The rise of China's smartphone makers

After Apple and Samsung, which companies are selling the most smartphones around the globe? If you guessed a growing group of Chinese smartphone manufacturers, you would be correct.

After Apple and Samsung, which companies are selling the most smartphones around the globe?

If you guessed a growing group of Chinese smartphone manufacturers, you would be correct.

Most Americans know little about the emerging Chinese smartphone makers, let alone how to pronounce some of their names. Most of these handsets are unlikely to be seen in use by U.S. customers, at least for now.

Yet, these Chinese companies, with names like Huawei, Xiaomi, Coolpad, Lenovo, ZTE, and even Alcatel (which is now part of TCL Corp., a Chinese electronics company) are having a big impact both inside China and in emerging economies.

These companies mostly sell unlocked smartphones that run the Android mobile operating system. They usually charge much lower off-contract prices than Apple and Samsung, and they're beginning to challenge some of the world's traditional smartphone makers.

Globally, Huawei of Shenzhen, China, was the No. 3 smartphone maker in terms of revenue in the third quarter of 2014. Huawei was well behind Apple and Samsung, but in a virtual tie with LG Electronics of Seoul, South Korea, according to Infonetics Research.

Meanwhile, market research firm IDC reported that newcomer Xiaomi, which is based in Beijing, shipped the third-most smartphones to retailers in the third quarter. Xiaomi was just ahead of Lenovo, also based in Beijing, which was in fourth place but virtually tied with LG. Xiaomi's smartphone shipments jumped an amazing 211% year over year, reaching 17.3 million units, according to IDC.

Out of the top 17 smartphone makers globally in the third quarter, 10 were based in China, according to Strategy Analytics. Xiaomi ranked third in total production, and Huawei ranked fifth. The rest of the Chinese group in Strategy Analytics' top 17 included Lenovo, ZTE, TCL Alcatel, Lenovo (formerly Motorola under Google), Coolpad, Oppo, Vivo, Micromax and Tionee.

"The Chinese vendors are absolutely having an impact on many smartphone brands that have to compete with low-cost Chinese smartphones," said Ken Hyers, an analyst at Strategy Analytics.

"People in the U.S. don't even know who these Chinese companies are," added John Byrne, an analyst at Infonetics.

"I was just in China recently, and you see phones in use with labels I'm not even familiar with," Byrne said. "It was an eye-opener. Especially in Asia, there's a much larger variety of phones in use and not the duopoly of Samsung and Apple that we have in the U.S."

Can you say 'She-ow me'?

The third-largest smartphone maker, Xiaomi (pronounced she-ow me), was founded in 2010 by a group of tech-savvy entrepreneurs that included Jun Lei, the company's chairman and CEO, and Bin Lin, its president. Xiaomi's global division is headed by Hugo Barra, who joined in 2013 after working as president of Android product management at Google.

Its first smartphone, an Android device called the Xiaomi Mi1, was announced in 2011.  Since then, the company has produced several smartphones and a tablet, the MiPad, announced in 2014.

The private company had $5.5 billion in revenues for the first six months of 2014. Xiaomi is the Mandarin Chinese word for "millet," or literally "little" (Xiao) "rice" (mi). But the name also links "Xiao" to "mi," the latter possibly short for "mobile Internet" or even "mission impossible," according to comments attributed to Jun, the CEO. He also has connected "Xiao" to a Buddhist belief that a single grain of rice is as great as a mountain.

A long-term threat?

Are these Chinese companies a threat to the established phone makers? They probably aren't a threat to Apple, which still holds a secure spot in the high end with its iPhone, but Chinese manufacturers do pose a threat to many other well-known smartphone makers, even powerhouse Samsung.

Some Chinese-made smartphones are sold at $100 to $200 without a carrier contract (compared to more than $600 for an iPhone 6), which puts several traditional manufacturers on guard.

"You'll never find Apple in the $100 off-contract range, but Samsung has tried some entry-level phones while Chinese vendors have included top-end specs and still reduced their prices to gain market share," said Ramon Llamas, an IDC analyst. "That move has pushed Samsung back on their heels."

Llamas said low-priced Chinese-made smartphones do indeed represent a threat to some manufacturers. "It's just a question of how long Chinese manufacturers can seek volume sales over profit," he said. "It's harder to compete on the lower end. Knowing how costly it is to manufacture a smartphone, I wouldn't be surprised if some vendors are losing their shirts."

Even in the U.S., Samsung is less able to sell a midpriced smartphone off-contract, Hyers said. For example, he pointed out that the Samsung Galaxy S5 Mini would cost around $250 without a contract and said consumers would be more likely to choose a low-priced Chinese device that can cost $150 and has the basic features that many buyers want. In the U.S., customers are skipping midpriced phones and buying either premium smartphones, like the iPhone 6 or the LG G3, or low-cost, entry-level or near-entry-level devices, like the Moto G or the Lumia 500.

"Midtier devices are not selling well at all in the U.S.," Hyers said. "Market dynamics really favor higher quality and very competitively priced smartphones from Chinese vendors."

"ZTE is really gaining U.S. market share along with TCL Alcatel," he added, noting that TCL Alcatel offers French design sense along with low-cost Chinese manufacturing.

China's advantages

Chinese smartphone manufacturers have an advantage over other phone makers in the global market in part because low-cost labor keeps their manufacturing costs down. But the cost of labor isn't the only factor.

For smartphone sales within their home country, Chinese manufacturers don't pay the patent and intellectual property royalties they would pay for sales in other countries because of lax government IP regulation, analysts said. Every handset made typically comes with scores of different IP royalties that are paid to various companies for network, hardware and software functionality, and those fees can add $20 to $40 to the cost of a device on top of the cost of parts and assembly, Hyers said. Stripping out most of that cost can help keep smartphone prices down in China's enormous market. And that, in turn, enables those vendors produce phones in higher volumes at lower costs.

For its part, Xiaomi aims to sell phones at just above the cost of parts and assembly and it keeps models on the market for around 18 months, instead of the usual six months favored other producers, according to comments made by Xiaomi CEO Jun. As that longer selling period progresses, the cost of components can fall, leading to higher profits. Like other smartphone makers, Xiaomi also sells phone accessories and software. The company relies on original sales from its own online store, and it puts a strong emphasis on advertising on social networks.

Xiaomi recently ran into trouble over intellectual property royalties when it tried to expand outside its home turf into India. On Dec. 11, the company said it halted sales in India due to a patent dispute with Swedish network equipment maker Ericsson.

If the patent dispute is resolved in India, Xiaomi will likely be forced to pay royalties, since it's a young company and has a relatively small patent portfolio. Companies that compete with Xiaomi and other Chinese smartphone makers might resort to using patent litigation to help stem the growth of Chinese vendors outside of China, analysts theorized.

For the third quarter, smartphone production volumes within China itself clearly favored Chinese vendors, leaving South Korea's Samsung as the only non-Chinese vendor in the top five. Xiaomi finished first, followed in order by Samsung, Lenovo, Huawei and Coolpad, according to Strategy Analytics and other analyst firms.

China's fit in the global smartphone market

Chinese smartphone makers clearly have a leg up in their own country, which by its sheer size has the largest smartphone market potential of any nation.

With a population of 1.35 billion, China is the world's largest country. It exceeds the U.S. population of 316 million by a factor of four. China has 160 cities with 1 million or more people, compared to 10 of that size or larger in the U.S.

In the third quarter, nearly one-third of all smartphones shipped by all vendors went to China, IDC said. In fact, China received 105 million of the 327 million smartphones shipped globally in the quarter. Outside of their home country, Chinese smartphone brands accounted for 13% of all global shipments, up from 9% a year earlier. That uptick is an indication of the growth expected for sales of Chinese smartphones outside of China in coming years.

Of course, 13% of the global market might not sound like much when you take into account the fact that it's spread across several Chinese vendors. But it's the specter of what's coming in the next year or two that has some competitors restless. Lenovo, which is top in PCs globally, is expected to be more aggressive in the smartphone market in the U.S. and other countries now that it owns the Motorola brand.

Google sold the Motorola handset division to Lenovo earlier this year after putting its imprint on the technology. A recent result of that effort was the 5-in. display second-generation Moto G smartphone with a quad-core processor that goes after the lower-cost segment so favored by Chinese vendors. An 8GB version sells for $180 unlocked and off-contract on Amazon.com.

Hyers called the Moto G "an amazing value in a smartphone."

Other Chinese smartphones are sold by U.S. carriers, but few get much attention from U.S.-based reviewers and they aren't well advertised. T-Mobile, for example, carries the ZTE ZMAX, which runs Android 4.4 (Kit Kat) and boasts a big 5.7-in. display, a Snapdragon quad-core processor and a 3400 mAh battery for $252 before rebate.

Buying an unlocked, off-contract Chinese smartphone on the Web to use with a U.S. carrier could prove to be a disappointment, however. That's because not all the wireless spectrum characteristics of a given smartphone will match up with a carrier's available spectrum.

In one example, an unlocked Xiaomi RedRice smartphone with a 4.7-in. display was selling recently on eBay for $160 . While it is listed as working worldwide on GSM and WCDMA networks, a Verizon Wireless representative said that even though Verizon has a CDMA network, there could be no upfront guarantee that the phone would be compatible with Verizon's service. It's possible to run an online test for compatibility, but that requires having the device available to run the test.

Growth potential for Chinese smartphone vendors

There's little doubt that smartphones made in China will affect the global market for years. Their biggest impact today is in helping drive down prices, but whether Chinese manufacturers can sustain lower prices and still make profits in the future remains to be seen.

Chinese manufacturers typically operate in the range of 2% to 4% profitability, but the question is how long that will be enough. "At a certain point, I'd think they'd like to be more profitable," Hyers said.

In recent years, Apple, Samsung and LG have "captured the lion's share of the smartphone industry's profits, while the rest of the vendors are just scraping by," Hyers said. "That leaves the Chinese vendors best-positioned to continue to make it on 2% to 4% profits."

Also, while economists talk of China's overall economic slowdown going into 2015, that nation's economy is still expected to grow by about 7% in 2015, down from as much as 15% in recent years. And even at 7%, China's economic growth rate is still well above those of the U.S. and other countries, and the decline is seen as having little impact on the ability of Chinese smartphone makers to produce devices, analysts said.

Some of the biggest growth markets for smartphones will continue to be in India, Indonesia and Thailand, partly as a result of sales of Chinese and Samsung smartphones. Those countries are expected to see 55% smartphone growth in all of 2014 compared with 2013, IDC said. Meanwhile, smartphone growth in all of North America will be much lower, in the 25% range. Central Europe, the Middle East and Africa are expected to see the highest smartphone growth, at 78% over the prior year, partly due to the influence of the low-cost Chinese smartphone ecosystem, IDC said.

China itself will see 11% growth in 2014 for all smartphones, down from recent years. That slowdown has helped spur a desire by Chinese vendors to expand to other markets.

And now, the losers

Who are the potential losers in a scenario that includes continued steady performance by Chinese smartphone makers? HTC, based in Taiwan, might be the most vulnerable, but other companies under threat include a range of international smartphone makers such as Microsoft, with the Lumia brand it acquired when it bought Nokia, as well as BlackBerry, among others.

Even Samsung saw a big drop in third-quarter profits, much of it due to the impact of cheaper Chinese smartphones. Samsung's global smartphone market share dropped to less than 25% in the third quarter, down from nearly 30% a year earlier, Hyers noted. "Part of that [Samsung] drop is due to the midtier market shrinking and the more competitive threat in the entry-level market," he said.

The irony of the low-cost smartphone

While low-cost smartphones, mainly from Chinese companies, are a driving force in the global market, there is still plenty of consumer lust for higher-priced products like the iPhone or Samsung Galaxy devices.

"How far can we take this low-price trend? Are Apple and Samsung doomed?" Byrne asked in an interview. "The answer is no. There's still real cachet around the iPhone. The Apple Store, even in Shanghai, is still as crowded as ever. There's certainly an appetite for these high-end phones and still status associated with an iPhone and with a Galaxy, to a lesser extent. People will still spend money on high-end phones."

Byrne said there's an interesting connection between the two groups of devices.

"There's an argument made that lower-end phones get people into buying smartphones and that [those people] will still have iPhone envy," Byrne said. "In that way, the lower-priced models become the gateway drug of smartphones."

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