Is Apple's China Mobile deal overhyped?

Investors have been looking forward to this deal for years, as China Mobile is the largest wireless carrier in the world, with more than 750 million subscribers

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In the last few weeks, it's become common knowledge that Apple (NASDAQ: AAPL  ) is finally on the verge of making the iPhone available through China Mobile (NYSE: CHL  ) . Investors have been looking forward to this deal for years, as China Mobile is the largest wireless carrier in the world, with more than 750 million subscribers!

China Mobile will soon start selling Apple's new iPhone 5s.

However, at least one analyst — Scott Craig of Merrill Lynch — thinks that the Apple-China Mobile partnership isn't such a big deal. In fact, he thinks the incremental opportunity for iPhone sales may be fewer than 10 million units annually.

Craig may be on to something: Some Apple bulls are overlooking the fact that there are already a lot of iPhones running on China Mobile's network. However, a short-term spike in iPhone sales is still likely, as current iPhone users on China Mobile will be able to upgrade from 2G to 4G speeds overnight. Moreover, China Mobile represents a significant long-term opportunity for Apple, as it can become a first mover for LTE-equipped smartphones in the Chinese market.

Factors to consider
The iPhone is expected to arrive on China Mobile's network next week, at the same time that the carrier starts 4G service under the TD-LTE standard. One of the biggest stumbling blocks to an Apple-China Mobile deal in the past was the incompatibility of China Mobile's 3G network with most other wireless networks. Apple never built an iPhone that worked on China Mobile's 3G network.

The upgrade to 4G will drastically increase the iPhone's appeal for China Mobile subscribers. There may be as many as 42 million people already using unlocked iPhones on China Mobile, but they are restricted to slow 2G data speeds. However, the 4G network won't be turned on everywhere at once: The initial rollout will be limited to Beijing, Guangzhou, and Chongqing. (The city of Shanghai is building its own 4G network that will be ready at a later date.)

These megacities account for tens of millions of China Mobile subscribers, and are relatively wealthy compared to the rest of the country. Still, only a small fraction of China Mobile's subscriber base will have 4G service anytime soon. For most people, buying an iPhone through China Mobile will still mean suffering through 2G data speeds.

Handicapping iPhone sales
Most of Apple's China Mobile iPhone sales will go to two different groups. First, there are perhaps 42 million people already using iPhones on China Mobile's 2G network. Those who are in the initial TD-LTE rollout cities are likely to upgrade to the new iPhones as soon as possible, in order to get faster data speeds.

Second, there are wealthy Chinese consumers who are already on China Mobile's 3G network and will want to move to 4G as soon as it is available. Since those subscribers are by definition using other platforms today (primarily Android), Apple may only get a small percentage of those users. Still, the absolute numbers could be significant (China Mobile currently has about 176 million 3G subscribers).

Summing this up, several tech analysts have suggested that Apple could potentially sell 20 million-25 million iPhones in the first year of an agreement with China Mobile. That number seems fairly reasonable given the scope of the initial 4G rollout.

However, as the Merrill Lynch analysts are quick to point out, not all of these sales will be incremental. Indeed, if there are really 42 million iPhones running on China Mobile's network today, it suggests that China Mobile users have already been activating iPhones at a rate of at least 10 million-15 million annually.

Some of these may be used iPhones that were resold to China, but others were bought factory unlocked in China, or were purchased in other countries and then shipped to China. By offering the iPhone directly, China Mobile will cannibalize these other sales channels. As a result, even if China Mobile activates 20-million-plus iPhones in the next year, the net increase in Apple's global iPhone sales could still be 10 million or less.

The real opportunity
Thus, while there may be an initial spike in demand for the new iPhones from China Mobile users looking to upgrade, beyond that, many of the phones sold through China Mobile will just cannibalize gray market sales. The real opportunity for Apple with China Mobile is longer-term in nature, and the Merrill Lynch team overlooks this growth driver.

First, China's economy is growing rapidly. As a result, premium smartphones like the iPhone will become affordable to an increasing cross-section of Chinese consumers over the next decade.

Second, the LTE-enabled iPhone 5c is likely to see a big price drop next year, making it more appealing to members of China's middle class. The iPhone 4S — which sits just below the 5c in Apple's current pricing scheme — is almost US$200 cheaper in China today. (The iPhone 4 is in turn more than US$100 cheaper than the 4S.)

The iPhone 5c could become a popular midrange phone if Apple cuts its price next year. Photo: Apple.

While Apple will never join the race to build smartphones priced at less than $200 unlocked, a cheaper 5c on China Mobile could be a powerful weapon, particularly if paired with a significant carrier subsidy. An iPhone 5c price drop is likely to occur when Apple unveils its next-generation iPhone in 2014.

Lastly, next year's expected "iPhone 6" is likely to sport a larger screen, according to numerous media reports. Large-screen phones (many of which have 5- or even 6"-inch screens) have become quite popular in China recently. Apple's entry into this market segment could make the iPhone more popular with China Mobile customers looking to upgrade from 3G Android phones.

Foolish bottom line
Scott Craig and his team at Merrill Lynch are correctly cautioning investors that many of the iPhones that will be sold on China Mobile in the next year would have been sold anyway, through gray market channels. There will probably be a brief surge in sales to iPhone loyalists looking to upgrade to 4G speeds, but after that, growth may recede.

Nevertheless, the long-term opportunity at China Mobile is massive. Over time, Apple will probably broaden the iPhone product line, while the iPhone 5c will become the entry-level phone many Apple watchers expected from day one. Meanwhile, the growth of China's middle class will move many China Mobile subscribers into Apple's addressable market. This will provide years of solid growth for the iPhone in China.

A version of this article, written by  Adam Levine-Weinberg, originally appeared on fool.com.

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