Fight for China's handset market, The

fight for China’s handset market, The

Dean, Ted

Chinese handset makers are chasing foreign firms-both at home and abroad

Diamond-studded mobile phones and a marketing blitz featuring a South Korean pop star helped China’s TCL Corp. climb from its roots as a maker of white goods and consumer electronics to its current position as one of the largest mobile phone handset makers in China. Now the company and a host of other Chinese handset makers are hoping to take their show on the road and expand overseas.

As they fight for market share at home and begin to target overseas markets, Chinese handset makers are not only relying on China’s lower labor costs. Instead they hope new investments in research and development (R&D) will help cut costs and power them into global expansion.

It will be an uphill battle. Chinese handset makers have much less R&D muscle than their global competitors, Nokia Corp., Motorola Inc., Samsung Electronics Co. Ltd., Siemens AG, and others. They still lack much of the core technology around which mobile phones are built and thus may stumble when the transition to third-generation mobile technology requires substantial new R&D investments from handset vendors.

Still, even modest gains in R&D could help Chinese handset makers lower their costs, improve their products, and put added pressure on foreign handset makers. The new emphasis on R&D could also mark a turning point for Chinese handset makers and for other Chinese technology firms seeking to expand overseas. Chinese firms have already proven that they can manufacture cheaply and sacrifice margins to win market share. But a successful push in R&D could transform TCL and other Chinese companies from industry spoilers forcing margins down to profitable industry players still able to win market share. R&D successes will also separate the stronger, more viable domestic manufacturers from their weaker counterparts.

Wired for success

Though domestic handset vendors are investing more in R&D today, their rise from also-ran status to market leaders in China was made possible by, until recently, ignoring technology in favor of marketing.

Not long ago, Chinese handset makers trailed far behind the global heavyweights-Motorola, Nokia, LM Ericsson AB-that have dominated the PRC market. Domestic companies lacked the technological expertise to build a competitive handset. As a result, even while most foreign makers were moving manufacturing to China, proving that China had an advantage as a low-cost production base, domestic companies could not gain ground.

This situation contrasted sharply with what was happening in the personal computer (PC) industry, where domestic maker Legend Group Ltd. beat out Dell Inc., Hewlett-Packard Co., and IBM Corp. for first place in the PRC market in the 1990s. Legend succeeded because it could buy the same Intel chips and install the same Microsoft operating system as foreign makers. But Chinese handset makers did not have that opportunity, as the technology required to build a handset remained within the global handset original equipment manufacturers (OEMs) such as Motorola. Only when independent technology vendors began to sell the building blocks of a handset could domestic players purchase the technology they needed to compete.

French handset module supplier Wavecom SA is one of the companies that unlocked the door to wireless technology for domestic PRC handset makers. Wavecom developed the handset module, a thin card-shaped product that integrates all of the chips, circuitry, and software that makes a handset work. A handset maker without the technical know-how to develop a handset or integrate these components on its own can buy a Wavecom module and assemble it with less technology-intensive components, including the casing and screen, to produce a competitive handset.

Products like Wavecom’s module enabled Chinese companies that had previously produced consumer electronics and white goods to move easily into the handset business. This gradual disintegration of the wireless handset value chain, and the increasing commoditization of wireless technology, allowed Chinese companies to focus on their strengths: marketing, distribution, and product design for Chinese consumers.

In marketing and distribution, however, domestic handset makers were forced to adopt different tactics from those used by foreign handset makers in China. Traditional handset channels favored the foreign brands, which had much larger monthly turnover and thus generated more revenue for distributors and sales agents than less-popular Chinese brands. To compete, domestic brands paid higher commissions to distributors, pushed into less-developed cities, and experimented with a wide range of new channels and promotions.

For Ningbo Bird Co. Ltd., another leading Chinese handset maker, this meant opening sales branches in almost every province in China. Other domestic vendors took advantage of their role as consumer electronics makers to push products through electronics retailers that foreign vendors had once ignored. This aggressive marketing and distribution, combined with flashy product designs that have included everything from phones covered with fish skin (admittedly a less-successful model from Hangzhou-based Eastern Communications Co. Ltd.) to diamond-studded phone casings (the tremendously successful series of models launched by TCL), has powered domestic makers to the top.

Data released earlier this year by China’s telecom regulator, the Ministry of Information Industry (MII), showed domestic handset makers already holding more than 50 percent of the market in the first half of this year. These numbers likely overstate domestic makers’ success, in part because they measure production rather than sales to consumers, but there is no question that companies like TCL, Bird, and Xiamen Amoi Electronics Co. Ltd. are winning market share from foreign makers. BDA believes that by December 2003 sales by domestic makers will have broken through the 50 percent barrier.

To the victor go the spoils-and more spoils

The rapid fall of technical barriers to entry has unleashed a torrent of competition in the industry-37 companies are now licensed to make GSM or CDMA handsets in China. Even as growth in the overall handset market slows, domestic companies continue to expand production rapidly. TCL has said that it plans to expand production from its current 12 million handsets to 42 million in the next three years. In Guangzhou, although Jinpeng Mobile Communication System Ltd. has not yet even been licensed by MII, it has already broken ground on a new handset production facility.

Unsurprisingly, this hyper-competition has led to huge increases in inventory (an estimated 20 million handsets are gathering dust in China), falling average sales prices, and depressed margins throughout the industry. According to information recently released by TCL, gross margins in its handset business fell 6 percent from the second half of 2002 to the first half of 2003. But even these numbers may paint an overly rosy picture of the industry-many domestic handset vendors are believed to be losing money.

With the industry under pressure, the largest domestic handset vendors are turning to domestic R&D and overseas expansion. Purchasing modules and designs from overseas made sense when Chinese handset makers were new entrants, but complete outsourcing of product development left domestic handset makers with little control over their own costs. New investments in R&D should allow Chinese companies to purchase basic components that they integrate themselves.

TCL, for example, the second-largest handset maker in China after Ningbo Bird, now has the scale to make these investments. Its sales revenue has enabled TCL to set in motion plans to double the size of its R&D staff to 1,000 people. As a result of increased R&D, it has cut the number of modules it buys from Wavecom and is relying more heavily on chipsets, purchased from Motorola and Texas Instruments Inc., that it integrates itself. Foreign vendors including Analog Devices Inc., Agere Systems Inc., and Texas Instruments also provide the chipsets that TCL, Bird, and other large handset makers use.

Some domestic companies are supporting their new R&D through partnerships with foreign technology vendors. TCL, for example, announced a broad partnership with UK-based design firm TTP Communications pic., and Bird has a 50-50 joint venture with French handset maker Sagem SA. Many other Chinese companies are purchasing designs from South Korean and Taiwan original design manufacturers (ODMs) such as Sewon Telecom Co. Ltd. Companies with less sophisticated R&D capabilities or that still seek to expand their product portfolio without designing new models on their own may simply import handsets designed and manufactured by ODMs overseas.

It is no accident that these foreign companies are not household names. By working with these non-branded technology suppliers and beefing up their own R&D, Chinese makers are taking control of their own product development. Chinese companies once only participated in the handset market as joint venture partners to foreign manufacturers. Now able to develop products based on their own R&D, and buy technology from a diverse list of vendors, Chinese firms are winning market share for their own branded products.

International expansion

With competition so intense in China and inventory piling up, domestic makers have little choice but to look more seriously at international expansion.

TCL has taken a step-by-step approach to tap the overseas market. In 2002, TCL exported 196,000 handsets, mainly to Southeast Asian countries such as Vietnam and the Philippines. In June this year, TCL announced it would start selling handsets in Thailand in the near future, and India, Singapore, and Taiwan are next on its list. Next year, TCL expects to export to the European and North American markets. In preparation, the company acquired bankrupt German television maker Schneider Electronics AG in 2002 to give it a recognizable brand in Europe.

Bird has set up overseas operations and a joint venture in its efforts to expand overseas. In June, the company set up Bird International in Hong Kong as the launchpad for its overseas operations. Bird plans to expand first in Hong Kong and then enter Southeast Asian markets including Thailand, the Philippines, Malaysia, Indonesia, and Singapore. Other firms like Shenzhen-based China Kejian Corp. Ltd., Nanjing Panda Electronics Co. Ltd., and Xiamen-based Amoi have also set their sights overseas.

Leaving the nest

Of course, early sales into developing countries don’t mean Chinese companies are poised to come roaring into the juicier markets in Europe and North America. Winning the trust of telecom operators that purchase handsets in these markets and building after-sales service networks there will take time.

But it may not take as long as many think. Foreign telecom operators that are focused on cutting costs on their handset purchases have reason to look to Chinese suppliers as a new source of handsets. As Chinese handset makers expand, they will be able to invest more in R&D in order to build better products.

Chinese handset makers are also benefiting from government support. In the past, Chinese banks have offered easy credit to state-backed enterprises, allowing them to invest in new capacity cheaply. Now the government is beginning to focus on the mobile phone industry’s balance of trade and whether competition in the industry is out of hand. Earlier this summer, the Ministry of Commerce and MII convened a meeting of Chinese handset makers in Xiamen, Fujian, to encourage handset makers to export more.

Aside from more general support for exports, MII is considering restricting ODM imports. If implemented, this could push out weaker players who rely completely on the resale of imported handsets. The government hopes that this move would help the top domestic handset makers consolidate their gains by lessening competition from smaller players. (Of course, the exit of small domestic makers would also be good news for leading foreign manufacturers.)

But the government is unlikely to follow through aggressively. Faced with the hard choice between bankruptcy-driven layoffs and debt defaults on one hand, and allowing imports from ODMs to continue on the other, the government may lose its will. The widespread sale of smuggled handsets already shows the limits of MII’s power to regulate the industry. In addition, many ODMs are moving to neutralize the balance-of-trade argument by shifting production to China. In June, South Korean ODM Pantech finalized a joint venture in Dalian, Liaoning, and in August, Telson, another South Korean ODM, announced an investment in a production joint venture in Shandong. If ODMs can find ways to stay in the market, sourcing their handsets from ODMs will allow small Chinese players to survive a bit longer.

R&D vs. consolidation

If Chinese handset makers can maintain their momentum, the pressure on foreign players will build. Losing share to domestic handset makers in China and facing increased competition at home may be more than many second-tier foreign handset producers can take, and inefficient players are likely to be forced out of the handset market. Global handset makers that manage to stay in business will need to create super-efficient operations such as Dell’s PC business model to maintain margins in the face of new competition. Agile component suppliers will, meanwhile, find new markets supplying rapidly expanding Chinese companies.

At the same time, it is not yet clear that the bulk of China’s handset makers will end up being much more than industry spoilers. The push to improve R&D is an important step up the value chain, but unless the government allows much-needed industry consolidation to take place, these efforts may be for naught. R&D will not help cool the hyper-competition created by the smaller, unprofitable Chinese firms, which are keeping margins unsustainably lean. Only mergers, acquisitions, and bankruptcies can reduce the number of players in the market. If China wants to create a global champion in the handset business with the brand and R&D muscle to back it up, it will need to convince its banks to let its unprofitable handset makers fold.

Ted Dean

(ted.dean@bdachina.com) is managing director at BDA (China) Ltd., a telecom and technology market research and consulting firm based in Beijing.

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