Strategy 2.0: Google’s Strategic Identity Crisis

Summary: Google’s shares have made little headway recently despite its dominance in search and advertising, and it faces increasing regulatory threats in this area. It either needs to find new sources of value growth or start paying out dividends, like Microsoft, Apple (or indeed, a telco). Overall, this is resulting in something of a strategic identity crisis. A review of Google’s strategy and implications for Telcos. (March 2012, Executive Briefing Service, Dealing with Disruption Stream).

Google's Advertising Revenues Cascade

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Below is an extract from this 24 page Telco 2.0 Report that can be downloaded in full in PDF format by members of the Telco 2.0 Executive Briefing service and the Telco 2.0 Dealing with Disruption Stream here. Non-members can subscribe here, buy a Single User license for this report online here for £595 (+VAT for UK buyers), or for multi-user licenses or other enquiries, please email contact@telco2.net / call +44 (0) 207 247 5003. We’ll also be discussing our findings and more on Google at the Silicon Valley (27-28 March) and London (12-13 June) New Digital Economics Brainstorms.

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Executive Summary

Google appears to be suffering from a strategic identity crisis. It is the giant of search advertising but it also now owns a handset maker, fibre projects, an increasingly fragmented mobile operating system, a social network of questionable success, and a driverless car programme (among other things). It has a great reputation for innovation and creativity, but risks losing direction and value by trying to focus on too many strategies and initiatives.

We believe that Google needs to stop trying to copy what Apple and Facebook are doing, de-prioritise its ‘Hail Mary’ hunt for a strategy (e.g. driverless cars), and continue to build new solutions that serve better the customers who are already willing to pay – namely, advertisers.

It is our view that the companies who have created most value in the market have done so by solving a customer problem really well. Apple’s recent success derives from creating a simpler and more beautiful way (platform + products) for people to manage their digital lives. People pay because it’s appealing and it works.

Google initially solved how people could find relevant information online and then, critically, how to use this to help advertisers get more customers. They do this so well that Google’s $37bn revenues continue to grow at double digit pace, and there’s plenty of headroom in the market for now. While the TV strategy may not yet be paying off, it would seem sensible to keep working at it to try to keep extending the reach of Google’s platform. 

While Android keeps Google in the mobile game to a degree, and has certainly helped to constrain certain rivals, we think Google should cast a hard eye over its other competing and distracting activities: Motorola, Payments, Google +, Driverless Cars etc. Its management team should look at the size of the opportunity, the strength of the competition, and their ability to execute in each. 

Pruning the projects might also lose Google an adversary or two, and it might also afford some reward to shareholders too. After all, even Apple has recently decided to pay back some cash to investors.

This may be very difficult for Google’s current leadership. Larry Page seems to have the restless instincts of the stereotypical Valley venture capitalist, hunting the latest ideas, and constantly trying to create the next big beautiful thing. The trouble is that this is Google in 2012, not 1995, and it looks to us at least that a degree of ‘sticking to the knitting’ within Google’s huge, profitable and growing search advertising business may be a better bet than the highly speculative (and expensive) ‘Hail Mary’ strategy route. 

This may sound surprising coming from us, the inveterate fans of innovation at Telco 2.0, so we’d like to point out some important differences between the situations that Google and the telcos are in:

  • Google’s core markets are growing, not flat or shrinking, and are at a different life-stage to the telecoms market;
  • Google is global, rather than being confined to any given geography. There are many opportunities still out there.
  • We are not saying that Google should stop innovating, but we are saying it should focus its innovative energy more clearly on activities that grow the core business.

Introduction

In January this year, Google achieved a first – it missed the consensus forecast for its quarterly earnings. There is of course no magic in the consensus, which is an average of highly conventionalised guesses from a bunch of City analysts, but it is as good a moment as ever to review Google’s strategic position. If you bought Google stock at the beginning, you may not need to read this, as you’re probably very rich (the return since then is of the order of 400%). The entirety of this return, however, is accounted for by the 2004-2007 bull run. On a five-year basis, Google stock is ahead 30%, which sounds pretty impressive (a 6% annual return), but again, all the growth is accounted for by the last surge upwards over the summer of 2007. The peak was achieved on the 2nd of November, 2007. 

As this chart shows, Google stock is still down about 9% from the peak, and perhaps more importantly, its path tracks Microsoft very closely indeed. Plus Microsoft investors get a dividend, whereas Google investors do not.

Figure 1: Google, Microsoft 2.0?

Google, Microsoft 2.0?
Source: Google Finance

Larry Page is reported to have said that “Google is no longer a “search company.” He says its model is now 

“invent wild things that will help humanity, get them adopted by users, profit, and then use the corporate structure to keep inventing new things.”

No longer a search company? Take a look at the revenues. Out of Google’s $37.9bn in revenues in 2011, $36bn came from advertising, aka the flip side of Google Search. Despite a whole string of mammoth product launches since 2007, Google’s business is essentially what it was in 2007 – a massive search-based advertising machine.

Google’s Challenges

Our last Google coverage – Android: An Anti-Apple Virus ? and the Dealing with the Disruptors Strategy Report   suggested that the search giant was suffering from a lack of direction, although some of this was accounted for by a deliberate policy of experimenting and shutting down failed initiatives.

Since then, Google has launched Google +, closed Google Buzz, and closed Google Wave while releasing it into a second life as an open-source project. It has been involved in major litigation over patents and in regulatory inquiries. It has seen an enormous boom in Android shipments but not necessarily much revenue. It is about to become a major hardware manufacturer by acquiring Motorola. And it has embarked on extensive changes to the core search product and to company-wide UI design.

In this note, we will explore Google’s activities since our last note, summarise key threats to the business and strategies to counter them, and consider if a bearish view of the company is appropriate.

We’ve found it convenient to organise Google’s business  into several themed groups as follows:

1: Questionable Victories

Pyrrhic victory is defined as a victory so costly it is indistinguishable from defeat. Although there is nothing so bad at Google, it seems to have a knack of creating products that are hugely successful without necessarily generating cash. Android is exhibit A. 

The obvious point here is surging, soaring growth – forecasts for Android shipments have repeatedly been made, beaten on the upside, adjusted upwards, and then beaten again. Android has hugely expanded the market for smartphones overall, caused seismic change in the vendor industry, and triggered an intellectual property war. It has found its way into an awe-inspiring variety of devices and device classes.

But questions are still hanging over how much actual money is involved. During the Q4 results call, a figure for “mobile” revenues of $2.5bn was quoted. This turns out to consist of advertising served to browsers that present a mobile device user-agent string. However, Google lawyer Susan Creighton is on record as saying  that 66% of Google mobile web traffic originates from Apple iOS devices. It is hard to see how this can be accounted for as Android revenue.

Further, the much-trailed “fragmentation” began in 2011 with a vengeance. “Forkdroids”, devices using an operating system based on Android but extensively adapted (“forked” from the main development line), appeared in China and elsewhere. Amazon’s Kindle Fire tablet is an example closer to home.

And the intellectual property fights with Oracle, Apple, and others are a constant source of disruption and a potentially sizable leakage of revenue. In so far as Google’s motivation in acquiring Motorola Mobility was to get hold of its patent portfolio, this has already involved very large sums of money. Another counter-strategy is the partnership with Intel and Lenovo to produce x86-based Android devices, which cannot be cheap either and will probably mean even more fragmentation.

This is not the only example, though – think of Google Books, an extremely expensive product which caused a great deal of litigation, eventually got its way (although not all the issues are resolved), and is now an excellent free tool for searching in old books but no kind of profit centre. Further, Google’s patented automatic scanning has the unfortunate feature of pulling in marginalia, etc. from the original text that its rivals (such as Amazon Kindle) don’t.
Further, Google has recently been trying to monetise one of its classic products, the Google Maps API that essentially started the Web 2.0 phenomenon, with the result that several heavy users (notably Apple and Foursquare)  have migrated to the free OpenStreetMap project and its OpenLayers API.

2: Telco-isation

Like a telco, Google is dependent on one key source of revenue that cross-subsidises the rest of the company – search-based advertising. 

Figure 2: Google’s advertising revenues cascade into all other divisions

Google's Advertising Revenues Cascade

[NB TAC = Traffic Acquisition Cost, CoNR = Cost of Net Revenues]

Having proven to be a category killer for search and advertising across the  whole of the Internet, the twins (search and ads) are hugely critical for Google and also for millions of web sites, content creators, and applications developers. As a result, just like a telco, they are increasingly subject to regulation and political risk. 

Google search rankings have always been subject to an arms race between the black art of search-engine optimisation and Google engineers’ efforts to ensure the integrity of their results, but the whole issue has taken a more serious twist with the arrival of a Federal Trade Commission inquiry into Google’s business practices. The potential problems were dramatised by the so-called “white lady from Google”  incident at Google Kenya, where Google employees scraped a rival directory website’s customers and cold-called them, misrepresenting their competitors’ services, and further by the $500 million online pharmacy settlement. Similarly, the case of the Spanish camp site that wants to be disassociated from horrific photographs of a disaster demonstrates both that there is a demand for regulation and that sooner or later, a regulator or legislator will be tempted to supply it.

The decision to stream Google search quality meetings online should be seen in this light, as an effort to cover this political flank.

As well as the FTC, there is also substantial regulatory risk in the EU. The European Commission, in giving permission for the Motorola acquisition, also stated that it would consider further transactions involving Google and Motorola’s intellectual property on a case-by-case basis. To put it another way, after the Motorola deal, the Commission has set up a Google Alert for M&A activity involving Google.

3: Look & Feel Problems

Google is in the process of a far-reaching refresh of its user interfaces, graphic design, and core search product. The new look affects Search, GMail, and Google + so far, but is presumably going to roll out across the entire company. At the same time, they have begun to integrate Google + content into the search results.

This is, unsurprisingly, controversial and has attracted much criticism, so far only from the early adopter crowd. There is a need for real data to evaluate it. However, there are some reasons to think that Search is looking in the wrong place.

Since the major release codenamed Caffeine in 2008, Google Search engineers have been optimising the system for speed and for first-hit relevance, while also indexing rapidly-changing content faster by redesigning the process of “spidering” web sites to work in parallel. Since then, Google Instant has further concentrated on speed to the first result. In the Q4 results, it was suggested that mobile users are less valuable to Google than desktop ones. One reason for this may be that “obvious” search – Wikipedia in the first two hits – is well served by mobile apps. Some users find that Google’s “deep web” search has suffered.

Under “Google and your world”, recommendations drawn from Google + are being injected into search results. This is especially controversial for a mixture of privacy and user-experience reasons. Danny Sullivan’s SearchEngineLand, for example, argues that it harms relevance without adding enough private results to be of value. Further, doubt has been cast on Google’s numbers regarding the new policy of integrating Google accounts into G+ and G+ content into search.

Another, cogent criticism is that it introduces an element of personality that will render regulatory issues more troublesome. When Google’s results were visibly the output of an algorithm, it was easier for Google to claim that they were the work of impartial machines. If they are given agency and associated with individuals, it may be harder to deny that there is an element of editorial judgment and hence the possibility of bias involved.

Social search has been repeatedly mooted since the mid-2000s as the next-big-thing, but it seems hard to implement. Yahoo!, Facebook, and several others have tried and failed.

Figure 3: Google + on Google Trends: fading into the noise?

 Google + on Google Trends: Fading Into the Noise?
Source: Google Trends

It is possible that Google may have a structural weakness in design as opposed to engineering (which is as excellent as ever). This may explain why a succession of design-focused initiatives have failed – Wave and Buzz have been shut down, Google TV hasn’t gained traction (there are less than one million active devices), and feedback on the developer APIs is poor.

4: Palpable Project Proliferation

Google’s tendency to launch new products is as intimidating as ever. However, there is a strong argument that its tireless creativity lacks focus, and the hit-rate is worrying low. Does Google really need two cut-down OSs for ultra-mobile devices? It has both Android, and ChromeOS, and if the first was intended for mobile phones and the second for netbooks, you can now buy a netbook-like (but rather more powerful) Asus PC that runs Android. Further, Google supports a third operating system for its own internal purposes – the highly customised version of Linux that powers the Google Platform – and could be said to support a fourth, as it pays the Mozilla Foundation substantial amounts of money under the terms of their distribution agreement and their Boot to Gecko project is essentially a mobile OS. IBM also supported four operating systems at its historic peak in the 1980s.  

Also, does Google really need to operate an FTTH network, or own a smartphone vendor? The Larry Page quote we opened with tends to suggest that Google’s historical tendency to do experiments is at work, but both Google’s revenue raisers (Ads and YouTube, which from an economic point of view is part of the advertising business) date from the first three years as a public company. The only real hit Google has had for some time is Android, and as we have seen, it’s not clear that it makes serious money.

Google Wallet, for example, was launched with a blaze of publicity, but failed to attract support from either the financial or the telecoms industry, rather like its predecessor Google Checkout. It also failed to gain user adoption, but it has this in common with all NFC-based payments initiatives. Recently, a major security bug was discovered, and key staff have been leaving steadily, including the head of consumer payments. Another shutdown is probably on the cards. 

Meanwhile, a whole range of minor applications have been shuttered

Another heavily hyped project which does not seem to be gaining traction is the Chromebook, the hardware-as-a-service IT offering aimed at enterprises. This has been criticised on the basis that its $28/seat/month pricing is actually rather high. Over a typical 3 year depreciation cycle for IT equipment, it’s on a par with Apple laptops, and has the restriction that all the applications must work in a Web browser on netbook-class hardware. Google management has been promoting small contract wins in US school districts . Meanwhile, it is frequently observed that Google’s own PC fleet consists mostly of Apple hardware. If Google won’t use them itself, why should any other enterprise IT shop do so? The Google Search meeting linked above contains 2 Lenovo ThinkPads and 13 Apple MacBooks of various models and zero Chromebooks, while none other than Eric Schmidt used a Mac for his MWC 2012 keynote. Traditionally, Google insisted on “dogfooding” its products by using them internally.

The Google Fibre project in Kansas City, for its part, has been struggling with regulatory problems related to its access to city-owned civil infrastructure. Kansas City’s utility poles have reserved areas for different services, for example telecoms and electrical power. Google was given the concession to string the fibre in the more spacious electrical section – however, this requires high voltage electricians rather than telecoms installers to do the job and costs substantially more. Google has been trying to change the terms, and use the telecoms section, but (unsurprisingly) local cable and Bell operators are objecting. As with the muni-WLAN projects of the mid-2000s, the abortive attempt to market the Nexus One without the carriers, and Google Voice, Google has had to learn the hard way that telecoms is difficult.

And while all this has been going on, you might wonder where Google Enterprise 2.0 or Google Ads 2.0 are.

5. Google Play – a Collection of Challenges?

Google recently announced its “new ecosystem”, Google Play. This consists of what was historically known as the Android Market, plus Google Books, Google Music, and the web-based elements of Google Wallet (aka Google Checkout). All of these products are more or less challenged. Although the Android Market has been a success in distributing apps to the growing fleets of Android devices, it continues to contain an unusually high percentage of free apps, developer payouts tend to be lower than on its rivals, and it has had repeated problems with malware. Google Books has been an expensive hobby, involving substantial engineering work and litigation, and seems unlikely to be a profit centre. Google Music – as opposed to YouTube – is also no great success, and it is worth asking why both projects continue.

However, it will be the existing manager of Google Music who takes charge, with Android Market management moving out. It is worth noting that in fact there were two heads of the Android Market – Eric Chu for developer relations and David Conway for product management. This is not ideal in itself.

Further, an effort is being made to force app developers to use the ex-Google Checkout system for in-app billing. This obviously reflects an increased concern for monetisation, but it also suggests a degree of “arguing with the customers”.

To read the note in full, including the following additional analysis…

  • On the Other Hand…
  • Strengths of the Core Business
  • “Apple vs. Google”
  • Content acquisition
  • Summary Key Product Review
  • Search & Advertising
  • YouTube and Google TV
  • Communications Products
  • Android
  • Enterprise
  • Developer Products
  • Summary: Google Dashboard
  • Conclusion
  • Recommendations for Operators
  • The Telco 2.0™ Initiative
  • Index

…and the following figures…

  • Figure 1: Google, Microsoft 2.0?
  • Figure 2: Google’s advertising revenues cascade into all other divisions
  • Figure 3: Google + on Google Trends: fading into the noise?
  • Figure 4: Google’s Diverse Advertiser Base
  • Figure 5: Google’s Content Acquisition. 2008-2009, the missing data point
  • Figure 6: Google Product Dashboard

Members of the Telco 2.0 Executive Briefing Subscription Service and the Telco 2.0 Dealing with Disruption Stream can download the full 24 page report in PDF format hereNon-Members, please subscribe here, buy a Single User license for this report online here for £595 (+VAT for UK buyers), or for multi-user licenses or other enquiries, please email contact@telco2.net / call +44 (0) 207 247 5003.

Organisations, geographies, people and products referenced: AdSense, AdWords, Amazon, Android, Apple, Asus, AT&T, Australia, BBVA, Bell Labs, Boot to Gecko, Caffeine, CES, China, Chromebook, ChromeOS, ContentID, David Conway, Eric Chu, Eric Schmidt, European Commission, Facebook, Federal Trade Commission, GMail, Google, Google +, Google Books, Google Buzz, Google Checkout, Google Maps, Google Music, Google Play, Google TV, Google Voice, Google Wave, GSM, IBM, Intel, Kenya, Keyhole Software, Kindle Fire, Larry Page, Lenovo, Linux, MacBooks, Microsoft, Motorola, Mozilla Foundation, Netflix, Nexus, Office 365, OneNet, OpenLayers API, OpenStreetMap, Oracle, Susan Creighton, ThinkPads, VMWare, Vodafone, Western Electric, Wikipedia, Yahoo!, Your World, YouTube, Zynga

Technologies and industry terms referenced: advertisers, API, content acquisition costs, driverless car, Fibre, Forkdroids, M&A, mobile apps, muni-WLAN, NFC, Search, smart TV, spectrum, UI, VoIP, Wallet

Handset IPR – a new cold war begins

This is an extract from a report by Arete Research, a Telco 2.0TM partner specalising in investment analysis. The views in this article are not intended to constitute investment advice from Telco 2.0TM or STL Partners. We are reprinting Arete’s analysis to give our customers some additional insight into how some investors see the Telecoms market.

This report can be downloaded in full in PDF format by members of the Telco 2.0 Executive Briefing service using the links below.

                            Read in Full (Members only)        To Subscribe

We’ll be analysing and discussing the Cold War, and also the ‘Great Game’ being played out between the online superpowers (Google, Apple, Facebook, telcos and others) at our upcoming EMEA ‘New Digital Economics’ Brainstorm (London, 9-10 November). Please use the links or email contact@telco2.net or call +44 (0) 207 247 5003 to find out more.

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A New IPR Cold War Begins

When we [Arete Research] published Software IPR: Into the Trenches (Nov. ’10), we emphasized how legal battles around software patents applied to handsets could radically alter a decade-old stable IPR landscape of a few wireless giants (Nokia, Ericsson, Qualcomm). Since then 1) a consortium of Apple, RIM, Ericsson, Sony, Microsoft and EMC paid a staggering $4.5bn for 6,000 Nortel patents, 2) an ITC judge ruled in Apple’s favour in its case against HTC on patents that we thought were too broad to be defended, and 3) after renewed interest in monetising Motorola’s patents, Google bid $12.5bn for Motorola ($9bn net of cash), further escalating the legal spat between three rival gangs: Apple, Google/Android and MSFT/Nokia.

In this note we lay out implications for the mobile device space and try to clarify some misunderstood issues around Google/Motorola, Nortel, and Nokia. We see this as the start of a long Cold War, where all parties are heavily armed, and risk destroying each other (and themselves) with overly aggressive legal actions.

Can Go-Mo Really Go, or Generate Mo?

Google’s acquisition is firstly a tacit admission, in our view, that the project to rescue Motorola Devices failed: despite extensive restructuring and its Android efforts, Motorola Devices could not make money due to a poor track record in execution and reaching scale. In 2Q11 it sold 4.4m Android devices vs. 11m+ for HTC and 18m+ from Samsung. Google has little experience bringing devices to market (see the NexusOne), and cannot change MMI’s cost structure while it runs on an “arm’s-length basis.” It is not clear what returns MMI is expected to deliver.

Contrary to the deal-related rhetoric, we do not think Google wants Motorola to increase its scope at the expense of other Android partners. Instead, we think Motorola will be used to pioneer new concepts like a Google+ phone (like HTC did with Salsa/Cha Cha Facebook models).

Google’s aim for Android is the widest possible search and advertising penetration; this will not be realised if Google aggressively competes with other Android OEMs: Samsung, HTC and Huawei all told us directly they do not expect Motorola to receive preferential treatment. We see little prospect of improvements in Motorola’s low market share or lack of profit. Google needs to avoid any perception of favouritism to prevent Samsung from further efforts in Bada, or HTC to toy around with MeeGo or focus design innovation on WinPhone. Any new Motorola design cycle with closer Google input would only come in 2013, assuming the deal closes in early ’12. 

Motorola’s IPR portfolio is clearly the bulk of the $9bn implied enterprise value: 15,000 wireless patents, another ~6,200 pending, and 3,000 granted or pending patents in Home. Google had the chance to assess both Nortel and MMI’s portfolios and how widely they were licensed. Now Google will own essential IPR – currently being asserted against Microsoft and Apple in multiple jurisdictions – to support all Android vendors, a point made to us in the last day by HTC, Samsung and Huawei.

How might this work in practice, and why did Google need to own a handset OEM, and not just IPR to support Android? This IPR would allow Google to directly negotiate cross-license deals with vendors like Apple on behalf of Android OEMs. It could offer them pass-through rights (PTRs) to Motorola’s IPR for Android devices (but not for WinPhone, Bada, etc.). Qualcomm similarly offers PTRs to vendors that use its chipsets; and MSFT justifies the licensing cost of WP7 as an insurance against IP infringement claims. This could even be a precursor to an Android patent pool – making a NATO-like alliance – in which all licensees share patents for mutual benefit.

Depending on Google’s policies, Android licensees could also save costs from not paying royalties to Motorola; Google cannot charge royalties for Android itself and also claim it is “free,” but may more strictly oblige vendors to use Google services, which it only does on “Google Experience” devices. Since vendors like Nokia and Ericsson license IPR only at the device level, Google has to be an OEM to negotiate directly with them, Apple and Microsoft. Some will argue against OEMs using Google’s “passed-through” IPR in cross-licensing, but Google can also assert Motorola’s non-wireless patents not covered by FRAND, notably in video. There is a lot of legal hard work ahead for Google, but at least it shored up its own weak patent position, and we believe Google has given assurances, if not outright indemnities, to Android vendors to support them.

There are other benefits for Google to realise: Motorola has large NOLs, largely on-shore cash, and Google will get a large video infrastructure installed base with $4bn of Home sales to bootstrap a weak Google TV business. It should help integration of Android tablets and smartphones in the living room. Motorola must show its separation was not done with a sale in mind for its shareholders to avoid tax liabilities (though in our initiation note, Motorola Mobility: Finally Moving Out [Jan. ’11], we said MMI would need a partner, seeing Huawei as a logical choice). Yet the principal benefit is to bolster Google’s own weak IPR position, not by buying a weak portfolio such as IDCC (see InterDigital: Tulip Mania?, Aug. ’11).

To read the Briefing in full, including in addition to the above analysis of:

  • Apple: Realpolitik
  • Making sense of Nortel
  • Nokia: tied up in alliances
  • Microsoft: no need to buy
  • RIM: not an IP superpower
  • Diplomacy or Total War?
  • New rules of engagement
  • The cost of war is always high

Members of the Telco 2.0TM Executive Briefing Subscription Service can download the full 7 page report in PDF format here. Non-Members, please see here for how to subscribe. Please email contact@telco2.net or call +44 (0) 207 247 5003 for further details.

Full Article: Handsets – Demolition Derby

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.Arete 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

demo_derby_01_cars.jpg

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.

demo_derb-table1.jpg


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.

dem0_derby-table2.jpg

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.

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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.

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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.

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Richard Kramer, Analyst
Arete Research Services LLP
richard.kramer@arete.net / +44 (0)20 7959 1303

Brett Simpson, Analyst
Arete Research Services LLP
brett.simpson@arete.net / +44 (0)20 7959 1320

 

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