The End of iPhone Cowboys Could Double Sales in China
John Paul is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
You’ll never hear it from Apple (NASDAQ: AAPL), but ever since the first iPhone was launched, there has been a thriving, extremely lucrative black market in China and Hong Kong for the latest iPhones. Oddly enough, the players in this back-alley world range from well-heeled and opportunistic Westerners to the poorest Chinese locals looking to get their first real taste of American entrepreneurship with a Chinese twist. It’s a world where black-market iPhone prices are updated daily in a manner eerily reminiscent of Wall Street in the 1920s. It’s a world where consumers pay twice the retail price right after an iPhone debuts. With profit margins so high, it’s not hard to understand why this back-alley business has flourished for so long but this world is about to come to a violent halt with the latest iPhone 5.
Now, some will say they’ve been to China numerous times or maybe even lived there for years and never heard or saw anything of this nature. Well, unless you live and operate among the locals in the backstreets of places like Chongqing, China (a rapidly growing megacity of more than 30 million people) you won’t see this black market. (Most visitors’ exposure to China is limited to highly Westernized cities such as Shanghai and Beijing.) As for those who would assume that Apple would attempt to stop this thriving black market that just isn’t the case.
With the iPhone 5’s latest technology the iPhone cowboys’ days are numbered. Apple now has the ability to negotiate a far better distribution network with Chinese telecoms, penetrate China as a whole, and operate with a worldwide product launch schedule that will finally prevent iPhone black-market arbitrage. The iPhone 5’s latest tech upgrades can finally illustrate the full potential of the Chinese market and - let there be no mistake - the sales numbers will show this moving forward as they blast past analyst estimates for the coming year.
The Untold Power of The Black Market:
Maybe you’re skeptical about how much Apple’s top and bottom lines could be affected by destroying the Chinese black market, so here is some simple perspective. When I first moved and lived near one of the many commercial districts of Chongqing, there were, perhaps, three knock-off Apple stores that exclusively sold iPhones. In just three months, that number sky rocketed to over 10 that I knew of – in this one commercial district alone – and each had a steady stream of customers. All of these stores were within a 1-2 mile radius. Some were competing so aggressively for prime foot-traffic zones that I could walk less than 20 yards from one store to the next.
I estimate that I saw 20 knock-off Apple stores when I lived in China, although I imagine there must have been plenty more. The point here is that if an industrial megacity, one most in the West have never heard of, can support that many knock off stores in such close proximity then it’s very likely that on some material level this is cutting into Apple’s top line numbers.
Why This Will All Change:
One major reason why the black market has flourished for so long and to such a high degree is due to Apple’s extremely limited distribution network. To date, Apple has primarily focused on first-tier cities such as Beijing and Shanghai, leaving most of China as whole untouched. iPhone cowboys have used this reality and other related variables such as travel within China to exploit the situation for years.
The iOS activation rate map below corroborate this reality: the highest rates of activation (or those worth noticing) have primarily been clusters along the coast. Of course, Apple has some level of third-party distribution for the rest of China. Still, when Apple knock-off stores are sprouting up like clusters of mushrooms all over the country it doesn’t take a rocket scientist to see the distribution network is failing to satisfy demand.
With the iPhone 5, this situation can finally change for the better. This is because the latest iPhone offers technology that’s compatible with China Mobile (NYSE: CHL) infrastructure. China Mobile is the nation’s largest mobile telecom service provider with a distribution network that puts every other business in the world to shame. In China, an inability to find a China Mobile store, large or small, is like not being able to find pollution in a major Chinese city. For black-market iPhone cowboys and knock-off Apple stores, this means immense competition for the first time. They will unofficially be pushed out of the market given most will not be able to operate profitability at this point. The recouping of lost iPhone sales that historically went through black-market channels will all but ensure Apple beats top- and bottom-line expectations in 2013.
Who Are these iPhone Cowboys?
A documentary that focused on Miami during the 1970-80s, spawned the popular term “cocaine cowboys,” which referred to those who transported illegal drugs. Today, there are the “iPhone cowboys” who smuggle iPhones into Mainland China and Hong Kong. These are self-proclaimed entrepreneurs and/or “mules” (people hired to transport illicit products) alike who often smuggle anywhere from 10 to as many as 50 brand-new iPhones per trip (perhaps even more) right after a product launch. These people know that the latest iPhone can take months to arrive through official distribution channels – and even then, there are usually product shortages. Chinese consumers aren’t known for their patience, as riots in front of Apple stores have previously demonstrated.
Example By Numbers
In one run, a batch of 50 new iPhones sold at a “wholesale daily price” to local Chinese distributors in Hong Kong could easily net a profit of well more than $20,000. The sooner these iPhone cowboys get their product to China or Hong Kong after a new iPhone launch, the higher the price they can command. And this is just one person. It’s literally a one-man operation. Now, imagine that there are hundreds, if not thousands, of people doing this very quietly after every Apple launch. This simple example illustrates the significance of this black market for iPhones and the money Apple has lost in one form or another relative to its bottom line.
The Reason Why iPhone Cowboys Will Go Out to Pasture
While the risk and consequences of being caught are theoretically low (typically a fine of a few thousand dollars or something comparable), the real risk has been offloading black-market iPhones too slowly. iPhone cowboys thrive on “iPhone arbitrage.” Basically, this is when they buy new iPhones (perhaps in the U.S.) and then smuggle them into a country that won’t receive them through official channels for an extended period of time. This period of time is what allows the cowboys to make the profit because they have a captive market with little competition (other than one another).
This will all change now because Apple is now more likely to operate on a more synchronized product launch schedule. Now that Apple has the potential to sign a new deal with China Mobile, Apple can launch its products worldwide simultaneously and effectively close this arbitrage window. In one fell swoop, Apple could put the iPhone cowboys out to pasture and, in the process, reap handsome profits very easily thanks to the iPhone 5’s compatible technology with Chinese infrastructure.
Apple's Secret Catalyst For a Higher Stock Price:
While most consumers will rave about the iPhone for a variety of different reasons, it should really be the investors who rave the most. The iPhone 5’s new technology that’s compatible with China Mobile infrastructure will launch its distribution network to an unimaginable level that should allow it to penetrate the entire Chinese market at once (assuming a deal gets done). This will also enable Apple to more easily conduct future iPhone launches that no longer generate any meaningful iPhone arbitrage window in major markets such as China.
Most importantly, this is Apple’s quiet new catalyst that will drive both top- and bottom-line numbers to higher levels - even if the rest of the world remains in some form of an economic quagmire. In a best case scenario investors could see Apple’s iPhone sale numbers almost double throughout 2013 and allow the stock to justifiably trade at an even a higher price.
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DragonBoss2012 has no positions in the stocks mentioned above. The Motley Fool owns shares of Apple and China Mobile. Motley Fool newsletter services recommend Apple. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.