January 2, 2001 INVESTMENT THESIS
Our outlook for the wireless equipment industry is extremely robust driven by
several factors including the upcoming transition to 3G technologies as well
as the ongoing growth in wireless subscribers and minutes of use. While we
are highly confident about the industry's prospects, we believe there are
some near-term issues in 2001 that could pressure our stock universe. These
issues include timing risk, the psychological impact of a delay in NTT
DoCoMo's widely anticipated 3G launch, overly optimistic handset unit
forecasts, subscriber growth limitations in highly penetrated markets and/or
double counting of European subscribers, difficult first quarter comparisons,
revenue recognition delays, and lingering concerns over vendor financing
pressure.
Given near-term concerns and rich valuations in several stocks, we recommend
a cautious investment approach for the next several months. We currently
rate our three large wireless equipment stocks, Ericsson, Motorola, and
Nokia, all 2M (Outperform, Medium Risk) given our current handset end-market
concerns, the overhang on the technology sector, as well as specific company
and/or valuation issues related to each stock.
Ericsson
In our view, Ericsson is the clear leader in mobile infrastructure and is
extremely well-positioned to dominate 3G network awards. To date, Ericsson
has been named a supplier in 21 of 30 announced 3G contracts. However, the
company's handset business remains an enormous drain on profitability even
though mobile phones represent only 20% of revenues. In our view, Ericsson's
best option is to sell its handset division in order to better position the
company for success in 3G networks. Given the uncertainty of its recovery in
its handset business, we believe Ericsson's valuation at 71x
Motorola
Motorola recently reduced its financial estimates a second time due to
slower-than-expected gains in handset profitability as well as slowing market
conditions in its semiconductor business. Further, the company has been
losing share in mobile phones while it refocuses on profitability.
Motorola's semiconductor business is being hurt by bloated component
inventories in the company's handset unit and a slowdown in specific end
markets (autos, networking and computing). We are concerned by the
relatively few (three) pure 3G networks wins announced to date, compared to
the company's assurances of "mid single digit" 3G wins by the end of 2000.
Although Motorola's valuation is currently near historical lows in terms of
forward P/E relative to the S&P 500 (1.1x
Nokia
Nokia boasts several high points including solid management, excellent
execution, and little or no near-term competition in mobile phones.
Additionally, the company's near-term visibility for operating results is
very strong. However, 70% of Nokia's sales are derived from mobile phones
and our estimates already assume a 310 basis point market share gain and only
2% ASP (Average Selling Price) decline in 2001. Given our current concerns
about the handset market, we believe Nokia, now trading at 59x
QUALCOMM
In our view, QUALCOMM remains extremely well positioned to benefit from
strong CDMA (Code Division Multiple Access) growth as all roads in 3G are
CDMA paved. The momentum and news flow for QUALCOMM, including CDMAOne
deployment in China, relative strength in South Korea, 1XRTT deployments and
chip shipments, a strong patent portfolio, and the upcoming IPO of its ASIC
business are favorable, a trend we believe is likely to continue. Thus, we
rate the stock 1H (Buy, High Risk) on the strength of its solid long-term
outlook.
INFRASTRUCTURE ORDERS AND SALES SHOULD DRIVE NEAR-TERM OPPORTUNITIES.
Over the past several years, we have witnessed strong wireless infrastructure
growth, driven by coverage expansion, new license buildouts, and capacity
constraints. We expect continued capacity constraints driven by increasing
worldwide subscribers and minutes of use (MOUs) as well as the deployment of
data services to be one of the major drivers for future infrastructure
growth. In fact, we estimate worldwide subscribers will increase from 481
million at the end of 1999 to approximately 1.4 billion by the end of 2003,
while Dataquest estimates an increase in U.S. MOUs from 174 billion in 1999
to 372 billion in 2003.
We believe these factors will continue to propel growth for the foreseeable
future, but the main driver of incremental infrastructure sales going forward
is the migration to next-generation (2.5G and 3G) networks. In addition to
the obvious benefit of this migration to manufacturers, we believe 3G
development is unlikely to be as significant a financial or resource drain on
vendors in 2001 as originally thought. The greatest risk we see to the
infrastructure opportunity is timing. We cannot recall when the delivery of
new networks did not slip past the originally stated time frames as was the
case with the initial construction of GSM networks in Europe during the early
1990s and PCS in the U.S. during the late 1990s.
2001 P&L Impact Less Significant Resource Drain Than Originally Thought
Although a majority of wireless infrastructure sales in 2001 and 2002 are
expected to be for 2G equipment (Nokia estimates 3G revenues will represent
less than 20% of 2002 total infrastructure sales), some concern surrounds the
impact of 3G on manufacturers' P&Ls in the near term. We believe 3G
development is likely to be a less significant financial or resource drain on
the manufacturers' P&L in 2001 than originally thought. We feel working
capital constraints could potentially be a greater area of discomfort for the
vendors than large amounts of 3G-related operating expenses.
Contrary to previously held conventional wisdom that operating expenses would
become bloated in 2001 as manufacturers begin to ramp up their 3G operations,
we believe the impact to manufacturers' P&Ls is likely to be more limited to
increasing SG&A for "wartime" staffing levels in preparation for 3G rollouts.
The reason for this is the matching principle. In accounting, an expense
cannot be recognized on a company's P&L unless there are corresponding
revenues, and vice versa. Given that 3G revenue recognition is based in full
or in part on either final network completion or various acceptance criteria,
the expenses associated with manufacturing 3G infrastructure will be delayed
until the corresponding revenues can be recognized. Another reason we do not
expect 3G to have as great an impact on the manufacturers' P&Ls in 2001 as
previously thought is because there is likely to be only one 3G network
rollout this year (NTT DoCoMo). Therefore, very limited revenue and profit
recognition of 3G sales is likely.
In our view, the greater financial impact could be on the balance sheet, in
the form of working capital constraints. The impact can vary widely as each
3G contract is very different in both its terms and acceptance criteria.
More importantly, cash delivery can vary significantly from time of shipment
to completion of the contract. For example, equipment that has already been
shipped to the customer could very easily remain on the manufacturer's
balance sheet for nine to 18 months before revenues and profits are
recognized. The impact of this will be to increase inventory levels or other
short-term asset accounts and may create "lumpy" sales throughout 2002 and
2003. Any delay in the receipt of cash by the manufacturers whether related
to contract terms or any slip in achieving contract milestones will create
working capital pressure. Given revenue recognition criteria are also
spelled out differently in each contract these same delays could result in
"lumpy" revenues.
Initial 3G Margin Impact Purely a Function of Timing
Although we expect vendors' P&Ls will be minimally affected in 2001 with
respect to 3G, we do believe they could eventually feel the effect when 3G
networks begin to launch in earnest, most likely in 2002--03. The impact on
manufacturers' P&Ls will come from poor initial 3G equipment margins as well
as lumpy revenues. Given revenue recognition criteria are more conservative
for new technologies (3G) and new licensee builds (greenfield operators) than
they are for 2G equipment and incumbent operators, we believe the timing of
commercial launches is one of the greater issues surrounding 3G. Although
the poor cost structure for initial 3G equipment should, in our view,
negatively pressure manufacturer operating margins, we feel the strength in
2G equipment sales over the next couple of years should be able to partially
offset this impact.
Another area of potential margin impact for vendors are contract penalty
clauses. Penalty clauses can vary widely from contract to contract. The
triggers, or events that enact a penalty clause, can range from missed
shipments to missed deployment milestones to handset availability at the time
of commercial launch. The penalties can range from reduced pricing to
expense sharing to a delay in revenue recognition. Although it is virtually
impossible to measure, or even handicap, this impact, we believe provides an
added risk to initial 3G operating margins based on our view that there could
be manpower resource shortages for network deployments as well as the
likelihood there will be a delay in commercial volumes for 3G handsets.
We expect operating margins to improve as network deployments increase and
the second and third versions of the 3G equipment are released, usually
within 12 to 18 months after the initial deployments. The margin improvement
should result from lower component costs (i.e., the move from programmable
chips to ASICs (Application-Specific Integrated Circuits) and volume
discounts) as well as from manufacturing efficiencies from higher volumes.
3G Migration - When?
While we remain confident that the migration to 3G will occur, the chief risk
to this transition, in our view, is timing. The first 3G network to go
commercial is likely to be in Japan launched by NTT DoCoMo. The official
timing of this launch remains May 2001. However, we believe this launch date
could be jeopardized by the complexity of launching new networks and, more
importantly, handset availability. In first quarter 1997, NTT DoCoMo stated
its intention to offer 3G mobile services beginning in 2000. In 1998, the
company moved this date to spring 2001, where it still remains (in fact, the
company initially stated April 1st and has since moved the launch date to
May). While some degree of slippage should be anticipated, we believe the
stocks in our universe could react negatively to a delay since this could be
seen as a harbinger of future 3G network delays, as most initial 3G networks
are expected to be launched in 2002. NTT DoCoMo could still meet its May
goal if it were to announce commercial availability even though service may
be extremely limited. For example, there have been carriers in the past that
have advertised commercial digital service even though only 3 base stations
were operational in a market with over 300 base stations.
In addition to the assumed delays related to overly optimistic forecasts by
operators and vendors, we believe 3G launches in 2002 could face delays
related to installation and engineering shortages as well as multimode
handset availability. With so many networks slated to launch in 2002, we
believe the vendors could be caught short of enough 3G terminals as well as
personnel to build all these networks simultaneously (despite current steps
by many of the vendors to outsource installation and planning services in
preparation for 3G launches).
Iinfrastructure Market in 2001 - Conclusion
We maintain a positive outlook for wireless infrastructure growth in 2001 and
beyond. In fact, we believe the overall wireless equipment market can grow
20% per annum on average over the next several years to over $100 billion by
2004. For 2001-2002 the main driver for infrastructure sales will remain
capacity constraints on existing networks, while the main catalyst for future
growth will be the migration to next-generation (3G) networks. However, as
this migration begins, we believe one of the biggest risks to our outlook for
the overall infrastructure market is the timing of 3G deployments as this
will play an enormous role on the finacial, and subsequently stock, impact to
the wireless equipment manufacturers.
THE LEVEL OF HANDSET SALES IN 2001 REMAINS OUR CHIEF CONCERN.
The 2001 handset forecasts are settling in the range of 525--575 million
units. We question the potential upside to the low end of this forecast due
to uncertainty about the number of replacement units to be sold in 2001. In
our view, replacement sales are driven by both new technologies (e.g.,
digital, data) as well as new features (battery life, appearance, churn,
etc.). We believe new features alone cannot push replacement sales to the
levels required to reach high-end unit forecasts. Therefore the deployment
of new technologies (2.5G and 3G) as well as data services and content is
also needed to drive the acceleration of replacement sales.
However, to date, WAP services have been cumbersome due to circuit-based
connections and thin content; we do not expect wide availability of 2.5G
(GPRS and 1XRTT) networks, services and, most importantly, handsets until
late 2001. Currently there is only one GPRS phone on the market (Motorola),
and other manufacturers are still targeting mid 2001 for availability of
their models (Nokia is targeting first half 2001; Ericsson, first quarter
2001 and Samsung, early 2001). 1XRTT deployments will be limited to South
Korea in the first half of 2001 while the U.S. and Japan are expected to
deploy commercial service in the second half of the year. We feel
significant handset volumes are unlikely before the second half of 2001.
Samsung is currently the only manufacturer to announce a 1X phone, although
we believe there are currently over a dozen 1X phone designs. The relative
lack of "new technology" phones, combined with some subscriber growth
pressure in the highly penetrated Western European market, causes us some
concern over handset sales.
Replacement Sales - The Mathematics
To put a finer point on the significance of replacement sales, let us assume
that the wireless industry adds 250 million new wireless subscribers in 2001.
We currently estimate worldwide subscribers will climb from an estimated 710
million in 2000 to approximately 960 million by the end of 2001. We believe
this is a reasonable estimate given both Nokia and Ericsson's predictions
that the worldwide wireless subscriber base could reach 1 billion in the
first half of 2002.
With the number of net subscriber additions (i.e. new phones) agreed on,
then, based on total unit shipment estimates at three points in the range of
current estimates of 525 million, 550 million, and 575 million units,
replacement units must represent 52%, 55%, and 57% of total shipments.
Replacement sales for 2000 is currently estimated in the range of 40%--50%
versus prior estimates set at the beginning of 2000 of close to 60%. We
estimate replacement units represented 45% of total unit shipments in 2000.
Let's take this a step further and look at the replacement rate that is
assumed by these replacement unit volumes. We define the replacement rate as
total replacement units sold in a given year divided by the average of the
prior two years' subscriber base. The reason we take the average subscriber
base is that it is difficult to assume that the new subscribers who purchased
a handset within the last 12 months would be replacing their phones so
quickly. (Of course, it is certainly feasible that some of these subscribers
will replace their handsets this quickly. Therefore, to get a better
statistical representation, we use the average subscriber base over the prior
two years.)
For example, the final worlwide subscriber count for 2000 is likely to be 710
million, up from 481 million at the end of 1999. Thus, there are estimated
to be 229 million new handset units sold to new subscribers in 2000. It is
difficult for us to imagine that a large percentage of those 229 million
brand new users in 2000 would be purchasing a new handset in 2001. We
believe this is a reasonable assumption since an increasing amount of phones
being sold are low-end (75% of Motorola's third quarter shipments were low-
end with an estimated 90% of fourth quarter shipments low-end phones), and
this type of consumer tends to be more cost conscious.
Given the replacement estimate in 2000 is for 184 units (45% of total units),
or a replacement rate of 46%, we ask ourselves, What is a reasonable forecast
for 2001 given the relative lack of a new technology, content or service to
drive demand for new cell phones? In our view, the most optimistic forecast
is for 525 million units in 2001 as we believe a majority of the replacement
phone sales will be a result of aesthetic upgrades (i.e. new features,
lighter phone, better battery, etc.) and not a result of new technologies or
services upgrades. Therefore, it is unlikely that the replacement rate can
accelerate any further.
Industry Events That Could Offset Replacement Pressures
Obviously the two biggest risks to our handset assumptions are: (1) greater
than expected subscriber growth and (2) incorrect replacement rate
assumptions. The industry events that could offset this pressure on handsets
include stronger-than-usual carrier promotions, greater-than-expected success
of prepaid service in the U.S., a return to or higher-than-expected handset
subsidies, and a faster-than-expected uptake of WAP and 2.5G services.
However, we feel that our 2001 estimates for subscriber growth take into
account continued success from the wireless servcie providers and our handset
replacement assumptions appear extremely reasonable given our outlook for a
slower than initially anticipated take-up of 2.5G services.
Subscriber "Double Counting" a Potential Thorn in the Side
Another potential thorn in the side could be the potential for subscriber
double counting in Europe. "Double counting" refers to a subscriber counted
by two operators, even though the subscriber is usually only currently using
minutes on one operator. This happens because of the prolonged inactivity
period a customer is allowed before he or she is "churned" (disconnected from
service). Although it is difficult to pinpoint, we believe double counting
in many of the Western European countries ranges anywhere from 10% to 25% of
the subscriber base. This "problem" is caused by the tremendous success of
prepaid service in Europe. A majority of the countries do not churn an
inactive prepaid customer (i.e., one that has used all of their prepaid
minutes and has yet to purchase additional minutes) until six months of
inactivity have elapsed, while in some countries (e.g., Germany) up to 12
months of inactivity are permitted.
THERE COULD BE MORE SPEED BUMPS AHEAD DURING THE FIRST SEVERAL MONTHS OF
2001.
Although the outlook for the handset industry in 2001 is our chief concern,
there are other factors that we believe could cause some investor
apprehension. As discussed above, timing risk (NTT DoCoMo and future 3G
delays) and European subscriber growth pressure are two such concerns, but
other potential investment issues include difficult first quarter comparisons
and continued fears around vendor financing.
Tough First Quarter Comps
For most handset manufacturers, the first quarter of 2000 witnessed
unseasonably strong growth in unit volumes related largely to the component
shortages of 1999. As a result, demand spilled into the first quarter, which
is usually the weakest seasonally. Thus, the first quarter of 2001 will see
very difficult year-over-year comparisons. In our view, we are expecting to
see a more normal seasonal pattern in 2001 of up to a 15% sequential decline
in handset unit volumes, unlike the flat to up sequential pattern we saw on
the first quarter of 2000. While this return to a more normal seasonal
pattern should be expected, we believe the stocks could react negatively when
the sequential growth rates become known.
Vendor Financing - Bark Likely Bigger Than its Bite
In the wake of the high spectrum fees paid in certain European countries
(e.g. Germany and U.K.), the potential significance of vendor financing in 3G
networks has understandably increased. While Ericsson claims to have
provided virtually no, if any, vendor financing to the 21 3G customers it has
announced, there are conflicting anecdotes from European operators that
vendor pricing and financing terms are extremely competitive. It will not be
until the initial 3G frenzy has past that we will be able to measure the true
impact of vendor financing; however, we feel the conflicting information will
continue to create investor uncertainty in the near-term.
In our view, vendor financing is an integral part of the wireless
infrastructure business, and the large vendors are financially positioned to
provide financing once other options have been exhausted. However, we are
currently not of the view that the vendors will be the primary sources of
credit in 3G and believe that current financing-related concerns, while
reasonable, are largely unwarranted.
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January 3, 2001 SUMMARY
* As we published yesterday, we are bullish on wless infra
mkt driven by capacity & 3G spending & believe timing of 3G
deployments is greatest risk.
* In our view, 3G should not represent majority of revs for
vdrs until 03/04 as 2G spending remains robust & possible
3G delays push out sales.
* News article today suggesting Korea Telecom, Korea's 2nd
largest mobile operator, could push out commercial launch
past its May 02 target, is evidence of the timing risk we
discuss in our 2001 wireless equipment thesis (See our Note
of 1/2/01). SK Telecom is sticking by its May 02 goal.
* We believe 2G capacity driven spending will represent
majority of revs in 01 and 02 while 3G should add to sales
& is unlikely to represent majority of infra revs until
late 03/early 04.
* Our full 200 page report, Global Wireless Equipment
Investor "2001 3G Odyssey" should be available within a week.
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by SSB |
