Equity Watch: New Connections

Mobile phone handset makers are in the trough right now. But take my advice: I'd avoid bottom fishing the usual big names Nokia, Motorola and Sony Ericsson. If you want to profitably play the handset maker game, you'd be better off buying shares of Apple and Research In Motion (RIM). Yes, shares of Apple and RIM are more richly priced. And, sure, Apple, with its iPhone, had only a 0.6-percent share

Mobile phone handset makers are in the trough right now. But take my advice: I'd avoid bottom fishing the usual big names — Nokia, Motorola and Sony Ericsson. If you want to profitably play the handset maker game, you'd be better off buying shares of Apple and Research In Motion (RIM). Yes, shares of Apple and RIM are more richly priced. And, sure, Apple, with its iPhone, had only a 0.6-percent share of the mobile handset market in the first quarter, and RIM, with its BlackBerry, had just a 1.5 percent slice (although, at times, it seems that everyone is carrying a BlackBerry). But Apple and RIM's impact both financially and strategically on their competitors has already been profound. And it is growing: Consider that Apple's recently released 3G iPhone is expected to sell 40 million units, making it the new blockbuster.

While everyone on Wall Street, and every pundit, was focused on the so called “living room convergence” of the TV and the PC, a funny thing happened: RIM and Apple realized that the public was ready for this convergence to happen in the palms of their hands. RIM's devices have made 24-hour slaves of white collar office workers, seamlessly linking the work PC to the cell phone, and making remote email access an addiction (hence the CrackBerry jokes). Apple has brought its usual panache to the cell phone by integrating an mp3 player with a mobile phone, email and global positioning device. (Oh, the iPhone and BlackBerry handsets are cool, too.) The convergence of these functions onto one handheld device, well, it demands an expertise that seems to have eluded old-line phone makers such as Nokia and Motorola.

Bumming In Schaumburg, Fuming In Finland

The real secret to a handset maker's success is in the software, not the hardware. Making products easy to use is what makes them ready for widespread consumer adoption. What Apple and RIM have done is written easy-to-use consumer “front end” software, and laboriously produced “back end” server applications that blend their platforms with pre-existing networks in a seamless and secure fashion. This has made their devices an easy sell for both consumers and IT managers.

And this is where Nokia and Motorola will be unable to keep up. Nokia's strength has always been its preeminence as a global low-cost manufacturer — the Dell Computer, if you will — of the cell phone world. By keeping software features standard across devices, and by focusing on supply chain management and competent if uninspired design, Nokia has produced reliable, work-a-day phones that, alas, lack sexiness. And sexiness is what sells at the high end, whether via new features or a compelling design.

But the focus on cost and reliability renders Nokia a slave to low-cost manufacturing at the cost of innovation. Nokia seeks to minimize software functionality, and refuses to chase changes in consumer taste (for example, Nokia was late to the “clamshell” design). Nokia's operating margins have fallen — even as their sales and market share have remained stable — because Nokia has become the default provider of low-end phones to the emerging world, rather than the supplier of high-end products to affluent consumers in the North American, Asian and European markets.

Nokia's strength is serving it well in emerging markets (China, India, Indonesia, etc.), which is where the growth is. Nokia's share in these geographies ranges from 41 percent to 55 percent, giving it a number one ranking in all of them. However, there is an obvious problem: While there are a billion people in China and a billion people in India, they certainly can't all afford expensive cell phones.

Nokia is trying to fight back: It recently purchased the remaining part of Symbian, a mobile phone software company, that it did not already own, and announced its intention to make the Symbian operating system available to other cell phone makers. That is the right move in theory — to establish the software as an industry standard. But the practice is likely to prove problematic, because companies generally don't like to buy vital parts of their products from competitors. Even RIM's efforts to license its software have been plagued by lack of adoption, for this reason, and RIM's products are far more established. Symbian's ability to deliver the server functions that RIM has mastered has yet to be established, and IT departments will be unwilling to endorse the software until it has made this readily apparent — not an easy task.

Over in Schaumburg, Illinois, Motorola's occasional success, in contrast, has been driven by hardware innovation and handset design. Both the StarTac- and the Razr-based platforms were hugely successful over the last 10 years, because they were splashy devices that redefined size and style in the cell phone market. But these advantages were short lived, as other manufacturers raced to copy their innovations. Motorola's attempt to extend the Razr platform with other devices, such as the Rokr, has been unsuccessful, and the inevitable discounting of the mature Razr has crushed margins and sales projections.

Consumers in industrial countries have always been willing to pay up for style and new features. Today, consumers want a mobile that can get email and play mp3s. The two phone giants now offer these features, but Motorola's phones have been notoriously difficult to use, while Nokia has relied too long on a common and prosaic software platform.

Motorola's problems are likely to get even worse, as it has thus far maintained its average selling price (ASP) while losing share. This is a losing battle, and when ASPs follow market share lower, the cell phone business will be hemorrhaging even more money. Motorola's past success has rested on innovations in its clamshell design, as well as strong aesthetic appeal. The new smart phones don't use clamshell forms, and the design teams responsible for the success of the Razr have splintered. This unit seems almost hopeless to me, and despite Carl Icahn's hopes (he has purchased about $1.75 billion shares worth only to watch the value of his holding get nearly wiped out), it is not impossible to imagine Motorola exiting the cell phone business entirely.

Given these trends, RIM and Apple have built themselves hard-to-beat wireless franchises — well, so far. Without dramatic changes, look for both companies to continue taking share and crushing the established OEMs' margins over the next 24 months, forcing Motorola out of the cell phone business and reducing Nokia to a low-cost provider of commodity phones to the emerging markets.


Nate Wendler is the nom de plume of an analyst at a hedge fund managing approximately $1 billion.

TALE OF THE TAPE

Apple and Research In Motion are attacking the mobile handset leaders Motorola and Nokia — and scoring.

Ticker mkt.- 12-mth return Operating margin most recent quarter Operating margin 12-mths ago Handset mkt.- Share Handphone mkt.- Share
AAPL 8.8 18.7 (06/08) 19.24 (06/07) 0.6 5
RIMM 59.5 28.8 (05/08) 26.2 (06/07) 1.5 13
MOT -58.4 (3.6) (03/08) (3.9) (03/07) 9.3 6
NOK -0.34 11.2 (06/08) 18.74 (06/07) 39.3 43
Source: company reports, Nate Wendler
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