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Apple's China Thesis: Will It Work?

Sunday - 5/12/2013, 2:35pm  ET

Is it even possible for smart phone makers to build, sell, and market a phone in China markets while holding onto the smart phone identity? The answer is a resounding yes, as according to Business Insider the total cost of making an Apple iPhone is $209.

Case for Apple in China

Apple needs to gain a foothold in China as it would be unwise to leave one of the fastest growing markets in the hands of HTC, Samsung, and Sony. That being the case, Apple has to market its phone to Chinese consumers at a price that the Chinese may be able to afford. The $100 to $300 range for phones is the sweet spot for Chinese consumers. Data plans are not expensive enough in China to cover the cost of phones, whereas in the United States. United States consumers may spend $2,400 throughout the life of a phone contract, making up for the $800 retail price Apple has set for its iPhone.

China’s GDP per capita has grown from a modest $1,500 to $5,444 in the span of just 8 years. The phenomenal growth in the amount of economic activity per person is incredible. However, while the growth rate is superb, the GDP Per Capita figure of $5,444 implies that the average person may not be able to afford an $800 iPhone.

In response to this, Apple will be selling phones at a cheaper price using Qualcomm chips.

Qualcomm a significant beneficiary

Qualcomm can sell its Snapdragon chips in even greater volume. In the first quarter, Qualcomm was able to report 14% year-over-year growth in mobile processing. With shipments projected to increase by around 22.7% in the following quarter. Qualcomm plans to sustain this double-digit growth by expanding into China. Qualcomm could be a larger beneficiary than Apple because Qualcomm relies heavily upon volume. Currently Qualcomm’s unit prices according to Arik Hesseldahl is $20 per unit. A larger number of shipments to China in the form of higher-end smart phones will lead to higher margins compared to the low-margin business of low-end phones.

Don’t forget about Baidu

Baidu is the leading web property in China. As Google and Facebook have both been banned from the country, it is likely that Baidu will be the primary mobile software provider in the Chinese market. That being the case, Baidu offers both search and social networking services through its mobile products. The difficulty in mobile that Baidu may be experiencing is in the quality of the phones.

After all, to access the internet with reasonable speeds and enough connectivity would require the use of a smart phone which is something that the average Chinese consumer cannot afford. Apple will be coming into the market offering Apple iPhone’s at a price that consumers can afford, Baidu would be a direct beneficiary.

The importance of Apple to Baidu is unquestionable as Apple’s iOS is an extremely light and fast software operating system. Even with inferior hardware specs, iOS can perform faster than other phones. This means that the iPhone would provide more value to Chinese consumers than any other smart phone manufacturer. It is also likely that Apple would have to partner with other app developers in the Chinese market in order to bring the full benefits of the Apple product to fruition. This could be a little challenging, but I see no reason for companies to ignore the Apple eco-system of products.

Baidu should be able to sustain its growth through mobile. The company was able to report 40% growth in its revenue year-over-year, along with net income growth of 8.5% year-over-year. Baidu is a huge beneficiary of economic growth and industrialization which can be clearly illustrated by the GDP chart below.

China’s growth has been decelerating with its most recent GDP growth figure in the 7 to 8% range, according to Bloomberg. Despite the growth deceleration, China remains a compelling investment opportunity for hardware companies like Apple.

Conclusion

The Chinese investment thesis has always been strong, but with China reporting $7.3 trillion in GDP, perhaps the United States is falling behind the red dragon from the east. Nonetheless, Apple has to make an appearance in one of the fastest growing economic zones by providing products that can clear the market at a reasonable volume. Apple has to accept a lower gross margin if it wants to compete in the Chinese space, but by being able to compete, Apple will incrementally grow its net income and revenue.

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This article was originally published as Apple's China Thesis: Will It Work?on Fool.com

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