Shades of gray in China’s ’black’ handset market

China’s booming handset market is a sprawling gray area where branded phones are often sold through less-than-legitimate channels and where counterfeits pop up overnight. And according to industry data, it’s getting harder to tell a black- or gray-market phone from an outright fake.

But the rapid evolution of China’s iPhone clones has provided a window into how its black market is structured--and how the counterfeit market can turn out knockoffs with such seeming ease. The problem appears partly rooted in the rising availability of chip solutions purposefully designed, with honorable intentions, to lower the barriers to entry for handset developers.

An executive at NXP Semiconductors voiced that conclusion after his company’s chips showed up in a Chinese iPhone clone. "System solution providers such as NXP are constantly striving to reduce our customers’ engineering effort on electronics and software development for mobile handsets so that our legitimate customers can go into production quickly," said Gerard Cronin, sales and market vice president for NXP’s mobile and personal business unit.

But legitimate customers are not the only ones with access to the chips. "Phones can be created without semiconductor companies’ even being aware of the existence of the [illegal-]handset manufacturer until the day they start buying from a distributor," Cronin said.

Moving target

Everyone agrees China’s cell phone market is rapidly growing, but there is little consensus on just how large it has become.

BDA, which tracks Asia’s telecom markets, predicts the Chinese handset sector will grow to 255 million units in 2011 from 137.9 million units in 2006. Analysts at iSuppli foresee more modest 2011 sales, of 158 million units, up from 120 million handsets this year. According to Gartner’s July 2007 report, the Chinese handset market in 2007 is expected to reach 170 million units, with a 30 percent compound annual growth rate (CAGR) from 2003 to 2007. Gartner predicts a CAGR of 18.8 percent from 2007 to 2011.

The estimates vary as widely as the definition of the black market in China. Indeed, some market watchers don’t count the black-market numbers at all.

BDA clearly states that its data includes black-market handsets. But the firm does not account for secondhand acquisitions or stolen good in its tallies.

China’s black market is a broad spectrum that includes multiple shades of gray. One component is the smuggling of brand-name handsets from Hong Kong and other developed markets that are then sold through illegitimate channels. Then there are what BDA calls "minor branded" phones, sold without legitimate network certificates. A third category comprises refurbished and coun- terfeit phones, usually based on electronics taken elsewhere and fitted with a new exterior.

At iSuppli, analyst Tina Teng calls the refurbished/counter- feit phone category the "gray market," where "consumers can buy pc boards and cases on the street and then assemble the phones themselves."

Accounting for the various shades of gray, BDA estimates the illegitimate-handset market in China at 20 million units, or roughly 15 percent of the handsets sold in the country in 2006. At iSuppli, the estimates are higher: Teng puts the 2007 gray market at 60 million units.

China Outlook Consulting goes even further. In a report issued last December, COC analysts wrote that China’s black-market handset products served about one-third of the country’s demand in 2005. That share could hit 45 percent this year, COC predicts, based on persistent market demand and the availability of up-to-date functions in addition to cheap prices. "International suppliers and distributors need to be careful when considering these types of market opportunities and be aware of the big risks in doing business with these illegal makers," COC wrote.

BDA believes the black market’s share of the total is stabilizing but that its internal dynamics are shifting. As more local OEMs become capable of building their own handsets, the number of refurbished and counterfeit phones is decreasing as a proportion of the total, while the percentage of smuggled handsets and minor branded phones is on the rise.

One hotbed of black-market activity, according to BDA, is Shenzhen, which enjoys "proximity to Hong Kong and [an] established handset production base."

A typical player in Shenzhen with some 30 employees can turn out 50,000 units per month and 12 models a year, according to BDA. The operations tend to purchase boards from design houses, completing the mechanical and industrial design themselves. The players produce both minor branded phones without network certificates and branded handsets under borrowed licenses. They usually provide after-sale services through distributors.

iClone stands alone

CEC Telecom’s Q130, a fake Apple iPhone that was the subject of a recent Semiconductor Insights teardown analysis (see story, page 4), is not included in black-market tallies. Rather, it is viewed as a local OEM product. CEC Telecom is "a major brand" in China, said BDA analyst Flora Wu, and iSuppli’s Teng agreed.

But just because the Q130 is not sold on the black market doesn’t mean its developer is not violating Apple’s intellectual property rights.

Local developers have been selling popular brand-name handset clones independently of the black market for some time. "It’s not just Apple" whose products are the subject of OEM knockoffs, said Jake Saunders, vice president of ABI Research Asia-Pacific. "Most major brand-name handsets--including Nokia’s latest phone, the N9--have been targets."

Counterfeiters adopt a form factor similar to that of the branded phone, use the same engine or similar hardware and add a cover that mimics the original. While Semiconductor Insights’ teardown specialists warn that the clones are gaining on the originals, Saunders argued that the clones in "no way" can match the usability and functionality of the brand names.

Teng of iSuppli also took issue with the assessment that counterfeits of Apple’s iPhone threaten to surpass the original. Pointing out the clones’ lack of a multi-touchscreen and of Wi-Fi support, she said, "Chinese OEMs want to get more bang for the buck. Adding a multitouch display wouldn’t be cost-effective enough. Second, Wi-Fi is still expensive--and to my knowledge, Wi-Fi functionality is being disabled when Wi-Fi-enabled handsets are shipped to China, as requested by the government."

Cost is clearly a paramount issue for counterfeiters. "The cosmetics and design as well as the basic functionality offered by chip sets can easily be copied," NXP’s Cronin said, but to reproduce the same functionality in cloned phones, clone makers would end up spending as much as, or even more than, branded OEMs.

"It’s because they are essentially buying from the same sources for the chips, LCD, camera sensors, memory--and all of them are the big-ticket items. They may be able to use some lower-quality components, but they don’t have the same bargaining power of the big players," Cronin said. "This begs the question of what the point of a counterfeit is."

What’s the remedy?

Nobody but the Chinese government can stop the gray market in China, said iSuppli’s Teng. But OEMs have options.

Teng suggested ending "regional discrimination"--that is, making popular models available in China--as a way to discourage Chinese OEMs and the gray market from doing their free "test marketing."

Second, Teng said, if you can’t beat ’em, join ’em: Handset manufacturers could easily "make lower-cost, scaled-down models [for China’s handset market] based on their own popular models outside of China."