead, it is aiming to use this and similar products as a pathway to a wholly new business model.  It has to hope it can create profitable new application-based markets, based on collecting health and fitness data and connecting to smart home devices.

And, of course, the smartphone market is not alone is facing this New Normal challenge.  They are coming to the online and High Street stores near all of us, if they haven’t already arrived.

Apple captures smartphone profits as market shifts to services

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.

China’s smartphones outsell Samsung & Apple combined in Q3

Xiaomi Mi4

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 low-cost smartphones start to dominate global market

Smartphone Aug14

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 carssmartphones 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.