In the “push” era—up to about 2005—people just wanted a phone, and there were few choices of brands and technology. Consumers basically bought a famous brand and went home. If it was not exactly shooting fish in a barrel, it was about that simple. The retail situation was relatively straightforward; the key was to get consumers to see your product and then to execute at the point of sale.

But with the introduction of the smartphone and the emergence of major new brands into the market—think Apple, Samsung and LG, as well as local players such as Oppo—phone makers began to have to pull consumers in. The cycle time between purchases has also shortened, putting a premium on brand loyalty.

Retail conditions on the ground are also changing, in particular the way that people buy their handsets. In 2008, as much as 71% of handset sales were sold at fragmented retailers such as small telecom store chains or independent and small mom-and-pop electronics stores. By 2014, we estimate that these channels, at most, will account for less than half. Who is likely to pick up market

share? Operator stores, consumer electronic stores, and—fastest of all—e-commerce.

Let’s take a look at each of these.

Operator stores: Once upon a time, there were numerous operators in China, fragmented across regions; even a mid-size city had its own local operator. In recent

years, though, the government has forced consolidation, reducing the domestic field to three major players—China Mobile, China Telecom and China Unicom. Since the release of 3G licenses in 2008, operators’ influence on the retail handset market has risen sharply. And that does not look likely to change.

Ringing the changes: The dynamics of China’s mobile phone market

Consumer and Shopper InsightsJanuary 2012

By Daniel Hui and Fang Gong

SOURCE: McKinsey internal analysis; SinoMR; CCID; Gartner; Euromonitor; Strategic analytics; GFK; annual reports; expert interviews

100%

Consumer Electronics Stores (CES)

22-26

3-5

10

189

14-18

Online B2C2

Online C2C

Large Telecom Store Chains

Independent / Small Chain Stores

Branded standalone stores

14E

297

18-22

18-22

8-106-8

20-24

27-31

36-40

2-3

1-3 4-6

24-28

34-38

3-5

2008

13-17

10-15

12-160 3-5

Operator stores3

154

1 Total market size is from GFK. GFK does not have complete store and geographic coverage and misses approximately 15-25% of the market2 Includes Gome and Suning Online, store-less B2C (e.g., 360buy) and B2C market place (e.g., Tmall)3 Does not include bundles sold through open channels4 Standalone stores or chains with less than 5 locations5 Chains with 5 or more locations

Mn Units, %

China handset retail channel split1

Exhibit 1:Where the sales are

From push to pull: That, in a phrase, defines the evolution of China’s mobile phone retail market.

Through policies and subsidies, the government is pushing a high subscription target (100 million for China Mobile by 2012) combined with strong push on 3G technology. This puts Chinese operators in a strong position, and they are using it to expand their presence into other channels, such as by opening counters in consumer electronics stores (CEs).

Subsidy strategies are designed to nudge customers to move from basic phones to data-enabled smartphones. We expect the level of subsidy to fall, however, as Android and other smartphone prices drop and get closer to basic handset prices. Lower subsidies will create a more competitive environment for non-Chinese firms. Also, if China implements number portability, customers will likely change operators more often; as the rate of “churning” increases, subsidies become less effective, and new entrants have more room to maneuver.

As one executive from China Mobile told us, “The growth of operators is an irreversible trend. It is only a matter of time before operators drive handset retail.” A rival from Motorola agreed:

“I believe that in less than five years, operators will be the main handset retail format in China, like the US.”

We believe operators will approach a 40%-plus share of the total mobile handset market by 2014, up from 24% in 2008. To succeed, phone-makers will have to think about two things: 1) how to continuously make killer products that can help it maintain bargaining power against operators; and 2) how to find new revenue streams that could compensate for the potential loss on phone sales.

Consumer electronic stores: Right now consumer electronics stores (CEs) account for only 29% of the mobile phone market in China, compared to 55% in the

US and 72% in Japan. That is changing—fast—for two reasons.

First, there is the rise of the hinterland. China’s cities can be divided into tiers. The top two tiers comprise the richest cities (ie, Beijing, Shanghai, Guangzhou) and those at the next level (ie, Chengdu, Wuhan, Nanjing). Tiers 3 and 4 are smaller and less prosperous; and CE stores there account for only a small fraction (perhaps 6%) of the mobile market.

CE stores will gain share by enlarging their footprint into lower-tier cities. Indeed, this is already happening. Before 2009, for example, Chinese retail giants Gome and Suning found that their stores in low-tier cities were generally unprofitable. In recent years, both improved their supply chains and developed store formats specifically designed for lower-tier markets. They have been able to create sustainable economics for larger scale growth. In fact, about 60% of new store growth in past two years for these two giants have been from low tier cities already. The opportunity is huge and we can expect they continue their aggressive expansion..

The second reason CEs are likely to win more market share is that digital product categories are not only growing, but growing more profitable. Digital products have traditionally been low-margin category, but in the last couple of years, the profit margin on mobile products has risen by a third (from 7.5% to 10%). At the same time, “3C” products (mobiles, computers, etc) amount to only 28% of the Gome / Suning portfolio, compared to 40%+ for their global peers such as Best Buy in the US. In terms of the overall market,we believe the 3C category will account for as much as 60% of future growth. Gome and Suning are therefore adapting their strategy to suit, increasing the selling space for 3C products and attempting to cut exclusive deals with

different brands. As Gome noted in its annual report, “3C products are becoming our focus. We have set up 3C business center to dedicate on further expansion.”

For foreign electronics retailers, though, it may be difficult to tap into these trends; they are all encountering difficulty, in large part because Gome and Suning are already far ahead, and are both ramping up in a very big way. They already account for about 30% of the mobile phone market—and are not finished yet. The duopoly is expected to have 5,000 stores by 2014, double their current figure. With that kind of scale, they will be in position to set industry standards and to create even stronger, higher barriers for the competition. Best Buy, for example, has retreated from the China market; though it continues to operate under the Five Star brand, expansion plans are limited. Yamada and Media Markt have opened only a handful of stores and plan a slow and steady expansion. They are unlikely to become competitive in next few years. Other retailers are either fragmented or regionally based, such as Shundian in Shenzhen and Wanbao in Kaifeng.

For phone makers, a weak retail presence has many consequences. Consumers, for example, routinely visit CEs to check out the merchandise even if they buy elsewhere. Brands who are not on display, then, are at a serious disadvantage in terms of finding and serving their customer base.

E-commerce, particularly business-to-consumer transactions, is likely to prove more promising. Until recently, while the technology was there, Internet penetration was relatively low, and limited to higher-tier cities with strong e-commerce players and logistics support. With the emergence of strong consumer-to-consumer platforms, Chinese shoppers have been educated into how to buy online, and are increasingly comfortable doing so.

A number of factors are encouraging the growth of e-commerce as a channel for mobile phones. First, the current operator subsidy level is low (due to competition from lower price point mobiles), consumer intention to buy mobile phones directly from operators declining. Therefore more people are prepared to buy a new phone online and simply put in their existing SIM cards. Second, the emergence of Taobao (China’s Amazon) as an online platform has educated consumers on e-commerce. They are increasingly used to buying items online, and feeling secure about doing so. An online electronics specialist like 360Buy.com has ridden this trend extremely successfully. The missing piece is logistics. E-commerce so far has focused on Tier 1 and 2 cities, where deliveries are speedy and reliable (360Buy, for example, can deliver a phone in one day). In lower-tier cities, where logistics are less reliable, bricks-and-mortar stores have the advantage—for now.

We estimate e-commerce sales could triple, to 1.2 trillion RMB, by 2014. By then, Internet penetration will have crossed the 50% threshold and there will be 270 million online shoppers. As a result, e-commerce should account for at least 15% of total mobile phone retail sales by 2014 and could reach as much as 20%.

Again, it is the local players who are adapting fastest. Taobao, China’s biggest online player by far, has aggressive growth plans, including introducing their own last-leg delivery teams and pick-up centers in key cities. Meanwhile, 360buy.com has raised $1.5 billion and plans to invest a large chunk of that in dozens of new distribution centers. Still, the barriers to entry to e-commerce are lower than in the CE store channel, and outside

firms at least have a chance to make a dent in the market.

E-commerce has always been a headache for phone makers. On the one hand, they are cautious about supplying phones to online players, as the price transparency will seriously affect their pricing capability in other channels that currently still take ~95% of their sales. On the other hand, they cannot ignore the growing importance of e-commerce—and online players can get the products they want even without direct supply from phone makers (for example, from different tiers of distributors). In short, phone-makers will simply have to deal with e-commerce. To do so, many have set up a dedicated online team to design strategy and policy.

Add it all up, then, and these three channels—operators, CE stores and e-commerce—are likely to grow to as much as two-thirds of total handset retail sales by 2014. And that is in the context of

a growing and still-fragmented market. For retailers, the landscape is pretty much set—we know who the operators and e-commerce players are likely to be. The bigger question has to do with the phone-makers. Given the increasing importance of on-the-ground execution, they will need to raise their game in terms of developing better relationships with CEs, operators and online players. In short, not only do they have to continue to make cool phones, they need to do better at marketing and selling them. That is what it means to go from push to pull.

http://csi.mckinsey.com

Daniel Hui is an associate principal in McKinsey’s Hong Kong office. Fang Gong is an engagement manager in Shanghai.

10816

0200400600800

1,0001,2001,400

China E-commerce market and its year-on-year growth1

SOURCE: Macquarie research; Forrester; iResearch; Euromonitor; team analysis

1 Using total trading volume announced by Taobao as an estimate of total market value, every year market reduces Taobao’s total market value by 20%-25%, deducts inflated trading volume, transferred funds, wholesale and other trades not incorporated in retail; meanwhile, adopting bottom-up approach, conduct verification by means of 2009 and 2010 total market value of sub-category

Reach US 2004 level

2010

+33% p.a.

+90% p.a.

2014

1200-1300

~400

20082005

Exhibit 2:E-commerce on the rise

Billion RMB, %