Menace called China’s Shanzhai Mobile Phones

Chinese PhoneHave you heard about HiPhone, Nckia and Sumsung? I bet you would have seen the phones but would not have realized that it is a fake. Welcome to the world of Shanzhai handsets or Knock-off phones.

I was surprised to read the quarterly results declared by MediaTek. In times of gloom, they managed to report a healthy 80% jump in 2nd quarter (y-o-y) in profits and more importantly predicted shipment of 300 million of their chipsets for mobile phones in 2009. Given the global handset market size is 1.2 billion units, if all the 300 million chipsets indeed find their way into a handset, MediaTek can claim to have 25% market share. This is no mean achievement for an unknown Taiwanese company which has quietly pulled the rug under the top brands.

MediaTek is a design house in Taiwan that specializes in designing the chipset. MediaTek does not own manufacturing facilities and has outsourced production to become “Fabless”. MediaTek was one of the late entrants (2004) into the market and developed a circuit board that could inexpensively integrate the functions of multiple chips, offering start-ups a platform to produce a low-cost mobile phone. The chip is called SoC (System on Chip) and has helped the smaller players mushroom as producing a handset has now become a lot simpler. A new cottage industry developed in China called the Shanzhai phones which sourced its chipsets from MediaTek. Shanzhai in Chinese means “Mountain Hideout” and they indeed are the bandits as they flout the IPRs and copy the designs of bigger brands to produce what we call illegal and fake handsets. These handsets got a boost in 2007 when companies no longer needed a license to manufacture a handset.

Shenzhen is the foremost production base for Shanzhai handsets. It boasts some 10,000 mobile-phone firms, including 2,000 handset makers, 200 design houses, 3,000 components and parts suppliers, and 1,000 channel firms. It costs just 500,000 yuan (USD 75K) and 10 engineers to start the handset production business which is a fraction of the cost of big players. The time to market is just 28-30 days as the entire solution is provided by MediaTek. Many of the manufacturing units are in the basement of homes or in a small apartment.

In 2007, an estimated 150 million, or 20 percent, of the 750 million handsets produced in China were either counterfeit or off-brand phones, according to CCID Consulting, a market research firm based in Beijing. Of those, over 51 million were sold in China while the remainder were sent to foreign markets. In 2008, the volumes increased to 250 million handsets.

NYT-BOM of Chinese HandsetShanzhai cell phones look exactly like the original branded products. When a new cell phone model is released, the copy hits the market soon after. The cost of production for shanzhai phones is much lower than for the actual products. Since they are technically illegal, the shanzhai producers do not pay any taxes or regulatory fees. Since they steal intellectual property from other companies there are no research and development costs. These phones do not follow standard safety checks leading to huge savings as compared to other brands. Lastly, the complete chain of core technology is provided by MediaTek at a much lower price than the other suppliers. The end result is a really good knock-off at 1/2-1/3 of the price of the branded product. An iPhone in China goes for around 4,000 RMB compared to a little over 1,000 RMB for the Star Phone. Interestingly, the shanzhai employ a concept called the “open BOM” — they share their bill of materials and other design materials with each other, and they share any improvements made; these rules are policed by community word-of-mouth, to the extent that if someone is found cheating they are ostracized by the shanzhai ecosystem. The figure alongside gives a break-up of the cost of a Shanzhai phone (source: New York Times)

The market for Shanzhai cell phones lies not only in China, but also in the surrounding developing countries in Asia or even third world countries in Africa and Latin America. They identify overlooked/underserved market segments by incumbents like the rural areas and focus on these segments. The outstanding sales performance of Shanzhai cell phones is usually attributed to their low price, (usually lower than $50), multi-functional performance and imitations of trendy cell phone design. Although Shanzhai companies do not use branding as a marketing strategy, they are known for their flexibility of design to meet specific market needs. For example, during Barack Obama’s 2008 U.S. presidential election campaign, Shanzhai cell phone companies started selling “Obama” cell phones in Kenya, with the slogan “yes we can” and Obama’s name on the back of the cell phone. They also designed “Bird Nest” and “Fuwa” cell phones in light of the Beijing Olympic Games.

For years, most users used “shanzhai” to just mean “fake”. But the vicious rivalry among Shanzhai mobile manufacturers is shifting the industry from imitation to innovation. With more than 10,000 black market handset makers in Shenzhen alone pushing units for profits of 10 to 20 yuan ($1.5-3) apiece, low revenues and high competition means Shanzhai mobile makers must now get creative to survive. MediaTek SoC has customized 100 different modules for customer differentiation. Shanzhai phones makers are now high on innovations like dual SIM, loud music (6-8 speakers), terrestrial television and even a telescopic lens attachment for the phone’s camera.

Who gains from Shanzhai Phones?

None of the stakeholders seem to gain from these low quality phones.

Consumers: The phones are low in quality and do not necessarily follow the safety standards. Most of the times, the radiations from these phones are beyond the permissible limits and can cause serious damage to the health of the consumer. The FCC has adopted limits for safe exposure to radio frequency (RF) energy. These limits are given in terms of a unit referred to as the Specific Absorption Rate (SAR), which is a measure of the amount of radio frequency energy absorbed by the body when using a mobile phone. The FCC requires cell phone manufacturers to ensure that their phones comply with these objective limits for safe exposure. Shanzhai phones do not follow the SAR norms.

These handsets do not have proper warrantee and have a high failure rate. This means, over time the consumer may have to pay the same amount as the branded handsets or in other words, the life time value of Chinese handsets is low.

Operators: Most of the Chinese handsets have dual SIM slots and allows the consumers to put SIM cards of two different operators. This means that operators would have to share their ARPU with other operators and the competition would lead to lower ARPU and multiple SIM phenomena

Government: The Shanzhai phones do not pay any taxes of regulatory fee resulting in revenue losses to Governments across the world wherever they are sold. Even the Chinese government is in a fix now as the exports benefits given out to these handsets are over claimed. Moreover, since the Shanzhai phones do not have an IMEI number, there is an increased threat from terrorists as it is very difficult to catch a terrorist who uses a mobile handset without IMEI

I believe that the issue of Shanzhai phones is not going to go away anytime soon. Chinese government is unlikely to clamp down on these phones as it would mean many would get unemployed. The entire business is worth over $ 10 billion as year and has already gained a critical mass by capturing huge market share in emerging countries. The consumers are still attracted to the innovative phone models which is a big driver for replacement sales and as the replacement sales increases in emerging nations as well, the established brands have a lot to worry.

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