How Credit Cards Can Predict The Future Of Phone Subsidies In China

Includes: AAPL, CHL
by: Geordy Wang

After Tim Cook's recent meeting with the chairman of China Mobile (NYSE:CHL), the rumor mills are hot with speculation that Apple (NASDAQ:AAPL) is finally preparing to launch a subsidized iPhone on China's largest wireless network. The subsidy model has been one of the most important growth drivers for Apple here in the U.S., but I've never been entirely comfortable with the notion that the story will play out the same way in China. The Chinese consumer has traditionally been much more fiscally conservative than his American counterpart, which doesn't mesh well with the subsidy model since subsidies don't actually save the consumer any money over the long run.

The seemingly great deal represented by the subsidized smartphone is just an illusion -- even though the consumer snags a cheaper phone up front, he eventually makes up the difference by locking himself into an expensive multi-year contract. Due to the more conservative spending habits of the average Chinese consumer, I used to believe that subsidies would not be as successful in China as they have been domestically. A recent study by the University of Missouri led me to revise my thinking: the study showed that from 2004 to 2009, Chinese credit card debt grew by 40% a year, and that according to Mastercard's (NYSE:MA) forecasts, this growth will continue at an average annual rate of 11% through 2025, with China outstripping the U.S. as the largest credit card market in the world by 2020.

Why does the growth of the Chinese credit card market matter for Apple and other smartphone manufacturers who rely on subsidies? Because a subsidy is essentially the equivalent of purchasing a smartphone on a financing plan: you pay a "down payment" up front, and the remainder of the cost is spread out over the life of your contract. It's no coincidence that T-Mobile decided to eliminate handset subsidies and offer interest-free financing for smartphone purchases simultaneously: they're basically the same thing. That's why I believe that the rapidly growing utilization of credit in China means that investors should expect a corresponding surge in the popularity of subsidized smartphones in the country. A consumer who likes buying the latest and greatest with borrowed money is exactly the kind of consumer that the phone subsidy is designed to target.

This is great news for investors in Apple, a company that is famous for extracting industry-leading subsidies from wireless carriers. ComTech reports that Apple currently controls 53.3% of the U.S. smartphone market, but according to IDC's data, this number drops to 18.8% in the global market. Domestic subsidies are responsible for a large part of this gap, and if China ever embraces the subsidy model to the same extent the U.S. does, the potential upside for Apple's bottom line is enormous. Although it's way too early to predict when, or even if that day will ever come, current trends in Chinese consumer debt are a major indication that the market is moving in that direction.

This win for Apple is also a win for Apple's competitors. Apple isn't the only smartphone company that stands to benefit from a rise in Chinese carrier subsidies. Google (NASDAQ:GOOG) also sells its Motorola Android phones in China, Research In Motion (RIMM) is preparing to amp up its China strategy, and Nokia (NYSE:NOK) made headlines last month for beating Apple to the punch in signing an agreement with China Mobile to collaborate on the new Lumia. As the fastest growing major economy in the world, China represents an extremely lucrative opportunity for all smartphone businesses, with subsidies representing the path of least resistance to the Chinese consumer's wallet.

Ironically, the companies that stand to lose from an upsurge in subsidies are the same ones that offer them: the carriers themselves, who have to face significant margin pressure due to heavy subsidy costs. However, Seeking Alpha contributor Adam Levine-Weinberg makes an excellent case for how phone subsidies represent a prisoner's dilemma that traps carriers into the subsidy model despite the costs involved. Although Levine-Weinberg wrote about U.S. companies, the same principle applies to Chinese companies. China Mobile has always shied away from the iPhone due to its huge subsidy costs, but this is the same company that increased subsidy spending from 17 billion yuan in 2011 to 26 billion yuan in 2012 due to competitive pressure. Regardless of how little they may like subsidies, carriers frequently have no choice but to offer them if the consumer demand is there.

Subsidies may be "here to stay" in the U.S., but in China, the trend of increasing consumer debt means that they're likely to grow, and fast. Although data on age demographics for the Chinese smartphone market isn't readily available, teens and young adults have been responsible for the lion's share of domestic smartphone growth, and there's no reason to expect anything different abroad. The UM study indicates that the majority of Chinese credit card holders are also young, with 67% under age 35. The generation that is driving more aggressive spending in China is the same one that is leading the charge in smartphone adoption. The dominance of the prepaid model over the subsidy model has always been one of the biggest obstacles for Apple and other smartphone companies that do business in China. As the values of the modern Chinese consumer shift from thriftiness to immediate gratification, investors have good reason to expect phone subsidies to gain significant ground in China over the years to come.

Disclosure: I am long AAPL. 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.