A Very Big Market
Unless you are running a government printing press, 1.2 billion of anything is a big number. By our estimates, China’s handset industry is going to ship about that many phones this year. This is a topic near and dear to us, something we have been discussing since the industry was about a quarter this size. Yet for a variety of reasons, it remains undercounted and generally poorly understood. We get a lot of questions about this, especially the size of the market. So, in this report, we are going to try to put some numbers around all this, and then get into some of the reasons why this market matters so much. Importantly, this market is moving beyond phones to tablets (and watches and more), so we will close on some discussion of this new frontier.
First, some definitions. Part of the uncertainty around the market stems from a lack of clarity as to what exactly we are talking about. We are looking at the ‘branded’ China handset makers, or China OEMs. People who design phones and then sell them on. This does not include contract manufacturers or ODMs, the people who manufacture phones. This distinction is important, because most phones are physically built in China, usually someplace within 100 miles of Shenzhen, but a growing number of these phones are also now carrying Chinese brands.
This market goes by a lot of different names. For many years it was known as the ‘white box’ market, the grey market or our favorite, the Shanzhai market. All of these terms convey a somewhat negative implication. We think the best way to sort this out is to refer to them as China Branded OEMs, or just China OEMs. And while many still build phones with other people’s brands on them, most of these vendors now have their own brands.
The history of this market stems largely from some smart moves (and a bit of luck) by Taiwan-based Mediatek. They created this market by standardizing ‘reference designs’ for phone boards, greatly simplifying the cost of designing a new phone, and allowing a whole new range of entrants to the market. We wrote a brief history of this ecosystem in a post on Vision Mobile’s blog a few weeks ago, and we would also refer you to the work of Harvard Business School professor Willy Shih who has written extensively on the ecosystem.
Our exposure to this market is a bit more personal. We first literally stumbled on to this market during a visit to Shenzhen’s Huaqiang Road electronics market in 2007. Over the years, this market has transitioned from selling foreign brands and used phones, to selling a huge range of components and repair services for China-based OEMs. Since then, we have visited China regularly, and we have gotten to know many of the ecosystem’s players from large companies like Huawei and Lenovo to many, much smaller entities. The big OEMs make north of 100 million phones every year, while the smaller ones make a few million. You can now order phones for manufacture in lots as small as 30,000 units, which tells us there are probably a host of much smaller players as well.
We have been visiting China regularly for almost 30 years, lived there for seven, and have been studying the phone market there for the past decade. Despite this, every time we look at this market we find a company we have never heard of before. This is part of what makes it so hard to research, but also part of the fun.
Transition from 2G Feature to 3G Smart
For many years, these companies mostly made 2G feature phones, and that remains the majority of their volume. But in the past two years, these companies have swung into mass volume for smartphones, mostly 3G and mostly Android, which is why this market is so important.
Market research firm Sino-MR recently published figures showing that the leading smartphone vendor in China this year was Samsung, Apple is #5 on the list, HTC is #7. The remainder of the Top Ten are all China OEMs. The figures for feature phones are even more heavily skewed towards domestic brands.
As you can imagine, this is something of a ‘long-tail’ market. There are five or six major companies that are well known globally, names like Huawei, ZTE and Lenovo. But they only claim so much of the industry’s volume. The top 10 domestic brands only constituted 56% of volume so far this year. By contrast, Apple has something close to 50% of the US smartphone market. The China market is incredibly competitive, one of its salient features.
Importantly, we also have to point out that most of the phones produced by these vendors are not sold in China. Instead, they are shipped overseas to every market on the planet. In recent years, these phones have even begun showing up in the US, the market with the tightest operator restrictions on handset sales.
The biggest five or six brands tend to have sales networks that look a lot like those of the global brands like Nokia and Samsung. Beyond that, few of these companies have the resources for a global sales force. Instead, they tend to focus on a small number of other markets. In fact, we think most of these companies tend to pick one country outside China and focus heavily on that. We know companies who are major brands in places like Ukraine or Uruguay, for example.
The pattern of development is generally pretty similar for all of them. They tend to start in one province or region within China. Typically, the home town of the company’s founder. China’s carriers have highly decentralized purchasing which opens the door to all these small suppliers. Once they have some volume domestically, these OEMs look for ways to expand overseas as a hedge against the fierce domestic competition. This pattern tends to be highly random. One company we speak with regularly has a founder who had a relative in El Salvador, which led to him building a Central American distribution network. Another company’s founder met someone from Bangladesh at a trade show years ago, and this eventually led to sales there as well.
Usually, these companies sell on the open market, not directly to carriers. This is changing as they grow, but for the most part is the norm. For readers in the US, this sounds strange, but most people in the world buy unsubsidized phones and swap SIM cards readily. This has given retailers in these countries considerable weight in the industry. Often, the China OEMs work with some “local King”, a distributor or retail chain, which distributes the phones around the foreign country.
This ties into a final point about this industry. These vendors thrive because they are highly flexible. As noted above, they can support very small order sizes, a few tens of thousands of units. By contrast, the large, global vendors tend to require minimum orders at least ten times larger. The exception to this rule is Samsung who designs a huge number of phone models, and may be one of the reasons they are so successful to date. This flexibility means the China OEMs can create essentially custom phones for a particular region. A green phone with a built-in compass app pointing to Mecca for Muslim markets, or a phone with regional languages in India. Even at its height, Nokia which has the world’s largest manufacturing system for phones could not customize to this level.
The only easy way to track this market is through its suppliers. Given the huge number of OEMs and the relative lack of concentration, there is no simple way to survey them all. Sino-MR makes a stab, as do other market watchers like Gartner and IDC, but as far as we know these firms can only track the top 100 or 200 OEMs, and in only a limited number of markets.
As the history of the industry indicates, these players largely owe their existence to their baseband supplier Mediatek. Today, Mediatek is not alone in this market it helped to create. Shanghai based Spreadtrum is very competitive with Mediatek, using a similar business plan. Taiwan-based M-Star also made a stab at the 2G market, but is now in the process of being acquired by Mediatek. In Shanghai, connectivity maker RDA has also entered into the feature phone baseband market through its acquisition of Cool Sands. These companies are all public, and give rough guides to the size of their shipments. In addition, global players have also started to enter this market. Qualcomm, in particular, is in the process of building up a massive sales and support infrastructure in China to chase Mediatek. Marvell sells some units into the market, though largely through sales of China-only TD-SCDMA basebands. And Broadcom has a few design wins among the second tier of China OEMs. We are not going to get into the silicon side of this market here, but want to illustrate that using data from these companies it is possible to size the market roughly.
Combing all that, we put together the table below sizing this market. We should note that this is just our best estimate. If anything, it probably undercounts the market.
Estimated China OEM Market phone units (m), by baseband vendor
These numbers look at all baseband shipments to these markets. A few issues back we also looked at smartphones using this same method.
Estimated China OEM Market smartphone units (m), by baseband vendor
These numbers are a bit more ‘wrinkled’ as they probably undercount shipments from the big vendors ZTE and Huawei. Regardless, by our math this year half of all Android phones will come from this market.
One thing that is not captured here is tablets. This data is proving to be very tricky to track. Increasingly, we see three separate categories of tablets:
- Brand-name, high-end tablets from the likes of Samsung, Acer, HP, etc.
- Ultra-low cost tablets, typically unbranded, starting at $40 for a 7-inch model
- The iPad, which remains, by far, the dominant branded-tablet
The tablet market is mostly Wi-Fi only. Something like 40% of iPads sold have cellular connections, but we believe only half of those are ever activated. Similarly, other branded tablets have been promoted by the wireless carriers, but sales of these other high-priced tablets are weak.
By contrast, we think the low-priced end of the market is generating very strong volumes. The trouble is no one really knows by how much. These devices are essentially 100% Wi-Fi only. And the processors that go inside them come from companies like Fuzhou-based Rockchip and Zhuhai-based All Winner. These companies are privately-held and have very low profiles in general. Our best guess here is that this category shipped about 30 or 40 million units last year, and will likely get close to 80 million to 100 million this year. These numbers are largely based on what people in the market tell us, so take them with a grain of salt.
As far as we can tell, there is very little data out there about either of these two companies. Strategy Analytics has put out some estimates as to their size, but without giving SA $7,000 for their report we cannot assess their data. Everyone’s favorite Taiwanese tech journal Digitimes also has a report out. They say Rockhip, Allwinner and Amlogic combined shipped 60 million units last year, with Allwinner at 22 million, Rockchip at 13 million and Amlogic at 6 million. If you factor in a portion of their chips going to set-top boxes and other devices, that come close to matching our 40 million total for tablets. However, Digitimes recently estimated that these vendors collectively grew only 20% year-on-year in the first quarter. Nonetheless, we still think this category will see significant growth this year as vendors begin shipping them for export. You can already purchase some of these devices in the US. As we have noted elsewhere we think tablets at these prices will start to get bundled into other sales, and we have already seen offers of “buy something and get a free Android tablet”. So companies other than operators may start to subsidize these tablets. Our plan is to buy a bunch on our next visit to China and give them away for Hannukah this year.
For us, the most interesting aspect of the China OEM market is that is it remains somewhat unformed. Over the next few years, several important changes have to take place here. These include: consolidation; the transition to smartphones; the adoption of 3G and 4G; and their expansion into new products.
Any industry using common components, with few technical barriers to entry and hundreds, if not thousands, of competitors would seem to be a textbook case for consolidation. This has been delayed, in part because of structural factors in China, and in part because growth has been so good. The structural issues are beyond our scope here, and will probably be summed up by many as “China is different”. But the second part we can point to evidence that growth has been a key factor, in 2009 as the global economy contracted, we saw a fair number of these companies shut their doors. In all our conversations with companies that year, there was a pervading sense of gloom, “the dream is over” as one of them put it. This lesson was not lost on the companies that survived.
The interesting part about watching this industry consolidate will be the ways in which survivors hold out. Coming out of 2009, the OEMs who were still around realized that something had to change. Many of the smaller companies we speak with now, have started to look for ways to improve their business. Many operate under a sense that the current good times will not last, and are either trying to maximize what they can for the next few years, or to build more structure into their company. For the most part, that means building bigger sales networks, often with repair centers and reverse logistics, but many are also looking to build brands. For many years, the China OEM phones were seen as having poor quality, a perception built on ample evidence. To overcome this, the more longer-term oriented companies are spending money on advertising and doing real marketing. For a while we were getting regular requests for marketing textbooks, until Chinese translations of these started to appear in all the bookstores in Shenzhen.
Our guess is that many of these companies will be able to build brands and establish real footholds in regional markets. There is evidence that this has already taken place. After that, it will become a game of scale as companies with the most efficient distribution networks generate sufficient cash to invest more than others in marketing, and slowly the cycle will work its way through, but this process is still in early days.
A second strategy has been to develop apps for their phones or some sort of ‘cloud’ service. This is trickier, as these companies typically have no expertise in building software. They are thus turning to outside partners to help with development, but if one company can do that, so can all their competitors. In the US and Europe, the global OEMs tried a similar strategy. Remember Moto Blur? Samsung and HTC also developed their own software layer to sit on top of Android. This did not work for the global brands, as consumers were able to get superior solutions on the various app stores or using their favorite Internet equivalents. The China OEMs are taking their products into emerging markets, where they are often providing consumers with their first glimpse of the Internet. We would argue that the China OEMs may find some success here. If a user has never heard of Skype before, they may be willing to try out some handset maker’s messaging or photo sharing service. Granted, it is a stretch, but we think a few companies may be able to get lucky and build a hit app for their phones. However, success will be few and far between, and ultimately the best they will be able to do is to enhance their brand in a crowded field.
Transition to 3G and 4G smartphones
Coming out of the 2009/10 downturn, a key element in the survival of the majority of the China OEMs was the release of Mediatek’s and Spreadtrum’s 3G platforms. Crucially, these came with Android baked into the reference design. And while, many of these companies still mostly sell 2G feature phones, they are quickly shifting to 3G smartphones. This matters because consumers are willing to pay more for a smartphone than a feature phone.
Our rule of thumb is that consumers whose last phone purchase was a $50 2G feature phone are willing to pay north of $100 for a smartphone, sometimes up to $200. By 2010, the smaller China OEMs were seeing average selling prices (ASPs) of $20, which cost them $15 to build, or 25% gross margins. In effect, they were making less than $1 in net profit per phone, often closer to $0.25. The downturn cleared the market a bit, and then the transition to smartphones took place. This meant they could now sell smartphones for $150, with gross margins above 30%, and operating profit per phone of $5 or so. The forward looking companies now had the dollars to invest in marketing and distribution.
However, prices are still falling fast. There are still a lot of competitors making the same transition. So this benefit will not last indefinitely. There are plenty of smartphones retailing for $70-$80 and heading towards $50, taking profits down with them.
Perhaps the most unexpected development of this industry has been the exploration of new products. Over a year ago, we saw some of these companies start to develop connected watches, for example. This came soon after the surprise interest for the Pebble, the Kickstarter-funded smartwatch, but long before the rumors of an Apple watch. The chip makers are building platforms for set-top boxes, TV Internet adapters and other media products. We have also seen Android-based laptop computers. Our guess is that other appliances are in the works as well. The idea of an Internet-connected refrigerator was made laughable in the US when OEMs tried to sell them for thousands of dollars more than comparable ‘dumb’ refrigerators. But with Android, the cost of developing embedded software are now close to zero, and maybe the idea merits a second look. This could go nowhere, but in the interim it will be interesting to watch what surprises come from this ecosystem.
Beyond the way in which this industry will change, we also think the China OEMs will change the broader consumer electronics industry. In the 1980’s we saw the emergence of a PC manufacturing complex in Taiwan which went on to define that industry. We think that this decade will see a smart-electronics complex emerge around this ecosystem in Shenzhen. While similar and related to the PC complex, its ultimate shape and scope are still to be determined.
A few years ago, we would have also argued that the China OEMs would determine the final shape of the global smartphone market. In 2010, it was still unclear which operating system these OEMs would adopt. Now, this argument is probably over. Android has won. Up to just a year or two ago, a concerted push by someone else might have had a shot at capturing some market share and building critical mass on a global scale. That now appears unlikely. Now the only question is how will the rise of the China smartphone OEMs shape Android.
When Google calls out their daily activation figures for Android, they are only counting officially certified devices. This involves some interaction with Google and comes with the key benefit of access to the Google API – Gmail, Google Maps, and crucially Google Play. In theory, devices which are not certified cannot tap into those. But if you buy a $45 tablet on the streets of Shenzhen chances are it will come with the full G-Suite, even though those devices are not certified by Google. This means Google’s activation figure, which is probably now close to 2 million a day, is actually undercounting the true size of the Android population. If we back that into our smartphone number above, it means that over half of this year’s Android devices will come out of China OEMs. This is one of those things that is good for Google and mixed for Android. The risk for Google is that these companies may adopt some of the re-skinned Android versions. These are ‘replicatns’ that look identical to Android, use the Android kernel, but redirect users to Google rivals like Baidu. As noted above, many people in emerging markets will have their first ownership of a computer and first personal access to the Internet through these phones. If that audience’s first exposure is through a true Google-powered Android phone, then the chances are good that they will remain Google users. However, if they use a Baidu- or Alibaba replicant phone, then the future is much less clear. This seems to be Google’s game to lose, but our point is that the market is far from settled.
There is a strong tendency in the West to ignore this market. Some of this is the willful blindness of companies like Nokia who did not want to look too closely at what is now an existential threat. But even interested observers have struggled to understand the market. China is far away and sometimes feels very different.
We think that oversight will prove a mistake. First, this market is going to prove very important to the whole supply chain. It is already important to component makers, and as new product categories emerge the carriers, retailers and distributors will want to be open to an opportunity.
Moreover, we would argue this market is not all that different. It has gotten very large, very quickly, but that does not mean it is immune to normal market forces. Ultimately, we will see consolidation here. Here again, the shape of that consolidation will matter. We think hundreds of vendors will eventually get winnowed down to dozens, then probably a solid top 5 or 10. Some of these may get acquired, or they may do the acquiring of foreign brands.
There is also the possibility that something entirely new emerges from this field. We believe that the days of high margin hardware businesses are behind us. So we have been watching carefully as the China OEMs experiment with mobile services of one sort or another. Something may come of this. Or more likely, the China OEMs could serve as a vehicle for China’s Internet companies to become major global brands in their own right. Take Shenzhen-based Tencent as an example. Ranked by market cap, it is one of the five largest Internet companies in the world, but it is operates almost entirely within China only. Their QQ messaging service is ubiquitous in China, and serves as a major engagement engine for driving traffic to their games, ads and other revenue-generating properties. [Note: we own 100 shares of Tencent in our personal account.] We are probably not that far from the day when Tencent will start paying the China OEMs to bundle their messaging app for export. At heart, this is the same strategy Google is pursuing with Android, so why not Tencent, Baidu and Alibaba?
The China smartphone OEMs may have started out as a local phenomenon, but they are on their way to becoming something bigger, and possibly far more important.