Cell phone industry’s dirty little secret: China’s 145 million unit gray market

EL SEGUNDO, USA: Like many other illicit enterprises, China’s vast gray-market cell phone business is one of those things that everyone knows about -- but few want to discuss.

However, with gray-market shipments in 2009 set to grow to 145 million units, or nearly 13 percent of the size of the legitimate global cell phone business, the gray market has become too big and too lucrative for the mobile handset supply chain to ignore anymore.

In a market-research first, iSuppli Corp. has managed to lift the veil on China’s secretive gray handset market and develop an estimate of market size.

China’s gray market wireless handset shipments are expected to amount to 145 million units in 2009, up a stunning 43.6 percent from 101 million in 2008. This will amount to 12.9 percent of the 1.13 billion unit global market for legitimate cell phones.

The gray market this year is set to nearly quadruple from 37 million units in 2005.
In contrast, worldwide unit shipments of legitimate cell phones will decline by 8 percent in 2009.

By 2013, the gray market will grow to 176 million units, expanding at a Compound Annual Growth Rate (CAGR) of 11.7 percent from 2008. In contrast, the legitimate cell phone market will achieve a CAGR of only 4.4 percent during the same period.
The gray market will peak in 2012 at 192 million units.

The figure presents iSuppli’s forecast of gray-market cell phone shipments.Source: iSuppli, Nov. 2009

Gray-market handsets are cell phones manufactured in China that are not recognized or licensed by government regulators. Makers of these products generally do not pay China’s value-added taxes and, therefore, profit illegally from their participation in the market.

Such phones employ fake International Mobile Equipment Identity (IMEI) numbers, which are used by wireless networks to identify valid devices. These phones also do not carry test/quality certifications or network entry permits.

“Because of its under-the-table status, China’s gray market has been difficult to size up,” said Kevin Wang, director, China Research, for iSuppli.

“However, with its vast size, growing competitive presence and increasing influence on the global supply chain, this market now must be reckoned with. That’s why iSuppli has leveraged its extensive research capabilities to provide an estimate and forecast of shipments, the first time this has been done by a market research firm.”

Gray market comes out of the shadows
The gray cell phone market long has been a fact of life in China, with domestic demand propelling sales growth. However, the business underwent a fundamental shift in 2008, as domestic shipments began to decline, and exports started to boom. In 2009, exports are expected to exceed domestic shipments by a factor of more than three to one.

These exports are starting to impact the sales of legitimate established global players.

“Chinese gray-market handset suppliers have become so successful that they are grabbing share from major international handset OEMs,” Wang said.

“Exports of gray-market cell phones are set to rise to 110 million units in 2009, up from 60 million in 2008. International consumers in both developed and developing economies are being lured away from established brands by the low cost of gray-market handsets.”

Ironically, the export explosion comes at a time when Chinese consumers are turning away from gray-market phones because these products often come up short in terms of after-sales service and quality and as consumers are gravitating toward brand-name products,

Gray-market handsets typically enjoy a lifetime of only two years, due to poor quality control during the manufacturing process.

Gray phones go upscale
While gray-market cell phones are low priced, they aren’t necessarily low end.

“In terms of features, gray-market handsets often are comparable with official phones,” Wang said. “Nearly all gray-market phones have 2-megapixel VGA cameras and Bluetooth connections. Gray-market firms are even offering smart-phone models for less than $150, featuring Wi-Fi, QVGA-resolution touch-screen interfaces and the Microsoft Corp. Windows Mobile operating system.”

Component opportunity
With its large size and rapid growth, the gray cell phone market has become a major revenue driver for suppliers of semiconductors and other components.

While MediaTek is one of the primary supplier of semiconductors to the gray market, many other makers of semiconductors for legitimate handset OEMs also sell to gray-market manufacturers. However, the chips sold into the gray market often do not meet quality specifications of mainstream handsets.

While this represents a lucrative opportunity for these semiconductor suppliers, it does come with some risks.

“As the gray-market handset gets bigger, component suppliers may get some pressure from the legitimate OEMs and others in the ecosystem to stop selling into this area,” warned Francis Sideco, principal analyst, wireless communications, for iSuppli.

“This pressure may come in the form of shrinking design wins and potentially, intellectual property lawsuits.”