With Apple’s (NASDAQ:AAPL) media event today (Sept. 10) nearing, speculation is rife that the company has signed a deal with China Mobile (NYSE:CHL) for the low-cost iPhone. Both The Wall Street Journal and Bloomberg have reported that Apple is preparing to ship iPhones to the world’s largest carrier in what is likely to be a landmark deal for both companies. While having access to the iPhone will help China Mobile better compete with rivals in the 3G/4G market and promote its soon-to-be-launched LTE network, having access to China Mobile can significantly increase Apple’s chances at penetrating the world’s largest smartphone market. Apple currently has subsidy arrangements with the two other wireless carriers in the country, China Unicom (NYSE:CHU) and China Telecom (NYSE:CHA), but that gives it access to only about 35% of the Chinese subscriber base. China Mobile, with over 700 million subscribers, is almost seven times the size of Verizon and will provide Apple a much wider scope to increase its low-end market share.
However, Apple’s investors need to watch the deal the company may have made to rope in China Mobile. One of the major reasons why both companies have taken so long to sign a deal is likely due to China Mobile’s reservations about the huge subsidies that carrying the iPhone entail. While launching a cheaper iPhone could take care of some of that concern, it is likely that China Mobile may have coaxed Apple into offering it a better subsidy deal. If so, it would limit the upside to Apple’s value from the China Mobile deal as well as make it imperative for Apple to set aggressive sales targets in order to make up for the margin loss. Given that the Chinese postpaid contracts are structured in a way that customers have to pay the high upfront cost of smartphones (but get refunds in their monthly bills), selling a lot of iPhones may not be easy if the pricing isn’t aggressive enough.
Sizable opportunity despite margin worries
Still, a deal with China Mobile could add billions to Apple’s value. China Mobile had 10 million iPhone users in October 2011. In four months hence, it added another 5 million, implying an addition of almost 1.25 million iPhone users to its network each month. For the four months prior to October 2011, China Mobile had added the same number of iPhone users. Although we don’t have data for the subsequent months, we can conservatively assume the rate of adoption of unsubsidized grey-market iPhones on China Mobile’s network to have remained fairly constant in the past year.
Since China Mobile is expected to receive its 4G LTE license before the end of 2013, we assume it will launch the low-cost iPhone only towards the middle of next year, giving it enough time to have a LTE network up and running in many of the important Chinese cities. If the carrier starts off by selling an additional 1.5 million iPhones every month, it could end up with about 10 million additional iPhone activations in 2014. The number could double if the launch happens close to the start of the year.
Going forward, it could sell around 25 million additional iPhones in 2015 at a little higher than the 2014 rate. For arriving at the long-term average sales, we look at AT&T’s percentage of iPhone activations to the total retail subscriber base for 2012. AT&T had about 21.3 million iPhone activations in 2012, and it ended the year with more than 77.8 million subscribers, taking the required percentage close to 27% in about five years for which it had the iPhone.
If China Mobile were to reach this percentage by 2020, it could be selling close to 200 million additional iPhones a few years out. In our analysis, we are taking a more conservative estimate of 100 million additional iPhones by 2020 considering the more competitive dynamics at the low-end in China and the way postpaid contracts are laid out there. Additionally, accounting for the potential margin hit of a China Mobile deal, we assume the iPhone average pricing to decline from about $600 currently to $350 and margins from about 50% currently to less than 30% by the end of our forecast period (2020). This increases our long-term estimate of Apple’s EBITDA by around $6 billion, which adds about $45 billion to Apple’s value and takes its price estimate to $650 – an upside of about 10% to our current $600 price estimate.
If long-term margins were to decline further to 25% due to the China Mobile deal, the upside would be limited at only about 5%. Admittedly though, Apple is likely to be selling far more iPhones at such low margins, offsetting some of the impact of the margin loss. You can move the iPhone margin trend-line in the chart below to make your own forecast for Apple’s value.
Our assumptions are contingent on China Mobile actually leading the 3G race in the same way as it has dominated 2G. The current 2G scenario is heavily biased in favor of China Mobile, but its 3G advantage is not so significant. If China Mobile is unable to leverage its huge 2G lead and turn it into a 3G/4G advantage, the scenario may not play out as described above. Having China Unicom and China Telecom in the bag may help Apple cover a bit of lost opportunity in China Mobile, but for the China story to play out, its largest wireless carrier must deliver.