Price Erosion>
Nordic Handset Makers Face Price Erosion
By Carolyn Whelan
GENEVA -- The new Millennium is almost upon us, yet we've only scratched
the surface of mobile phone penetration in much of the world.
That could change quickly as mobile devices add
more and more features, like data communications
and enhanced Internet connections. And as growth in
regular phone service slows, service providers are looking to wireless for new
revenue streams.
That would seem to be good news for manufacturers of wireless handsets,
who are bound to see increased demand for their products. Two market
leaders, Nokia and LM Ericsson, are in particularly strong positions in this
area -- Nokia gets 60% of its revenues from handset sales, while Ericsson
gets a healthy 23%, and wants more. (The largest U.S. manufacturer,
Motorola, gets about a third of its total revenues from wireless
communications products.)
But the consolidation that's sweeping
the global telecommunications market,
heralded by such recent business
combinations as Vodafone and
Airtouch and MCI WorldCom and
Sprint (see Weekday Trader,
"Free-For-All Begins for Euro
Telecoms," October 12) threatens to
change the balance of power on the
equipment side as well.
These days, stronger telecom carriers
have much more clout to extract big concessions from leading manufacturers.
Their enhanced buying power, along with rapid developments in technology,
could lead to serious price erosion in wireless handsets soon.
"The big OEMs (original equipment manufacturers) ruled over hundreds of
cellular operators [and] decided what technology would be available, when
and at what price," explains Pete Peterson, an analyst with Volpe, Brown and
Whelan.
But no longer. As near-monopolies
develop among the carriers, they can,
collectively, demand higher volumes of
handsets at lower prices, he says,
thereby slashing margins.
"The cellular phone business is going to
be more and more commoditized --
and it's going to be a volume deal," says
Thomas Mengel, a fund manager at
Waddell & Reed, who believes such a
development could occur within two
years.
We may be seeing some price erosion already: Some wireless carriers are
giving handsets away, and a panel of service providers here at Telecom '99
showed little inclination to make big capital investments in advanced
data-communications services, which offer higher margins for manufacturers.
That doesn't bode too well for Sweden's Ericsson and Finland's high-flying
Nokia, both of whose stocks are near their all-time highs. It's even worse
news for those who are playing catch-up.
"Some of the second-tier manufacturers like Siemens and Alcatel will have a
tougher time to compete with the big boys," says Mengel.
As for Ericsson, an emerging price war in handsets would be a setback for its
much-touted "turnaround." In fact, some analysts say the Swedish
manufacturer still faces major challenges.
"The word 'turnaround' might be a little premature," says Peterson.
"It's like waiting for Godot," adds Alex Cena, an analyst with Solomon Smith
Barney.
Ericsson has been treading water in fixed line gear and handsets, and Ericsson
expects a slowdown in orders from China, whose economy is weak. Nearly a
quarter of Ericsson's sales originate in Asia.
And then there's the technology. "They have problems building out their
infrastructure equipment in a timely manner with the latest technologies,"
Peterson says. Ericsson also has a large proportion of older voice
telecommunications products that are under pricing pressure. "Companies
need a data capability -- that's where the growth is," says Mengel.
Sums up Peterson: "Ericsson's market strength will be of smaller and smaller
relevance as we move forward. It's a race against time to find the formula of
management and product that allows them to regain their former glory."
Cena flatly predicts "there'll be another round of estimate cuts."
At Monday's closing price of 33 5/16, Ericsson's ADRs are hovering near
their highs and change hands at a lofty 50x expected 1999 earnings of 66
cents, according to First Call, and at 33x the $1.01 the company is expected
to earn in 2000. Both are big premiums to its projected 20% long-term annual
earnings growth rate.
When asked here about possible declines in handset margins, Ericsson's
President Kurt Hellstrom said the company is focusing on managing costs and
developing new markets, but provided few specifics.
Some investors even worry about market leader Nokia. "They've had a 'free
run,' since few new viable products have emerged from others," says Susan
Anthony, an analyst at Credit Lyonnais Securities. "They'll find tougher
competition" from the likes of an Ericsson, Motorola, or Siemens, she says,
making Nokia more "vulnerable."
Lauri Kivinen, a spokesman for Nokia, doesn't agree that handset
commoditization is inevitable. "The number of operators are much larger than
the number of carriers," he told Barron's Online, and he expects subscriber
growth to explode. "But what is [around] the corner I cannot speculate or
comment on," he said.
Maybe not, but if the company stumbles or price pressures escalate, Nokia
shares could be hit hard. "The stock is priced for perfection," says Anthony.
That's why Cena is neutral on both Nokia and Ericcson. "I'm concerned
about margins for Nokia, while the stock's going up," he says. ""I worry about
their earnings estimates."
"Nokia is not cheap," says Mengel. That's for sure. At Thursday's closing
price of 95 3/8, Nokia is close to its high, and has a lofty P/E of around 85x
the $1.11 it is expected to earn in its 1999 fiscal year closing in July and about
45x expected 2000 earnings of $2.13. Those are huge premiums to its 21%
long-term projected annual earnings growth rate.
These companies have surprised people before -- and they can again. A new
CEO at Ericsson could try to fix problem areas and focus the company more
on data communications. (Qualcomm is offloading its handset business, while
Siemens is moving away from equipment, too) Meanwhile, working together
with 3Com, Nokia is moving into the smart phone area. And wireless data
communications could take off faster than people expect, creating a new
source of revenues.
But as power shifts to the service providers, manufacturers will find it harder
to push more of those new revenues to their bottom lines -- and that can't be
good news for these stocks.
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