Apple's Next Big Leap Forward

Apple is yet to tap the world's biggest pool of potential iPhone buyers: China Mobile's customers. That is set to change. When and how will help determine whether the U.S. technology company's flagging stock can regain momentum.
At about $395, Apple's shares have fallen 44% from an all-time high hit last September. Once the most valuable company in the world by market capitalization, it recently ceded that crown back to Exxon Mobil. Adjusted for net cash, its market cap also has just been surpassed by archrival Google.
 AP A man leaves an Apple store with an iPhone and an iPad in his hands in central Beijing. A big concern weighing on Apple is that the tailwind from increasing distribution for its most lucrative product has dissipated. When the iPhone first launched in 2007, it was sold by just one carrier, AT&T, in just one country, the U.S. That is now up to 275 carriers in 114 countries, says Strategy Analytics.
The most glaring omission is China Mobile, the world's largest wireless carrier with more than 700 million subscribers. Among them are about 80 million wealthier ones that can afford Apple's pricey smartphone, estimates HSBC analyst Tucker Grinnan. And of that elite group, more than half may be likely buyers of the iPhone, considering that Apple's market share of high-end smartphone sales in China is 55%, according to HSBC. Indeed, more than 20 million of China Mobile's customers already use "unlocked" versions of the iPhone on the carrier's aging 2G network.
For Apple, which sold 261 million iPhones in 2012, those extra tens of millions of potential unit sales represent a big opportunity. Pressure is increasing, too, as Apple's market share for all smartphones in China, high- and low-end, dropped to 9% in the first quarter from 13% in the same period a year before, according to Strategy Analytics.
So Apple investors have anxiously awaited some sort of deal, especially since the fall 2012 launch of iPhone 5, which is the first model that is compatible with China Mobile's 3G network technology.
One reason a deal hasn't been struck may be that China Mobile's controlling shareholder, the Chinese government, doesn't want the company to offer the iPhone yet. Allowing the biggest fish in China's telecom sector to carry Apple's popular device might lead to further market concentration that Beijing would rather avoid.
A problem on Apple's side, meanwhile, may be that it doesn't want users subjected to a relatively poor experience. China Mobile's version of 3G technology, called TD-SCDMA, is less reliable than those supported by smaller rivals China Telecom and China Unicom.
Still, several factors suggest the companies will strike a deal eventually.

First, China Mobile is planning to rapidly roll out its next generation "TD-LTE" network. The iPhone is compatible with that technology as well, which will offer much faster data speeds for users. And Beijing wants to promote the technology world-wide because Chinese companies like Huawei sell supporting equipment. With a $31 billion capital-expenditure budget for 2013, nearly as much as AT&T's and Verizon Communications' combined, China Mobile already is a big buyer of TD-LTE equipment. Getting the iPhone onto that standard would give it additional momentum.

Meanwhile, the risk of fostering additional market concentration may be mitigated later this year if, as some expect, Beijing allows consumers to keep their numbers when they switch networks, as happens in the U.S. That will make it easier for China Mobile customers who have wanted to jump to rival carriers to do so.

One potential sticking point in formulating a deal is high smartphone subsidies. To date, Apple's significant market power has enabled it to extract sweet deals whereby carriers subsidize much of the iPhone's cost. They do so because they can get subscribers locked into expensive wireless plans.

But the big financial hit that Apple's terms appear to have inflicted on rivals won't have been lost on China Mobile. China Unicom was the first Chinese carrier to get the iPhone, in late 2009. But its accounts show that from that year through 2011, while absolute operating profit in its mobile business increased, the margin fell to 27% from 37%. And China Mobile likely has a strong negotiating position due to its size and Apple's need to reignite momentum.

A wild card is the lower-end iPhone that Apple is working on. This could actually help the two companies reach a deal because it would enable China Mobile to attract customers in the fast-expanding lower end of the market while likely not breaking the bank in terms of subsidies. For Apple, the profit impact from widening the potential market for its smartphones is less clear. That is because it also may eat into sales of more lucrative high-end devices, eroding margins.
So how important is China Mobile to Apple? It has historically made percentage gross margins on the iPhone in the mid-50s, according to Sanford C. Bernstein analyst Toni Sacconaghi. Even assuming Apple makes only a 40% gross margin on iPhones sold through China Mobile, taking into account the latter's potential negotiating leverage, selling 25 million more iPhones in the first year could mean an extra $6 billion of gross profit.
That would be a welcome boost: Analysts forecast Apple's gross profit at $69 billion for the fiscal year ending in September 2014.

With technology and strategic aims increasingly aligned, for the iPhone and China Mobile, it still is a question of when, not if. A revolutionary new product could always be in the works when it comes to Apple. But a deal in China represents one of the company's biggest potential profit bumps on the immediate horizon.