Mobile service in the US is experiencing a slow, but inevitable change. The stronghold cellular contracts had on consumers are gradually becoming less and less dominant as clients are finding alternative means of servicing their mobile devices. The emergence of the no-contract mobile service has benefited budding Chinese smartphone manufacturers like ZTE (OTCPK:ZTCOF) and Huawei, who are seeking expansion in the sophisticated American mobile market. This trend may also have the potential to level the playing field against the giants known as Apple (NASDAQ:AAPL) and Samsung (OTC:SSNLF).
A Developing Trend
PricewaterhouseCoopers released a recent study verifying the development of US consumers toward no-contract mobile services. According to PwC, 29.2% of total mobile phone service revenue was generated by no-contract plans in 2012, an increase from the 2011 figure of 22.5%. For 2013, studies showed that one in four people will opt for the no-contract plan; this same number is expected to rise to one in three people by 2014. The allure of a free phone is slowly dying amongst American consumers who want to enjoy the flexibility associated with no-contract service plans instead of repaying the subsidized phone over time with higher monthly plans. Having access to the same high-end smartphones that multi-year plans offer, the differences between the two services is narrowing.
A trivial option in the US, no-contract mobile services are quite common in European nations and the world's largest mobile market - China. US customers demand the latest smartphones, but yet are unwilling to pay the high price tags that follow in the range of >$600. The reduced price that contract carriers offer is a subsidy on the device which is repaid throughout the contract life. However, without the commitment to a contract, the price of smartphones suddenly becomes a trait that influences purchasing decisions.
A report by The NDP Group, a global information company, found that prepaid smartphone unit sales doubled in Q1 YOY and accounted for 32% of total smartphone unit sales. American consumers are becoming more value conscious with regards to mobile devices which, in turn, is altering their service preference. T-Mobile (NASDAQ:TMUS) announced a service plan which doesn't require a contract as a strategy to complement the growing trend of no-contract plans. Hoping to increase competitiveness and gain market share, T-Mobile's strategic move is surely to be matched in time by the likes of other big wireless carriers Verizon (NYSE:VZ), Sprint (NYSE:S) and AT&T (NYSE:T).
Opportunity for Chinese manufacturers
Smartphone manufacturers that offer lower priced devices have the most to benefit from the growing trend of no-contract mobile services. Price awareness will undoubtedly sway decisions when the full price of the device will be burdened solely by the consumer. High-end Chinese developers, who aim on prying US market share away from Apple and Samsung, will utilize this trend to penetrate into the US market with lower priced devices offering similar features.
ZTE and Huawei have faced several headwinds with their western market invasion strategy. In October of 2012, US Congress flagged both Chinese companies as potential national security threats to consumers due to their relation with the Chinese government. These regulatory barriers have raised concerns of consumer security, while also indicating trade protection between the world's two largest economies. Allegations were strongly denied by both companies which continued their expansion in the US with damaged reputations. Earlier in 2013, the US Government Accountability Office released a report that found no recent evidence of cyber-security incidents affecting the country's telecommunications networks. Although no threats have been found, brand image for both Chinese companies had been stained in the eyes of American consumers and US businesses, who were urged to halt business with the foreigners.
As a result of the accusations, Chinese companies have ineffective consumer retail channels. None of ZTE's premier smartphones are available with contracts through the big 4 US networks which greatly limits the potential for expansion. Nonetheless, ZTE achieved a YOY growth rate of over 85% in US unit sales during the first quarter of 2013. ZTE's growth in the US is attributed to the company's increasing share of no-contract market, in which it has launched 18 smartphones with the country's major no-contract carriers. According to ITG Market Research Inc., in the first quarter of 2013, ZTE was ranked the third largest smartphone manufacturer with 17 percent market share in the U.S. no-contract market.
Even with present headwinds, ZTE managed to gain great traction in the US market by taking advantage of the growing trend in no-contract mobile service. As the company's ever-important brand recovers, ZTE overcomes the biased reputation of having inferior "Chinese quality" amongst US consumers. With the help of enhanced brand awareness, ZTE expects to deepen its relationships with carriers and consumers to continue its expansion and success in the US market.
The larger and more resourceful Huawei looks to build on its successful 2012, when it became the number 3 vendor of smartphones worldwide, selling 27.2 million units. Though the company has not given guidance on its US operations, it expects to sell 50-60 million smartphone units worldwide for 2013, resulting in target revenue of $9 billion, or a 12.5% YOY revenue growth. Huawei's global first quarter results came in below expectations as the company shipped only 9.3 million smartphones during the period, dropping it one spot to fourth place. The Chinese giant experienced some turbulence in reorganizing its high level management, but reassured stakeholders that it will utilize mass resources to launch more marketing campaigns in order to meet annual targets.
The next step for both Chinese producers is the need to launch their high end smartphones in the western market. Huawei's Ascend D2, Mate and ZTE's premium Grand models, announced at the 2013 CES, should be aimed to grow brand perception of the Chinese quality products. A successful integration into the top tier of the US mobile market would allow both firms to compete in the higher margin business while chipping away at Apple and Samsung's global dominance. This stride will be a lengthy process, but offering feature-filled devices at a discounted price will garner the attention of bargain consumers regardless of being a relatively unknown brand. In addition, the shifting mobile service environment towards no-contract plans is advantageous for smartphone manufacturers that offer lower priced devices.
What does this mean for established players like Apple?
With more smartphone manufacturers entering the already saturated market, competitive pressures begin taking their tolls on company margins. This has been evident with Apple's eroding margins from about 45% a year ago to a forecasted low of 36% for the upcoming quarter. As new entrants introduce cheaper devices with challenging features (Chinese for example) to pry market share away, established players will be facing additional pricing pressures.
If the studies mentioned above are correct, then one in four people will opt for a no-contract plan during 2013. Paying $650 for an iPhone 5 or Samsung Galaxy S4 outright is a steep price for the average consumer, who may now "settle" for a lower priced device with similar features.
To counter this growing concern, Apple has started an iPhone trade-in program which will lower consumer's out of pocket expense and, in turn, reignite sales of the latest iPhone 5. The objective of the program will be to turn in older models of the iPhone, such as the 4 and 4S, in exchange for the newest model. This will increase Apple's focus on the refurbished iPhone market for emerging nations while boosting sales of their high margin device in developed markets such as the US. Theoretically, Apple's trade-in program will lower the steep price of a new iPhone 5 by providing a credit for the old exchanged device. This would make top echelon iPhone 5s more competitive with cheaper devices to the growing consumers taking the no-contract route.
Android and iOS have developed advanced ecosystem familiarity with respective users in forms of synergies that go beyond a price tag. Changing conventional habits is a hassle that a number of Apple supporters will pay no attention to. The Apple cult followers will demand a great deal of enticement to switch over devices. With that said, the similar-featured, yet cheaper phones Chinese manufacturers have to offer may not be enough incentive for the Apple faithful. For Android users however, (such as the 22% US market share of Samsung) new ecosystem shock would be minimized as both ZTE and Huawei high-end smartphones operate Android OS.
The emergence of the no-contract mobile service has benefited lower priced smartphone producers by diminishing the subsidies large carriers offer to make high end devices affordable. Value consumers are drawn to discounted devices that offer better value service models. Consequently, Chinese mobile manufacturers are expected to take full advantage of this shift, as shown by ZTE's immense growth thus far in 2013. Facing an already competitive market, domestic smartphone maker Apple must defend its turf against the potential Chinese invasion. As second quarter mobile figures approach, investors and tech junkies should keep an eye on this developing movement that may forecast the future of mobile industry.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.