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Apple's Bad Omen From Losing To Nokia In China

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China Mobile (Photo credit: Wikipedia)

Nokia exploited Apple's Achilles' heel of subsidies to beat Apple in China.

China Mobile Limited (CHL) is the largest cellular provider in the world by number of subscribers.  At the end of October it had 703 million subscribers including 79.3 million 3G users.

China Mobile has been in desperate need for a flagship high end smart phone.  Apple has been negotiating with China Mobile to make iPhone its flagship phone.  Apple bulls have been counting on the big subscriber base of China Mobile to fuel further iPhone growth in China.

In a surprise move, China Mobile chose Lumia 920T, a phone based on Microsoft (MSFT) Windows Phone 8 over iPhone 5.

The biggest fall in four years in Apple stock on December 5th was attributed by some experts to Nokia’s win in China.

Apple’s Achilles’ heel is that it demands larger subsidies from carriers compared to its competition.

The big carriers provide a higher amount of subsidies on iPhones than on Android devices.  An iPhone that costs the consumer $199 may cost a carrier $500 to $700 even though they may be buying millions of these devices.  The carriers more than make up for the upfront subsidies over the life of the contract due to huge margins on data plans.

Major carriers have already conceded that the money is not in voice but in data. Similar subsidies are offered by carriers in most developed markets.

Imagine what will happen if subsidies go away and consumers have to pay $700 to $1000 for an iPhone. My own research at The Arora Report shows that in such a scenario, Apple may easily lose over 50% of its sales of iPhones.  Considering that Apple derives over 70% of its profits from iPhones, such a scenario will be a virtual death knell. My research shows that Apple is more dependent on subsidies than its competitors.

Apple’s insistence on high subsidies to maintain its margins left an opening at China Mobile that Nokia exploited.  A comment from Li Yue, the CEO of China Mobile, is widely interpreted to confirm that the issue with China Mobile carrying iPhone is the high level of subsidies demanded by Apple.  It will be interesting to see how many China Mobile subscribers are willing to upgrade from cheap Google (GOOG) Android phones to Lumia 920T.

The iPhone is available in China through two smaller carriers, China Unicom (CHU) and China Telecom. Apparently the smaller carriers have been willing to cede to Apple’s demands to attract customers away from China Mobile.

From an investor perspective, heavy dependence on subsidies poses a serious risk to Apple.  According to my model, if subsidies were completely eliminated, Apple will lose about 40% of its sales of iPhones. The effect will be a direct drop of about 28% in Apple earnings.  Such a scenario may turn into a vicious circle.

During Apple’s ascent, Apple’s other products have benefited from the halo effect of iPhones. In a descent, the halo effect will be in force but in reverse.  In such a scenario, as a vicious circle takes hold, Apple earnings may drop to around $30 per share.  Considering that Apple has been dependent on hit after hit and for this reason even during its ascent, Apple has been able to garner a forward P/E of only about 12, in a descent Apple forward P/E may fall as low as 6.

Not only will  Apple’s earnings drop, its stock price will drop under $200 in such a scenario supported mostly by the cash that Apple holds.

While Apple stock has fallen, Nokia stock has almost doubled.  As of this writing, Nokia stock was trading at $3.80.  On any pull back, Nokia stock is still a reasonable speculation.  For details, please see Nokia Is A $2 Call Option On Microsoft Windows Phone.

About Me: I am an engineer and nuclear physicist by background. I founded two Inc. 500 companies, and have been involved in over 50 entrepreneurial ventures. I am the chief investment officer at The Arora Report, which publishes four newsletters to help investors profit from change. Write me: Nigam@TheAroraReport.com.  Follow me here and get email notification when I publish a new article.  Subscribers to The Arora Report are long Apple from $131 and have taken partial profits at $360, $525, $629, $568 and $610. Subscribers to The Arora Report are also long Nokia and have just taken a starter position in Microsoft.

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