Telco 2.0™ Executive Briefings

Summary: The device market has been transformed by smartphones and tablets but who do institutional investors see as the winners and losers?

This is a Guest Briefing from Arete Research, a Telco 2.0™ partner specialising in investment analysis.

The views in this article are not intended to constitute investment advice from Telco 2.0™ or STL Partners. We are reprinting Arete's Analysis to give our customers some additional insight into how some Investors see the Telecoms Market.

[Members of the Telo 2.0TM Executive Briefing Subscription Service, please see here for the full Briefing report. Non-Members, please see here for how to subscribe or email contact@telco2.net or call +44 (0) 207 247 5003.]

Device Divsions

In Handsets: Demolition Derby (Nov. '09), we said the market would grow more than anyone imagined (+14%, with consensus at ~8%), but competition would bring brutal price declines. In 1Q10, units grew 22% yoy to 332m, while 2Q10 should top 13%, on track for 1.5bn in '10 (incl. Mediatek-based vendors). The industry is entering an excellent 2H10 product cycle, but a crowded market will bring fresh lows in pricing: this forecast can already be seen in poor Nokia and LGE results (a combined 42% of '09 industry units).

As new entrants seek share gains and smartphones hit $100/€100 prices, market leader Nokia trimmed guidance twice and LG, Motorola and SonyEricsson combined lost 150bps of share, all hovering around breakeven (or in losses). Palm was sold in distress. We still expect a second-half punch-up, with lower pricing, rising units, and stubbornly low margins at many Tier Two vendors, even as Apple, RIM and HTC ramp units in a buoyant smartphone market (up 49% to 303m units). We see a bare-knuckle brawl for share coming in 4Q10.

Jabbing at Profits? Value (and profit) share is shifting: Nokia, Samsung and LG sold 60% of industry units in 1Q10, unchanged from 1Q09, but saw value share drop from 53% to 51%. RIM, HTC and Apple grew industry value share from 19% to 25% in the same period. The top three smartphone vendors should have '10E profit of $10.5bn, far ahead of the top three volume brands ($6.7bn).

Pummeling Costs. Mobile devices face relentless pressure on gross margins, with little left to squeeze out of struggling component suppliers. New models need better cameras, displays, processors and more memory. New PC-led entrants hope for 15-20% gross margins, not the 30%+ targeted by leading OEMs. We see a return of "market entry" pricing in 2H10, clouded by FX and cross-subsidies from infrastructure, services, or components.

Tablet Mania. Dozens of OEMs aim to copy Apple’s iPad, but cannot rely on carrier subsidies (which failed to support netbook sales). We see $200-300 wireless tablets becoming a major new product segment in developed and emerging markets.

Fight or Flight? A $175bn mobile device market – one of the largest tech end markets – growing 16% in '10 (or 10% excl. Apple) is bound to attract new entrants. There are simply too many me-too models: until some exit, the fight will not end.

We re-worked our global handset forecasts to fully reflect Mediatek-based vendors, early 2011 estimates, and to break out smartphones.

*Others incl. Japanese OEMs, Mediatek-based ODMs and OEMs, and PC vendors      Source: Arete Research estimates

Nowhere to Hide in the Ring

The handset market structure long had one heavyweight (Nokia) battling a clear contender (first Motorola, then Samsung) with a host of other challengers waiting in the wings. Since '08, the gap between the top two major vendors and the three legacy followers (LG, Motorola and SonyEricsson) widened. Yet volume share only tells part of the story, since two are shifting their model to smartphones. Indeed, the last two years showed a dramatic shift in industry value
and profit distribution, led by software and services platforms. We expect Apple, RIM and HTC to generate 1.8x Nokia and Samsung combined profit in '11, when they only accounted for 48% of it in '08 (see Figure 1). 

Table 2 makes clear why this industry is so attractive: it is large, and growing, even if Apple is taking the largest share of incremental sales.

Table 2: Handset Industry Sales Value

Source: Arete Research estimates

While industry value shifted towards "pure play" smartphone vendors, following this shift has not worked for everyone: Palm was struggling to boost low gross margins, limit cash burn, and clear unsold channel inventory when it was bought by HP for $1.2bn. From '05, we saw a raft of Taiwanese vendors (Asus, Acer, iMate) seek share with WinMo; they all failed. Now every vendor thinks it can find growth in smartphones: Nokia and now Samsung are responding by offering open OS devices at mid-tier price levels. 

Table 3: Smartphone Units Expected in '10 (m)

Source: Arete Research estimates, Company reports

The market mix is shifting roughly 1% per quarter towards smartphones (19% of 1Q10 units) helping to stabilise overall industry ASPs. Table 3 shows ~49% growth in smartphone units to 303m in '10; we see another 32% in '11, as low-cost Android devices add to volumes. While nearly every vendor expects smartphones to accelerate in 2H10, there will still vast disparities. Apple, RIM, and HTC collectively made more EBIT than Nokia in '09; their sales will pass Nokia's total sales in '10 (see Table 4).

Table 4: Nokia Passed by Smartphone Peers

Source: Arete Research estimates for all companies for '10E

LGE, Motorola and SonyEricsson are showing the beating legacy featurephones have taken: LG sold just 400k smartphones out of 27.1m units in 1Q10, while US$ ASPs plunged 20% yoy in two quarters to $107. Its FY10 target of 140m units looks unreachable, and it is close to breakeven from 4Q09 through 3Q10E, after 7% margins in '09. LG has yet to provide a differentiated UX/UI with its SClass (Arena) UI failing to get traction. Motorola and SonyEricsson are also transitioning from featurephones to smartphones, both trying to defend a few core geographic markets (for Motorola, N. America is ~60% of sales, for SonyEricsson, EMEA is ~50%).

Neither now pursues double-digit volume share or has achieved sustainable profit. SonyEricsson is partly phasing out its Walkman and Cybershot subbrands, but like LGE, still supports an unfeasibly wide range of platforms (WinMo, Android, Symbian and their own legacy platform) for their scale, resulting in long product cycles; while they are not ramping a fresh portfolio, their long-term fate remains unclear. Motorola has committed itself near-term to Android, though it is gradually acquiring software assets to widen its portfolio. Operators are increasingly using own-brand ODM models to fill range planning slots that had gone to featurephones from LGE, SEMC, and Motorola.

Table 5: Shifts in Share Among Leading OEMs, 1Q08 to 1Q10

Source: Arete Research estiamtes

One way to mitigate featurephone declines is to target 3G rollouts in BRIC markets. Even with China's "managed competition", operators expect rising 3G subs growth in 2H10, led by China Mobile's target of 15.5m TD subs by YE10 and 12m each at China Telecom and China Unicom. CT boosted subsidies in May, and shifted focus away from datacards, launching EVDO/WiFi phones from 2H10. Samsung, LGE and Nokia should benefit as 3G handsets (across all technology variants) see ASPs drop to $100-120. India will start to see 3G voice-centric devices ramp into 1Q11 service launches, first targeting high ARPU 2G customers. Nokia, Samsung and LG seem well-positioned to benefit from this trend, but operator-branded devices and local vendors are gaining traction. Emerging markets' 3G offers another healthy boost to volumes, but will again invite lower "market entry" pricing in pursuit of share.

The two Korean suppliers saw share rise from 23% in '08 to 28% in 1Q10, even as LG lost share and Samsung added few new models. Now, a new set of Asian suppliers are further shifting units Eastwards. ZTE sold 8.6m units (+18% yoy) while Huawei shipped 9.5m units (+41% yoy), each nearing 3% share. Together, they aim to ship 108m units in '10; if Huawei reaches 60m units it would be the 4th largest handset maker by volume (and the 7th or 8th by sales).

Both are collaborating on operator-branded devices moving from the low-end (e.g., ZTE's V125/V225 models for Vodafone's emerging markets units) to mass-market smartphones (e.g., Orange's Boston and Tactile Internet models, T-Mobile's Pulse Mini, and Vodafone's new Huawei 845). Huawei and ZTE have cleartraction with operators for €100-150 own-brand smartphones. The implications for leading OEMs like Nokia are clear (see Nokia: Icebergs Ahoy!, June '10).

To read the rest of the report, covering...

• Android, Mediatek: Jabbing Away
• Ducking Margin Pressure
• Bobbing and Weaving: New Business Models
• Coming Next; TKOs

 ...Members of the Telco 2.0^TM Executive Briefing Subscription Service can access the full item here. Non-Members, please see here for how to subscribe, or email contact@telco2.net or call +44 (0) 207 247 5003.