Can Huawei And Zte Do An Alcatel To Apple And Samsung?

by: Sneha Shah

The Chinese telecom equipment giants Huawei and ZTE (OTCPK:ZTCOF). have become very aggressive in the smartphone industry. These companies have achieved extremely high growth rates in 2012 as they expanded rapidly in their domestic market. The Chinese smartphone industry accounts for more than 300 million units and local vendors enjoy a majority market share. The massive size of the Chinese market has already made Lenovo (OTCPK:LNVGF) and Huawei amongst the top 5 smartphone producers in the world. Now these companies are looking at foreign shores to challenge the dominance of Apple (NASDAQ:AAPL) and Samsung (OTC:SSNLF). The Chinese pair has destroyed western competitors in the telecom equipment market, by selling equipments at 20-30% lower prices. Alcatel Lucent (ALU) and Nokia Siemens (NSN) have both come close to bankruptcy, while Ericsson (NASDAQ:ERIC) has turned around after facing huge problems in the past. The question is whether these Chinese companies do a similar feat in the smartphone industry by taking down the market leaders through their low cost strategy.

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Source - IDC

Huawei release high end smartphone targeting Apple and Samsung

The Chinese technology companies have mostly restricted themselves to making and selling low to mid end smartphones in China. However, the companies like Lenovo and Huawei have recently started to spend aggressively in expanding in foreign markets. Huawei released a new 6.1 inch smartphone "Ascend Mate " to take on Apple and Samsung in the high end smartphone segment. This new smartphone based on Google's (NASDAQ:GOOG) Android OS has been touted as the slimmest smartphone in the world. The smartphone has been priced at a much lower price than the flagship smartphones from Apple, Nokia (NYSE:NOK) and Samsung. Lenovo too recently released a whole host of smartphones in different countries. Lenovo's flagship K900 smartphone is based on top of the line Intel (NASDAQ:INTC) Clovertrail dual core SOC. This smartphone is also based on the free Android OS. ZTE too is firming up its plan to expand beyond its domestic market.

So can the Chinese Tech Giants do an Alcatel to the current smartphone leaders?

There is no doubt that the Chinese companies are looking at the smartphone market seriously. They have huge resources; and players like Lenovo are happy with low margins unlike western companies who command 40-50% gross margins for their smartphones. The Android OS has leveled the field for these companies as it gives them decently sophisticated software at a zero price. As the Chinese companies learn the smartphone ropes, they can use a similar low cost strategy to displace the smartphone leaders from the leading positions. Apple and Samsung currently account for more than 90% of the profits generated by the smartphone industry.

ALU Total Return Price Chart
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ALU Total Return Price data by YCharts

Why they will not be able to pull a similar feat

The smartphone industry is a very different animal from a telecom equipment industry. Here are some reasons why Huawei and ZTE will not be able to become dominant players:

  1. Consumer Technology is not just about costs - The consumer technology market is very different from enterprise telecom as cost alone is not sufficient. Brand is also very important and Huawei and ZTE do not have the premium brand recall like Apple or BlackBerry (NASDAQ:BBRY). These companies will not be able to command a premium for their products and may even have to discount their products.
  2. Lack of a software and service ecosystem - The software ecosystem is very important for a smartphone user. BlackBerry's BB 10 has a large loyal fan base while the Windows 8 OS is also winning over users. The Android OS does not have too much loyalty due to fragmentation and lack of regular updates by carriers and smartphone makers. The biggest reason for Android's success is that it is free.
  3. Competition is much more - There are only 5 serious players in the telecom equipment market, while there are almost a hundred smartphone companies. Cheap hardware components and Android has enabled even small companies sell big volumes. Huawei and ZTE have been beaten by Coolpad in the Chinese market. In India, the local companies such as Micromax, Lava, Spice, Karbonn have taken a big chunk of the low end smartphone segment. The Japanese companies and PC vendors like Acer (OTC:ACEIY), Asustek etc. too have started to make big investments for a share of the $350 billion smartphone market.
  4. Security Concerns - Huawei and ZTE have been on the firing line due to security concerns. The recent "PRISM" revelation by a former NSA worker shows that foreign countries will be more wary of non-domestic companies. Though consumer products have not been affected by these issues, one cannot ignore the risks.

So how will Huawei and ZTE perform in the Smartphone Market?

The smartphone market has too many players who have entered recklessly, enamored by its size and growth. Hardware alone is not enough to generate huge profits as companies will need to differentiate through design and software. BlackBerry is flirting with the idea of selling its hardware business to become a pure software and services player. Apple is generating billions of dollars from its iTunes store and is expanding into other areas like streaming music. I think that Huawei and ZTE will remain low to mid end smartphone vendors and will not make meaningful profits. Like Lenovo, they will become a commodity seller.

The Stocks of the Smartphone leaders remain low and a good Buy

The valuation for all these companies is quite low as competition has increased significantly in the mobile devices market. All of these stocks are trading much below the average stock market valuation. Apple continues to trade near its yearly lows despite announcing the biggest stock buyback in history. BlackBerry and Nokia are also priced very attractively in my view making them great buyout targets. Huawei recently sparked a strong rally in Nokia stock after it announced its interest in buying the company. Samsung has corrected sharply after lower than expected shipments of S4 were predicted. The mobile device industry is seeing a phase of high growth and high competition. These companies have unique strengths which the Chinese companies don't have. BlackBerry has BES, BBM and its new BB 10 OS, Apple has the iOS, Samsung has vertical integration and Nokia has excellent services and design strengths. I think that these stocks have the potential to give good return despite the Huawei and ZTE onslaught.

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.

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