Globally, telcos are pursuing a wide variety of strategies in the consumer market, ranging from broad competition with the major Internet platforms to a narrow focus on delivering connectivity.
Some telcos, such as Orange France, Telefónica Spain, Reliance Jio and Rakuten Mobile, are combining connectivity with an array of services, such as messaging, entertainment, smart home, financial services and digital health propositions. Others, such as Three UK, focus almost entirely on delivering connectivity, while many sit somewhere in between, targeting a single vertical market, in addition to connectivity. AT&T is entertainment-orientated, while Safaricom is financial services-focused.
This report analyses the consumer strategies of the leading telcos in the UK and the Brazil – two very different markets. Whereas the UK is a densely populated, English-speaking country, Brazil has a highly-dispersed population that speaks Portuguese, making the barriers to entry higher for multinational telecoms and content companies.
By examining these two telecoms markets in detail, this report will consider which of these strategies is working, looking, in particular, at whether a halfway-house approach can be successful, given the economies of scope available to companies, such as Amazon and Google, that offer consumers a broad range of digital services. It also considers whether telcos need to be vertically-integrated in the consumer market to be successful. Or can they rely heavily on partnerships with third-parties? Do they need their own distinctive service layer developed in-house?
In light of the behavourial changes brought about by the pandemic, the report also considers whether telcos should be revamping their consumer propositions so that they are more focused on the provision of ultra-reliable connectivity, so people can be sure to work from home productively. Is residential connectivity really a commodity or can telcos now charge a premium for services that ensure a home office is reliably and securely connected throughout the day?
A future STL Partners report will explore telcos’ new working from home propositions in further detail.
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The UK market: Convergence is king
The UK is one of the most developed and competitive telecoms markets in the world. It has a high population density, with 84% of its 66 million people living in urban areas, according to the CIA Factbook. There are almost 272 people for every square kilometre, compared with an average of 103 across Europe. For every 100 people, there are 48 fixed lines and 41 broadband connections, while the vast majority of adults have a mobile phone. GDP per capita (on a purchasing power parity basis) is US$ 48,710, compared with US$ 65,118 in the US (according to the World Bank).
The strength of the state-funded public service broadcaster, the BBC, has made it harder for private sector players to make money in the content market. The BBC delivers a large amount of high-quality advertising-free content to anyone in the UK who pays the annual license fee, which is compulsory to watch television.
In the UK, the leading telcos have mostly eschewed expansion into the broader digital services market. That reflects the strong position of the leading global Internet platforms in the UK, as well as the quality of free-to-air television, and the highly competitive nature of the UK telecoms market – UK operators have relatively low margins, giving them little leeway to invest in the development of other digital services.
Figure 1 summarises where the five main network operators (and broadband/TV provider Sky) are positioned on a matrix mapping degree of vertical integration against the breadth of the proposition.
Most UK telcos have focused on the provision of connectivity
Source: STL Partners
Brazil: Land of new opportunities
Almost as large as the US, Brazil has a population density is just 25 people per square kilometre – one tenth of the total UK average population density. Although 87% of Brazil’s 212 million people live in urban areas, according to the CIA Fact book, that means almost 28 million people are spread across the country’s rural communities.
By European standards, Brazil’s fixed-line infrastructure is relatively sparse. For every 100 people, Brazil has 16 fixed lines, 15 fixed broadband connections and 99 mobile connections. Its GDP per capita (on a purchasing power parity basis) is US$ 15,259 – about one third of that in the UK. About 70% of adults had a bank account in 2017, according to the latest World Bank data. However, only 58% of the adult population were actively using the account.
A vast middle-income country, Brazil has a very different telecoms market to that of the UK. In particular, network coverage and quality continue to be important purchasing criteria for consumers in many parts of the country. As a result, Oi, one of the four main network operators, became uncompetitive and entered a bankruptcy restructuring process in 2016. It is now hoping to to sell its sub-scale mobile unit for at least 15 billion reais (US$ 2.8 billion) to refocus the company on its fibre network. The other three major telcos, Vivo (part of Telefónica), Claro (part of América Móvil) and TIM Brazil, have made a joint bid to buy its mobile assets.
For this trio, opportunities may be opening up. They could, for example, play a key role in making financial services available across Brazil’s sprawling landmass, much of which is still served by inadequate road and rail infrastructure. If they can help Brazil’s increasingly cash-strapped consumers to save time and money, they will likely prosper. Even before COVID-19 struck, Brazil was struggling with the fall-out from an early economic crisis.
At the same time, Brazil’s home entertainment market is in a major state of flux. Demand for pay television, in particular, is falling away, as consumers seek out cheaper Internet-based streaming options.
All of Brazil’s major telcos are building a broad consumer play
Source: STL Partners
Table of contents
Executive Summary
Introduction
The UK market: Convergence is king
BT: Trying to be broad and deep
Virgin Media: An aggregation play
O2 UK: Changing course again
Vodafone: A belated convergence play
Three UK: Small and focused
Takeaways from the UK market: Triple play gridlock
Brazil: Land of new opportunities
The Brazilian mobile market
The Brazilian fixed-line market
The Brazilian pay TV market
The travails of Oi
Vivo: Playing catch-up in fibre
Telefónica’s financial performance
América Móvil goes broad in Brazil
TIM: Small, but perfectly formed?
Takeaways from the Brazilian market: A potentially treacherous transition
Index
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In 2013, it looked like Samsung Electronics could challenge Apple’s hegemony at the high-end of the handset market. The Korean giant’s flagship Galaxy smartphones were selling well and were equipped with features, such as large high definition displays and NFC, which Apple’s iPhones lacked.
But in 2014, Samsung’s Galaxy range lost some of is lustre – the latest flagship model, the S5, amounts to a fairly modest evolution of its predecessor, the S4. The Galaxy S5 underwhelmed some reviewers who criticised its look and feel, hefty price tag and erratic fingerprint sensor. Meanwhile, Apple launched two new high-spec handsets – the iPhone 6 and iPhone 6 Plus. These phones markedly close the hardware gap and fill a significant hole in Apple’s portfolio by venturing into the so-called phablet market, which sits between smartphones and tablets. Now that Apple has grasped consumers’ desire for larger form factors and bigger displays, Samsung may struggle to hold on to high-end buyers.
After out-innovating Apple in some respects in recent years, Samsung is now on the back foot again. While Apple is broadly back to parity in terms of hardware, Samsung continues to trail the Californian company in terms of software and services. Most reviewers still regard the iPhone as the gold standard when it comes to user experience.
It is now well understood that the iPhone’s lead is largely down to Apple’s absolute control over hardware and software. Samsung and other vendors selling handsets running Google’s Android operating system have struggled to achieve the slick integration between hardware and software exemplified by Apple’s iPhones. Samsung has often exacerbated this issue by presenting customers with a confusing mix of overlapping Google and Samsung apps on its Galaxy handsets.
Samsung’s Annus Miserablis
In the second quarter of 2014, research firm IDC estimates that Samsung shipped more than 18 million Galaxy S5s, along with nine million S3 and S4 units. That implies Samsung shipped 27 million models in its flagship Galaxy S range, compared with 35 million iPhones distributed by Apple. For the third quarter, IDC didn’t break out Galaxy sales, but the research firm flagged “cooling demand for [Samsung’s] high-end devices,” adding: “Although Samsung has long relied on its high-end devices, its mid-range and low-end models drove volume for the quarter and subsequently drove down average selling prices.”
But Samsung can’t afford to cede more of the high end of the market to Apple. The Korean giant is facing increasingly intense competition from low cost Chinese manufacturers in the low end and the mid-range segments of the handset market. The net result has been a marked decline in Samsung’s market share and falling revenues. As the global smartphone market has expanded to serve people in lower income groups, both Samsung and Apple have lost market share to the likes of Xiaomi, Lenovo and Huawei. But Samsung is suffering far more than Apple, whose devices are squarely aimed at the affluent (see Figure 3).
Figure 3: Samsung’s share of the global smartphone market share is sliding
source: IDC research
Worse still for Samsung, the decline in average selling prices is hitting its top line, damaging profitability and its ability to realise economies of scale. In terms of revenues, Apple is now almost as large as Samsung Electronics’ three divisions combined and is much bigger than Samsung’s information technology and mobile (IM) division, which competes directly with Apple (see Figure 4).
Figure 4: Apple is now generating almost as much revenue as Samsung Electronics
Source: Financial results, Apple guidance and analyst estimates captured by www.4-traders.com
The declining performance of Samsung’s IM division has had a major impact on Samsung Electronics’ profitability. The Korean group’s operating margin is slipping back towards 10%, whereas Apple’s operating margin has stabilised at about 28%, after sliding in 2013, when it faced particularly intense competition from Samsung and the broader Android ecosystem (see Figure 5).
Figure 5: Samsung’s margins are low and going lower
Source: Financial results, Apple guidance and analyst estimates captured by www.4-traders.com
Although Samsung Electronics still generates slightly more revenue than Apple, the U.S. company is likely to make more than double the operating profit of its Korean rival in 2014 (see Figure 6).
Figure 6: Apple’s operating profits are set to be more than double those of Samsung
Source: Financial results, Apple guidance and analyst estimates captured by www.4-traders.com
Naturally, declining operating profits mean lower net profits and a less attractive proposition for investors. Samsung clearly needs to avoid slipping into a downward spiral where low profitability prevents it from investing in the research and development and the manufacturing capacity it will need to compete effectively with Apple at the high end. Apple is now generating about $20 billion more in net income than Samsung each year, meaning it has far more financial firepower than its main rival, together with a virtual blank cheque from investors (see Figure 7).
Figure 7: The gap between Apple and Samsung’s financial firepower is widening
Source: Financial results, Apple guidance and analyst estimates captured by www.4-traders.com
Samsung should also be concerned about competition from Microsoft at the high-end of the market. Another company with a surplus of cash, Microsoft has a strong strategic interest in creating compelling smartphones and tablets to shore up its position in the business software market. Now that it is developing both software and hardware in house, Microsoft may yet be able to create smartphones that provide a better user experience than many Android handsets.
In summary, Samsung’s flagging performance in the smartphone market is having a major impact on the financial performance of the group. There could be worse to come. If Samsung concedes more of the premium end of the smartphone market to Apple and possibly Microsoft, it risks competing solely on price in the low and mid segments, where its expertise in display technology and semiconductors won’t enable it to add significant value. Samsung’s margins would erode further and it would be in danger of going into the terminal decline experienced by the likes of Nokia and Motorola, which have also both led the mobile phone market in the past.
An implosion by Samsung would have grave consequences for telcos and their primary suppliers. Aside from Microsoft, the Korean conglomerate is the only company in the smartphone and tablet markets that has the resources to provide credible global competition for Apple. Although the leading Chinese smartphone makers are strong in emerging markets, they lack the brand cachet and the marketing skills to mount a serious challenge to Apple in North America and Western Europe.
Internet-Driven Disruption
Introduction
Executive Summary
Samsung: slipping and sliding
How will Samsung respond?
The opportunities for Samsung in the smartphone market
The threats to Samsung in the smartphone market
Samsung’s next steps
Apple isn’t impregnable
Conclusions and implications for telcos
About STL Partners
Figure 1 – Apple financial firepower far outstrips that of Samsung Electronics
Figure 2 – How Samsung could shore up its position in the smartphone market
Figure 3 – Samsung’s share of the global smartphone market share is sliding
Figure 4 – Apple is now generating almost as much revenue as Samsung Electronics
Figure 5 – Samsung’s margins are low and going lower
Figure 6 – Apple’s operating profits are set to be more than double those of Samsung
Figure 7 – The gap between Apple and Samsung’s financial firepower is widening
Figure 8 – SWOT analysis of Samsung at the high end of the smartphone market
Figure 9 – Samsung Electronics is the largest investor in tech R&D worldwide
Figure 10 – Apple’s expanding portfolio is making life tougher for Samsung
Figure 11 – Potential strategic actions for Samsung in the smartphone market
Figure 12 – SWOT analysis of Apple in the smartphone market
Figure 13 – Potential strategic actions for Apple in the smartphone market
Summary: ‘Hyper-competition’ in the mobile handset market, particularly in ‘smartphones’, will drive growth in 2010, but also emaciate profits for the majority of manufacturers. Predicted winners, losers and other market consequences.
This is a Guest Note from Arete Research, a Telco 2.0™ partner specialising in investment analysis.Members can download a PDF of this Note here.
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.
Handsets: Demolition Derby
Arete’s last annual look at global handset markets (Handsets: Wipe-Out!, Oct. ’08) predicted every vendor would see margins fall by ~500bps. This happened: overall industry profitability dropped, as did industry sales. Now everyone is revving their engines with vastly improved product portfolios for 2010. Even with 15% unit and sales growth in ’10, we see the industry entering a phase of desperate “hyper-competition.” Smartphone vendors (Apple, RIMM, Palm, HTC) should grab $15bn of the $23bn increase in industry sales.
Longer term, the handset space is evolving into a split between partly commoditised hardware and high margin software and services. Managements face a classic moral hazard problem, incentivised to gain share rather than preserve capital. Each vendor sees 2010 as “their year.” Individually rational strategies are collectively insane: the question is who has deep enough pockets to keep their vehicles in one piece. Revving the Engines. Every vendor is making huge technology leaps in 2010: high end devices will have 64/128GBs of NAND, 8-12Mpx cameras, OLED nHD capacitive touch displays, and more features than consumers can use. Smartphones should rise 50% to 304m units (while feature phones drop 21% in units). As chipmakers support sub-$200 complete device solutions, we see a race to the bottom in smartphone pricing.
Software Smash-Up. The rush of OEMs into Android will bring differentiation issues (as Symbian faced). Beyond Apple, every software platform faces serious issues, while operators will use “open” platforms to develop their own UIs (360, OPhone, myFaves, etc.). Rising software costs will force some OEMs to adopt a PC-ODM business model, while higher-margin models of RIM and Nokia are most at risk.
Finally, the Asian Invasion. Samsung, HTC and LGE now have 30% ’09E share, with ZTE, Huawei, MTEK customers and PC ODMs all joining the fray. All seek 20%+ growth. Motorola and SonyEricsson are being forced to shrink footprint, and shift risk to ODM partners. Nokia already has an Asian cost base, but lacks new high-end devices outside its emerging markets franchise. Apple looks set to claim 40% of industry profits in ’10, as other OEMs fight a brutal war of attrition, egged on by buoyant demand for fresh products at record low prices.
Forget Defensive Driving
Our thesis for 2010 is as follows: unit volumes will rebound with 15% growth, with highly competitive pricing to keep volumes flowing. This will be driven by highly attractive devices at previously unimaginably low prices. Industry sales will also rise 15%, by $23bn, but half of the extra sales ($11bn) will be taken by Apple. Industry margins will remain under pressure from pricing and rising BoM costs. Every traditional OEM, smartphone pure-play, and new entrant are following individually rational strategies: improve portfolios, promise the moon to operators, and price to gain share. Those that fail to secure range planning slots at leading operators will develop other channels to market. Collectively, the industry is entering a period of desperation and dangerous self-belief. There are few incentives to exercise restraint for the likes of Dell (led by ex-Motorola management), Acer (the consistent PC winner at the low-end), Huawei and ZTE (which view devices as complementary to infrastructure offerings) or Samsung (where rising device units help improve utilisation of its memory and display fabs). Motorola and SonyEricsson must promote themselves actively, just to find sustainable business models on 4% share each.
Table 2 shows industry value; adjusted for the impact of Apple, it shows a continuous 4-5% decline in ASPs (though currencies also play a role). The challenge for mainstream OEMs (Nokia, Samsung, LGE, etc.) is to win back customers now exhibiting high loyalty after switching to iPhone or Blackberry. Excluding gains by Apple and RIM, industry sales are on track to fall 13% in ’09. Apple, RIM, Palm and HTC will collectively account for $15bn of our forecast incremental $23bn in industry sales in ’10E.
Within this base, we see smartphones rising from 162m units in ’08 (13% of the total) to 304m units, or 23% of total ’10E shipments. At the same time, featurephone/mid-range units will drop by 21% in ’09 and 21% again in ’10.
Key Products for 2010
Both SonyEricsson and LGE have innovative Android models coming in 1H10, LG with distinctive designs and gesture input, and a new SonyEricsson UI and messaging method.
Nokia’s roadmap features slimmer form factors, but a range of capacitive touch models will not come until 2H10. It will update the popular 6300/6700 series with a S40 touch device in 1H10.
Samsung has its usual vast array of product, and plans for 100m touch models in ’10 underlining the extent of their form factor transition.
Motorola’s line-up will focus on operator variants, with a lead device shipping in 2Q10, but a number of operators think Motorola lacks distinctive designs and see little need for Blur.
RIM will not change its current form factor approach until 2H10, when it moves to a new software platform to enhance its traditional QWERTY base. It faces commercial challenges around activation and services fees with carrier partners.
We expect Apple to reach lower price points and also launch CDMA-based iPhones in ’10.
HTC must also reduce its costs to address mid-range prices.
Every vendor plans to widen its portfolio with several “hero” models in 2010; if anything the window to hype any single launch is narrowing.
Main Trends
Discussions with a wide range of operators, vendors and chipmakers about 2010 device roadmaps point to an explosion of attractive products – a few trends stand out:
Operators are now deeply engaging Chinese vendors. Huawei and ZTE have Android devices coming, while TCL and Taiwanese ODMs offer low-end devices. Chipmakers confirm Android devices will drop under $100 BoM levels by YE10. This will pressure both prices and margins. The value chain is shifting rapidly to more compute-intensive devices, with Qualcomm and others enabling Asian ODMs to be active in new PC segments with smartphone-like features (touch, Adobe Flash, 3G connectivity, etc.) in large-screen form factors, to leverage their LCD base.
All devices will become “smartphones.” Samsung and Nokia are opening up APIs for mass market phones. The smartphone tag (vs. dumb ones) will be applied to devices of all sorts, the way we formerly spoke of handsets. By the end of 2010, all devices (except basic pre-paid models) will be customisable with popular applications (e.g., search, social networking, IM, etc.) even if they lack hardware for video content (i.e., memory and codecs) or mapping (GPS chipsets). Open OS devices should rise 50% to 304m units, 23% of the total market.
Pure play smartphone vendors (RIMM, HTC, Palm) must transition business models to emulate Apple (i.e., linking devices with services and content). Launching lower-cost versions of popular models (RIMM’s 8520, HTC’s Tattoo, Palm’s Pixi) implicitly recognises how crowded the high-end ($400+) is becoming. This will get worse as Motorola and SonyEricsson seek to re-invent themselves with aspirational models, and Android devices hit mid-range prices in ’10.
Fearless Drivers
We had said before that key purchase criteria (design, features, brand) were reaching parity across OEMs, splitting the market into basic “phones” (voice/camera/radio) and Internet devices. The former has room for two to three scale players: Nokia, Samsung, and a third based on a PC-OEM model using standard offerings (e.g., Qualcomm or MTEK chipsets). LG and ZTE are both seeking this position, from which SonyEricsson and Motorola retreated to focus on Internet devices. This does not mean mobile devices are now commodities, like wheat or steel. The complexity of melding software and hardware in tiny, highly functional packages is not the stuff of commodity markets. But we see a split where a narrow range of standard hardware platforms will accommodate an equally narrow set of software choices. Mediatek is blazing a trail here. Some operators (Vodafone, China Mobile, etc.) aim to follow this model for pre-paid and mid-range featurephones. Preserving software and services value-add for consumers in a market where hardware pricing is fairly transparent is a challenge for all OEMs.
This model is not confined to the low-end: In Wipe Out! we said Motorola (among others) would adopt an HTC/Dell model (integrating standard chipsets/software and cutting R&D). This is happening, with Motorola no longer trying to control its software roadmap, having fully adopted Android. SonyEricsson is following suit, with initial Android devices coming in 1Q10.
Recent management changes make it even more likely SonyEricsson gets absorbed into Sony to integrate with content (as its new marketing campaign pre-sages). Internet devices will become even more fragmented by would-be new entrants in ’10. In addition to Nokia, Apple, RIMM, HTC and Palm, LG and Samsung intend to build a presence in smartphones, as do Huawei, ZTE and PC ODMs. We had expected LGE or Samsung to consider M&A (i.e., buying HTC or Palm) to cement their scale or get a native OS platform. We forecast the shift to Internet devices would bring 27m incremental units from RIM, HTC, and Apple in ’09E. This now looks like it will be 21m units (partly due to weaker HTC sales), a growth of 58% vs. an overall market decline of 6%.
Growth: Steaming Again
After a long string of rises in both units and industry value, the global handset market retreated in ’09. We see risk of a weaker 1H10 mitigated in part by trends in China (3G) and India (competition among new operators). The industry had already scaled up for 10-20%+ growth during the ’05-’08 boom; most vendors have highly outsourced business models and/or partly idle capacity, meaning they could produce additional units relatively quickly. Paradoxically, 15% unit and sales growth will further encourage aggressive efforts to gain share.
Our regional forecasts are in Table 3. Emerging markets are two-thirds of volumes in ’09E and ’10E, and will lead growth – at ever lower price points – as they adopt 3G. Market dynamics vary sharply between highly-subsidised, contract-led markets (i.e., the US, Japan/Korea, and W. Europe) and pre-paid-led emerging markets (China, India, E. Europe, MEA and LatAm). In the former, operators are driving smartphone adoption; while price erosion helps limit subsidy budgets, we see growth in handset market value. As Table 4 shows, mobile data handsets hit 10%+ of EU operator sales, but are not yet driving operators’ sales growth.
In emerging markets, the growth in value is led by further volume increases for LCHs. In ’05, we saw an inflection point around Low-Cost Handsets: Every Penny Counts (July ’05) and A Billion Handsets in ’07? (Aug. ’05). Since ’05, there were 1.2bn handsets shipped in China and India alone. LCH chipsets now sell for <$5, with only Infineon and Mediatek actively supplying meaningful volumes. The ongoing mix shift to emerging markets and weak sales of mid-range devices in developed markets were behind the 13% decline in industry value in ’09E, excluding Apple’s sales. Of the extra 170m units we see shipping in ’10E, 105m come from emerging markets, with ~50m sold in China and India.
Costs: Relentless Slamming
In Wipe Out!, Arete laid out four areas where costs might rise in ’09 and beyond, as the source of structural pressure on industry margins. None of these costs are easing or receding. First, the chipset market is increasingly concentrating. TI is exiting, ST-Ericsson continues to lose money, Infineon recovered but still lacks scale in 3G, and Mediatek dominates outside the top five OEMs. This leaves Qualcomm in a de facto leadership position in 3G. This structure does not support meaningful cost reduction for OEMs. Intel may seek an entry to disrupt the market (see Qualcomm v Intel, Fight of the Century, Sept. ’09) but this is unlikely to happen until ’11. Memory may be in short supply in ’10, while high-end OLED displays still face shortages. Capacity cuts and losses at smaller component suppliers in ’09 limit how much OEMs can save. Outsourced manufacturers like Foxconn, Compal, Jabil, BYD, and Flextronics have low margins and poor cash flow. OEMs want to transfer more risk to suppliers that have little room to cut further.
Second, feature creep also thwarts cost reduction efforts: packing more into every phone is needed to stimulate demand, but adds cost. There are rising requirements in the mid-range, going from 2Mpx to 3.2/5Mpx camera modules, and adding touch, more memory, and multi-radio chipsets (3G, WiFi, BT, FM, etc.). Samsung already offers a 2Mpx touchscreen 2G phone for <$100 on pre-paid tariffs.
Third, software remains the fastest-rising element of handset costs. In Mobile Software Home Truths (Sept. ’09), we discussed how software was adding costs, but how many OEMs were struggling to realise value from software investments? Adopting “licence-free” or open source software does not necessarily reduce these costs: it must still be managed within industrial processes. Yet saving licence costs will be the argument used by OEMs forced to limit the number of platforms they support, as Samsung did by recently indicating it would abandon Symbian. We understand WinMo efforts have been largely mothballed at Motorola and SonyEricsson, even as LG is increasing its spend around Microsoft. Costs are also rising for integration of services, while Software costs are not falling; vendors are just shifting them from handset bill-of-materials (BoM) to other companies’ R&D budgets.
Finally, marketing costs are also rising. Vendors must provide $10m-50m per market of above-the-line marketing support and in-store promotions, to get operators to feature “hero” products. Services adds costs for integration and (often-overlooked) indirect product costs (testing, warranty, logistics, price protection in the channel). SG&A must rise to educate users about new services. OEMs cannot retain or win customers in a mature market without more marketing.
The case for services remains simple and compelling: Nokia’s 33% gross margin on €65 ASPs yields €22 gross profit per device, or €1/month over a two-year lifetime. This is the only way to offset further pressure on device profits. The drive to launch Services is another cost OEMs must bear, with a longer payback than that of 12-18 month design cycles for devices.
Margins: Beyond Fender Benders
When Motorola has lost $4bn since ’07 and SonyEricsson may lose as much as €1bn in ’09, we are no longer talking about minor dents. Gross margins for both are already low (sub-20%). The most notable feature of the past few years was how exposed some vendors were when extensions of hit products (or product families) fell flat. SonyEricsson went from 13% 4Q07 margins to breakeven by 2Q08, and RIM saw group gross margins drop 1000bps. Only Nokia (at 33%), RIM, Apple and HTC have gross margins above 30%. Few OEMs managed to raise gross margins after seeing them decline, though we see SonyEricsson and Motorola seeking to do so by vastly reducing their scope of activities.
Having an Asian low-cost base is a necessary but not sufficient condition of survival. Nokia is already the largest Asian producer, with the industry’s two largest plants (in China and India) giving it the lowest cost structure (i.e., the lowest ASPs, but consistently among the highest margins). Few OEMs other than Nokia make money selling LCHs (i.e., sub-€30). Nokia made ~60% of industry profits in ’08, but will be surpassed in profits in ’09 by Apple, which should make 40% of industry profits in ’10, while Nokia has 25%. It is also worth noting that we forecast margins to fall at nearly every vendor in ’10, though Motorola and SonyEricsson must end large losses, and Nokia will benefit for IPR income within its Devices margin.
Software: Mutual Destruction?
The mobile industry is rapidly adopting the IT industry’s software as a service (SaaS) model. The handset is becoming a distribution platform for services and content; vendors aim to monetise a “community” of their device users. Yet for all the attention it gets, software is a means to an end, and not part of the product. Beyond RIM and Apple, only Nokia can afford its own smartphone platform R&D (i.e., Symbian), yet we see Nokia itself moving closer to Microsoft. Money alone cannot solve software or services issues; if so, Nokia’s industry-leading €3bn R&D budget would have yielded more success, while Apple would not have grabbed as much profit share with a $1.3bn group-wide R&D budget.
No vendor yet excels at ease-of-use for multiple applications (voice, SMS, music, video, browsing, navigation, etc.). RIM offers best-in-class messaging, but falls short in other use cases. The iPhone’s Web experience allowed it to overcome shortcomings in multi-threading and voice/text. Samsung has few services to accompany its sleek designs or high-spec displays and cameras. Just going to 70-100m touch-screed devices in ’10 will not resolve ease-of-use issues.
A number of vendors risk getting addicted to “free” software platforms where others reap the benefits (e.g., Android). Few OEMs have embraced regular updates of components (media players, browser plug-ins, etc.) to meet changing requirements. This is Apple’s edge (and in theory Microsoft’s, but it has not managed handset software efficiently). The current slowdown will only hasten moves to abstraction of hardware and software, long the case in PCs. What is the point of OEMs having their own “developer programmes” (e.g., MOTODEV, Samsung Mobile Innovation, SonyEricsson Developer World, etc.) if they adopt Android? To escape high software costs, some vendors are adopting a PC-OEM model: sub-20% gross margins, 1-5% R&D/sales, with little control over how services are implemented on devices.
When the Dust Settles…
After turmoil and consolidation in ’06, industry margins were robust in ’07, then plunged in ’08. Yet a hoped-for recovery in ’09 has given heart to a range of weaker players, sealing the industry’s fate.
Even with a resumption of growth, rising costs and hyper competition look set to put pressure on margins. The precipitous impact of this may not be seen until 2011; for now, managements are not inclined to call it quits, or admit they lack a services or software play. The handset market is hardly gone ex-growth, but its rules and value chain are shifting, as seen in Apple and Google staking their claims.
The market looks to be falling less than the $11bn we forecast for ’09 (“only” $9bn), but it is Apple’s incremental sales that are changing the dynamics most. We are no fans of M&A, but would welcome moves to remove industry capacity. There are few obvious options, beyond HTC and Palm. We also think Samsung and LGE would benefit from deals that might open up their insular corporate cultures. Nokia has showed how difficult it is for an OEM to assemble a portfolio of Services offerings: none are yet best-in-class. Our verdicts on the key questions for vendors are listed in the following table: We see room for two to three scale players in LCHs/feature-phones (Nokia, Samsung and one other following a PC-OEM model). Smartphones will grow even more fragmented and hotly contested. We are not certain whether the others – SonyEricsson, LGE, Motorola, ZTE, HTC, and Japanese vendors – will emerge from 2010 in one piece.
Richard Kramer, Analyst Arete Research Services LLP richard.kramer@arete.net / +44 (0)20 7959 1303
Regulation AC – The research analyst(s) whose name(s) appear(s) above certify that: all of the views expressed in this report accurately reflect their personal views about the subject company or companies and its or their securities, and that no part of their compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this report.
Required Disclosures
For important disclosure information regarding the companies in this report, please call +44 (0)207 959 1300, or send an email to michael.pizzi@arete.net.
Rating System: Long (L), Positive (+ve), Neutral (N), Negative (-ve), and Short (S) – Analysts recommend stocks as Long or Short for inclusion in Arete Best Ideas, a monthly publication consisting of the firm’s highest conviction recommendations. Being assigned a Long or Short rating is determined by a stock’s absolute return potential, related investment risks and other factors which may include share liquidity, debt refinancing, estimate risk, economic outlook of principal countries of operation, or other company or industry considerations. Any stock not assigned a Long or Short rating for inclusion in Arete Best Ideas, may be rated Positive or Negative indicating a directional preference relative to the absolute return potential of the analyst’s coverage group. Any stock not assigned a Long, Short, Positive or Negative rating is deemed to be Neutral. A stock’s absolute return potential represents the difference between the current stock price and the target price over a period as defined by the analyst.
Distribution of Ratings – As of 15 October 2009, 10.8% of stocks covered were rated Long, 6.8% Positive, 25.7% Short, 10.8% Negative and 45.9% deemed Neutral.
Global Research Disclosures – This globally branded report has been prepared by analysts associated with Arete Research Services LLP (“Arete LLP”) and/or Arete Research, LLC (“Arete LLC”), as indicated on the cover page hereof. This report has been approved for publication and is distributed in the United Kingdom and Europe by Arete LLP (Registered Number: OC303210, Registered Office: Fairfax House, 15 Fulwood Place, London WC1V 6AY), which is authorized and regulated by the UK Financial Services Authority (“FSA”), and in the United States by Arete LLC (3 PO Square, Boston, MA 02109), a wholly owned subsidiary of Arete LLP, registered as a broker-dealer with the Financial Industry Regulatory Authority (“FINRA”). Additional information is available upon request. Reports are prepared using sources believed to be wholly reliable and accurate but which cannot be warranted as to accuracy or completeness. Opinions held are subject to change without prior notice. No Arete director, employee or representative accepts liability for any loss arising from the use of any advice provided. Please see www.arete.net for details of any interests held by Arete representatives in securities discussed and for our conflicts of interest policy.
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General Disclosures – This research is not an offer to sell or the solicitation of an offer to buy any security. It does not constitute a personal recommendation or take into account the particular investment objectives, financial situations, or need of the individual clients. Clients should consider whether any advice or recommendation in this research is suitable for their particular circumstances and, if appropriate, seek professional advice. The price and value of the investments referred to in this research and the income from them may fluctuate. Past performance is not a guide to future performance, future returns are not guaranteed, and a loss of original capital may occur. Fluctuations in exchange rates could have adverse effects on the value or price of, or income derived from, certain instruments.
