Hidden Dragons
By Dmitri Ragano, Jun 20 2002
A new generation of Chinese mobile companies is changing the dynamics of the world’s largest market.
You can hear the sucking sound across Asia, as China’s potent combo of dirt-cheap manufacturing and rising technical proficiency gobbles up whole industries of products, from Furby toys to 0.18 micron semiconductors, to sell at home and around the world.
Will mobile phones be next?
The global powerhouses such as Motorola, Nokia and Ericsson have come to regard China as their great stronghold in the vast East Asian market. In coastal boomtowns such as Shanghai, these mobile giants communicate colorful, exuberant brands that epitomize cool for the young generation of consumers. This is a sharp contrast to Japan and Korea, where phone users prefer local makers and view Western products as being several years behind in both technology and design.
A new generation of Chinese companies is pushing hard to develop their own technology base and compete with foreign brands for their home turf, which at 120 million users is still only at 10 percent penetration.
To be sure, foreign firms still dominate. While the local industry is still in its infancy and its ambitions still largely aspirational, an ascendant generation of Chinese mobile manufacturers represents a hidden challenge to the industry status quo. More proof that the world’s last great, unsaturated market for everything is never what it seems.
Behind the Wall
The Chinese Communist Party has quietly cultivated a homegrown industry with a protectionist stance that requires foreign companies to transfer knowledge and capital to get access to the local market.
“China has been the anomaly among developing nations,” according Tim Kelly of the International Telecommunications Union in Geneva, Switzerland, “in protecting and carefully regulating the development of its wireless market.”
“China wants technology from foreign companies more than anything, and their leverage to get it has been their market,” said Will Strauss of Forward Concepts, an electronics research firm in Phoenix, Arizona.
It was not until 1998, that an appliance maker named Keijan produced the first Chinese-branded mobile phone. Since then more than 16 other local companies have entered the fray including TCL, Huawei, Haier, Ningbo Bird, Nanjing Panda and Eastcom. Legend, China’s largest personal computer maker, also announced recently that it will enter the handset market. These local companies now hold approximately 25 percent of the market, though no single Chinese company holds more than 4 percent.
To overcome fragmentation, an industry consortium of domestic manufacturers has pledged an alliance aimed at taking 50 percent of the Chinese market within 5 years, which they believe will then have 350 million subscribers. This goal can be interpreted in different ways, since the government has dictated that 50 percent of all cell phones sold in China must be made locally in the future, according to Strauss. This is one reason why all the major foreign companies have set up assembly facilities in China.
It is clear that Chinese and foreign mobile companies will remain connected for the foreseeable future. Chinese manufacturers understand the challenge involved in matching foreign companies in technical capability. The strategy so far has been to partner with leaders. Nanjing Panda, for instance, has a joint venture with Ericsson. Huawei recently partnered with Japanese firms, NEC and Matsushita Communications Industrial, to form a joint venture called Cosmobic. The joint venture will focus on W-CDMA handsets.
Some local companies are also manufacturing partners for global phone makers and have leveraged this experience to launch their own product lines. Eastcom (East Communications) for instance until now has primarily produced mobile equipment for Motorola. The company is shifting its focus to production of its own branded handsets and will introduce 12 new Eastcom models for GSM, CDMA and GPRS service in China.
Engineering the Future
An example of the new breed of up-and-coming local players is a company called ZTE (Zhongxing) Corporation. ZTE was originally an SOE (state-owned enterprise) that has grown into the nation’s largest telecommunications equipment maker.
During the past two years, the company has expanded its focus on wireless and seen its revenue grow from $300 M in 1999 to $1.3 billion in the last fiscal year.
The company produces equipment for the country’s predominantly GSM market but is increasingly focused on spread spectrum. ZTE was the first local company to acquire CDMA expertise and license it to local manufacturers.
Dr. Wang Shou Chen, who manages company’s PHS product line, believes his company’s investment in research and intellectual property are the reasons for its recent growth. ZTE has 11 R&D centers in China, Korea and the United States and 300 patents either granted or pending.
“There is a tendency to underestimate the local engineering talent in China,” said Ted Dean of BDA Connect, a telecoms consultancy based in Beijing. “They are not just reverse engineering everything. Companies such as Zhongxing (ZTE) and Huawei have good IP even if it is half a generation behind.”
In the area of 3G, ZTE is concentrating on product development for Wideband-CDMA and cdma 2000. ZTE has focused on these standards instead of China’s original TD-SCDMA 3G standards. The reason for this is that China Mobile and China Unicom, the two main operators, have adopted these standards. These standards are also globally recognized, which is important for the company’s strategy to win more business internationally.
“Everyone has a piece of the Chinese market so we need to look outside as well,” said Chen. “Right now, we are trying to develop international marketing capability and a global business culture in our company. In the future, our revenue will be higher internationally than in China.” ZTE fixed-line telecommunications business has already sold networking equipment for videoconferencing and intelligent platforms to operators in developing nations in Africa, South Asia and Eastern Europe.
A Tale of Two Markets
“People didn’t have confidence in the local Chinese brands before but it is changing,” said Shin King, a Shanghai-based phone retailer in the city’s central Huaihai road. In this upscale, shopping area, cell phone stores are scattered between European brand fashion outlets and Starbucks coffee shops. On the narrow, gritty back streets behind Huaihai, unlicensed phone retailers sell cheap models on the gray market alongside steamed dumplings, corn-on-the-cob and pirated “Lord of the Rings” DVDs.
“The Chinese see their country as a two-tier market,” said Will Strauss, an electronics industry analyst for the research firm Forward Concepts. “On one level there are premium foreign brand phones that are pricier but have better design and functionality. Then, there are local phones that a cheaper but less worthy.”
This multi-tier structure may actually be a good fit for China, given the country’s complex demographics and huge inequalities in income and lifestyle.
In thriving coastal cities like Shanghai, business executives and educated twenty-something consumers have rising incomes, cosmopolitan tastes and enthusiasm for the latest brand and fashion. In smaller cities and rural areas, however, hundreds of millions of low-income Chinese are also more concerned with functional benefits and price.
“China Mobile and China Unicom introduced a monthly fee plan of 50 RM ($6.30) per month for low-income customers but they could not pay it,” said Chen. “The operators had to switch to a pay per call fee structure.”
Indeed, many foreign companies are still learning to decipher the complexities of this giant, segmented and rapidly changing society.
“The hardest thing for foreign companies here in China is that there is no concept of the average customer,” said Shunichi Karasawa, director of the Shanghai office for the Japanese operator KDDI. In Japan, Karasawa claims, mobile marketers know that the same economic and psychographic assumptions apply to most of their target users. But in a city like Shanghai, for instance, it is impossible to generalize. A high-flying, Prada-clad executive may use his sleek, new Bluetooth-enabled Ericsson for non-stop, hands-free conference calls and SMS-based stock trading. Meanwhile, a migrant laborer, surviving on a few dollars a day, may have a no-frills, local-brand handset as his only possession for occasional calls home to his native village.
“In big cities like Beijing and Shanghai, people are interested in the foreign brands. I would only buy foreign because I prefer the design,” said Kelly Yang, a young businesswomen browsing in an electronics shopping center on Huaihai road. “But in the outlying cities Chinese brands like TCL and Haier have more recognition since they already are top sellers of TV sets, refrigerators and other appliances.” Other firms, such as Bird, are marketing towards the urban consumer with outdoor advertisements that emulate the cosmopolitan image of their foreign competitors.
Commoditize This
All of which begs the question: will the handset be on the slippery slope toward becoming an appliance. In other consumer electronic products, the rise of industrial China has exacerbated pressures already squeezing the establishment: reducing margins, barriers to market entry and eliminating the value premium for design and assembly labor. Market leaders have been forced to swim upstream with greater investments in brand, innovation and services once their product spirals toward appliance-hood. In the case of the personal computer, this commodity effect eventually infected everything except software and silicon, creating the Wintel monopoly.
The crowding field of manufacturers now gives leaders in chips and software more options and leverage. Software companies have waited patiently for an opportunity to circumvent the clout and power of today’s mobile manufacturers. Certainly Microsoft would relish relationships with a diverse base of hardware makers that could help it introduce a standard into the proprietary world of cell phone operating systems and applications.
The software giant recently announced a partnership with the Hong Kong-listed manufacturer TCL to create handsets based on its Pocket PC and Smartphone operating system and applications.
The phones will be available next year for China Mobile’s GPRS network and China Unicom’s CDMA 1x system. TCL’s sales in China have increased almost ten-fold during the past year from 114,000 in Q1 last year to over 1 million handsets during the latest quarter. Microsoft will receive royalty payments that could supplement its revenue in China, where many use pirated copies of Windows.
As China Mobile and China Unicom prepared to roll out 2.5 generation data networks, mobile data phones are becoming a more important part of the market. Silicon design becomes increasingly important while other aspects of phone production are less valuable. Serving phones with more processing horsepower, digital signal processors are actually rising in price and functionality. Strauss believes that global players may end up focusing on leading-edge chip designs and then licensing this technology to Chinese manufacturers. The latest phones require DSP with 0.13 micron geometry, which has not yet reach fabs in the mainland, so there is a clear contribution that foreign firms can provide. For instance, Legend has already announced that it will extend its relationship with Intel into its mobile phone production, using chip sets from the semiconductor giant.
Foreign companies that can provide both silicon and software may have an advantage in selling their products. Strauss believes that Chinese firms will be more likely to pay for chipsets bundled with software and consulting services, since payment for stand-alone software is still a relatively unfamiliar concept in the business culture. NEC and Matsushita seem to be taking this approach for the recently-announced Cosmobic joint venture, which will leverage the firms’ experience creating W-CDMA chips and handsets in order to develop 3G application software that can be licensed in the future.
The Shangri-La Myth
Since the days of the Roman Empire, traveling merchants and dreamy prospectors have been seduced by what journalist Joe Studwell refers to as “The China Dream” of a limitless, untapped market that can lead to infinite riches.
But the shifting dynamics of the market here and the rise of a local industry make it clear that China is a threat as well as an opportunity. One thing is certain: the country is no panacea for the woes afflicting the industry worldwide.
“There is this China myth about limitless growth,” said Dean of BDA Connect, “but the mobile market here is facing the same challenges as everywhere else – such as slowing subscriber growth and declining average revenue per user.”
“The whole handset industry is in a crisis right now. If you look at the financial position of many handset players it is difficult to predict where they will be in five years. It is also difficult to know what will be the key to survival: whether it will be technology, scale, brand, software or media.”
This is just as true in China as anywhere else.
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