Gray-Market Cell Phones Impacted by Chinese Government Investigation

Shipments will fall 25 percent in June.

A Chinese government crackdown will cause shipments of gray-market cell phones to decline in June and result in shipments falling short of iSuppli Corp.�s previous forecast for the year 2010.

Total shipments of gray-market cell phones manufactured in China, which are not recognized or licensed by government regulators, are expected to fall 25 percent in June compared to the previous month in May. iSuppli predicts gray market cell phone unit shipments will amount to 172 million in 2010. While this is up 18.6 percent from 145 million in 2009, this represents a significant decline in the growth rate from the 43.6 percent expansion in 2009.

Gray market phones not only employ fake International Mobile Equipment Identity (IMEI) numbers�which are used by wireless networks to identify valid devices�but also do not carry test/quality certifications or network entry permits. The makers of these products profit illegally by generally not paying value-added taxes to the government.

Shadows Fall on Gray Market
In early June, Hualong Trade Co, Ltd., a Chinese handset EMS company located in the city of Suzhou in eastern China, was investigated by Chinese Customs for suspicion of smuggling and manufacturing counterfeit handsets. The initial investigation was followed by more inquiries from the Chinese Tax Bureau and Administrative Bureau of Industry and Commerce into Hualong�s clients, including Independent Design Houses (IDH) for handsets and gray-market cell phone manufacturers.

Likewise, numerous IDH firms in Shanghai now are under investigation for allegedly being employed by Hualong to build primary boards and assembly products. Finally, the investigations have snared a number of firms�which have turned out to be investors of Hualong�as well as several gray-market cell phone suppliers for their supposed ties to Hualong.

Meanwhile, in the North Huaqiang area of the city, regulators have started looking into the the distribution centers of so-called Shanzhai phones�or Chinese imitation and pirated brands and goods.

Collectively, these developments indicate that the Chinese government is beginning to take seriously the long-festering problem of smuggled handsets and counterfeit handsets, a thorny issue that not only undercuts the government�s profits but also tarnishes China�s image abroad. As a result, iSuppli believes that the gray handset market will be greatly affected by the government investigation.

Impact Could be Felt Worldwide
While local governments have tried for years to defeat the sale and manufacturing of counterfeit cell phone and smuggling, such a large investigation by the Chinese government caught many by surprise.

Given that thousands of handset system integrators purchase handset solutions from Chinese design houses and sell the products both in China and around the world, it is possible that the effects of the investigation could carry over and be felt globally. Typically, these companies are attracted by the higher margins of the counterfeit and illegal products, while some evade the 17 percent Value-Added Tax (VAT) through smuggling.

Winners and Losers
While the investigations are likely to put a crimp on illegal handset manufacturing activity, a number of legitimate Chinese handset OEMs stand to reap benefits�including companies such as Tianyu Technology, OPPO Electronics Corp., BBK Communication Tech, and the Chinese giants Huawei Technologies and ZTE Corp. And with the competition from gray handset makers easing in the next two months, global OEMs like Nokia Corp. will also benefit from the Chinese government�s moves to defeat counterfeit products and their makers.

A possible downside to the crackdown might be that smaller design houses end up not surviving in the marketplace, unable to compete effectively with China�s leading design houses, such as Wingtech Group and Longcheer Holdings. With gray handsets trimmed and competition reduced, the leading design houses are likely to become even more dominant, sweeping away the minor players in the process.

Semiconductor supplier MediaTek Inc., a leading fab based in Taiwan, may also find itself on the losing end of the investigations. It is likely the company will see its baseband Integrated Circuit (IC) shipments fall to 30 million units in June, down from 40 million units in May. At present, the company owns more than 80 percent market share of baseband units for gray handsets in China, and its MT6223 chip�the most popular platform for gray handsets�is currently short on supply.