Technology

Booming Gray Market Threatens Cell-Phone Industry


The iPhone's official carrier in China is enduring meager sales, just one result of the expansion of the global market for copycat handsets

Gray is the new black. Just as trafficking in black market goods has eroded sales of consumer electronics, a burgeoning "gray" market for cheap look-alike cell phones now threatens the wireless handset industry. Just ask the folks at China Unicom and Apple (AAPL). When China Unicom recently began offering Apple's iPhone for as much as $1,172, the company sold a measly 5,000 units its first weekend, according to Reuters. By contrast, when the iPhone 3GS was released in the U.S. earlier this year, it sold more than 1 million units in its first weekend. At full price, the phone flopped. Part of the reason is that since 2007, the Chinese market has been flooded with iPhones sold in other countries and then modified, or "unlocked" so they work on other networks, before being sold for as little as $650. In other cases, Chinese consumers had already purchased low-priced, repurposed used phones. But much of the blame lies with a burgeoning gray market for copycat phones, often made to look like the real thing but sold for a fraction of the price. "Anyone who'd buy an iPhone from China Unicom is insane," says Charlie Wolf, senior analyst at Needham. Fewer than 5% of Chinese can afford China Unicom's iPhones, says Neil Mawston, an analyst at consultant Strategy Analytics. Knockoffs Make Up 13% of Handsets

Lackluster iPhone sales dealt a blow to China Unicom, which hoped the iPhone would boost subscriber growth the way it helped AT&T (T), the exclusive U.S. iPhone provider. It was also bad news for Apple as it tries to forge ties to wireless carriers in new countries, beyond the 64 where the iPhone is already sold. The gray market extends well beyond China, however. In Africa, Eastern Europe, Latin America, and even the U.S., handset clones are on the march. Gray market phones may resemble the real thing but don't carry warranties, and their makers often don't pay licensing fees to such component makers as Qualcomm (QCOM). Gray market phone shipments from China are up 43.6%, to 145 million units, this year, according to estimates by consultant iSuppli. They now constitute 13% of the global legal handset supply. In contrast, worldwide unit shipments of legitimate cell phones will decline 8% this year. Many knockoffs are made in small factories across Asia. "You have all these little workshops, and they do some extremely creative things" to adapt phones to local markets, says Frank Meehan, CEO of cell phone maker INQ, which supplies carriers such as Hutchison Whampoa. "There are hundreds of them [in China], and they are springing up in India." In the coming years, some smaller workshops could morph into larger enterprises turning out legitimate goods and competing with Nokia (NOK), Apple, and Samsung. "What's going to happen is, as these players develop the expertise, some of these players will start to enter the legal market," says Jagdish Rebello, senior director at iSuppli. "Legal handset manufacturers are extremely concerned." Pickup in Sales of Used Phones

Some gray market handsets carry names similar to the mainstream brands but often don't work as well. "We discourage the use of phones acquired through unknown channels for a very simple reason: doing so may ultimately saddle the consumer with an incomplete experience and raise the possibility that what they are buying through gray markets is not a genuine Motorola product," Motorola (MOT) said in a statement. Apple and China Unicom didn't respond to requests for comment. In another trend that may erode revenue for handset manufacturers, sales of used phones have picked up as well. At CellularCountry.com, sales are up 3% to 5% this year, says CEO Doug Morgen. In fact, the Huntington Beach (Calif.) site, which currently sells 10,000 phones a month, is looking to open physical stores in California and Europe in the next six to 12 months. "Business is good," Morgen says. "People are starting to buy more used; they need to cut their bills." To combat all these players, handset manufacturers have long tried suing gray market phone makers and various distributors. Others are starting to pressure component suppliers, such as MediaTek, believed by analysts to supply gray market phone makers. MediaTek did not return a request for comment. But mainstream manufacturers and carriers may need to adapt their strategies to this changing marketplace instead and strive for agility, lower prices, and product innovation. "It's very hard to fight it in courts," INQ's Meehan says. "They just need to get leaner and meaner. Look, it's just competition at the end of the day."

Kharif is a reporter for Bloomberg Businessweek in Portland, Ore.

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