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You would think the mobile-phone business was a dying industry. The last week in July and the first week in August, the stocks of the Big Three mobile-phone manufacturers took a heavy hit. Motorola (
MOT) got off the easiest, with a 3.6% drop. Nokia (
NOK) was hit the hardest, with a 32% fall. Nor did Ericsson (
ERICY) escape unscathed -- its stock lost 21%.
What's causing this dive is a slowdown in the growth rate of mobile-phone purchases. Such shrinkage shouldn't be too surprising considering the industry increased sales 70% in 1999. Yet investors ran for the exits when the three companies announced they would not meet expected sales goals over the next quarter.
In the case of Motorola, the severity of the punishment was minor, as it should have been. Motorola's main business is making semiconductors and telecom equipment, so a shortfall in its handset division is of less importance. In Nokia's case, fewer handset sales are of more concern since they account for 75% of the company's revenue. Hence, the dramatic drop.
ASIAN INVASION. But in the case of Ericsson, investors appear to have fled too hastily. Despite being the third-largest seller of telephone handsets worldwide, the Swedish company derives only about 20% of its revenue from selling phones. The lion's share of sales comes from telecom-infrastructure equipment, a business that's not showing any signs of deterioration. "The bottom line is that there is a sustained build-out among telecom carriers that is driving Ericsson's growth to 25% to 30% a year," says George Smith, an analyst with Davenport & Co. who has a buy recommendation on the stock. "The market perceives Ericsson as a handset play, so they got caught up in the hubbub concerning that area. Their strength, though, is infrastructure."
In fact, two-thirds of the company's revenue comes from selling equipment to telecom carriers. Although it has a wire-line equipment arm, the core of Ericsson's equipment business is in the wireless arena. The collective thinking of the market seems to be that if handset growth is trailing off, then overall wireless growth should be slowing down also.
That's not necessarily the case. For one thing, the slowdown in sales by the top three phone makers doesn't necessarily result in a slowdown in overall sales. Customers are starting to choose cell phones in much the same way they purchase televisions or camcorders: They want a brand they know and trust but price is also a factor. As a result, companies like Sony and Samsung have flooded the European market with new phones that are often cheaper than their counterparts from Nokia or Ericsson. The Asian invasion is about to hit U.S. shores, too.
3G EXPECTATIONS. Another factor in the slowdown is that many of the high-end customers are aware that a new generation of cell phones will soon appear, possibly by the end of this year but more realistically by the end of 2001. These phones, named for the 3G standard that is being adopted worldwide, will allow higher bandwidth and more data services. Many people are putting off replacing older phones until 3G takes off.
While Ericsson isn't expected to gain market share when 3G arrives, it will get a big boost as carriers buy new equipment to provide 3G services. "Ericsson will capture 35% to 40% of 3G spending," says Brantley Thompson, an analyst with J.P. Morgan Securities who rates the stock a buy. Thompson expects global 3G spending on equipment over the next four years to range from $150 billion to $200 billion.
Even the low end of those spending estimates means Ericsson could get an additional $50 billion in new revenue over the next four years. That comes to about $13 billion a year. Considering that the company produced about $21 billion in revenue in 1999, that would have a huge effect on the top line.
SWEDISH RULES. The bottom line is another matter because Ericsson loses so much money on its handset sales. If you read the company's earnings release at face value, you would guess it breaks even. But Sanford C. Bernstein analyst Paul Sagawa, who has a hold recommendation on Ericsson, estimates that the handset division has a negative 20% operating loss margin. That's because the company is allowed to count money made by divesting its operations as operating income, according to Swedish accounting rules. Filter that through U.S. GAAP (Generally Accepted Accounting Principles) rules, and you end up with a loss. "No matter how you look at it, their handset business is horrible," says Sagawa. "They shouldn't be making phones to begin with. They need to either sell the unit or find a contract manufacturer to make the phones for them."
Of course that would cause Ericsson to lose its only opportunity to keep its brand close to the hearts and minds of millions of customers. Nearly half a billion people around the globe carry a phone with the Ericsson logo, and that has immense, if immeasurable, marketing value. But Sagawa isn't convinced. "The only thing they are branding into people's minds is that Ericsson stands for poorly designed, drastically discounted phones," he says.
Whether or not Ericsson unloads its handset business, the equipment division is what really matters. Thanks to heavy growth in that area, analysts expect the company to earn 27 cents a share this year and 39 cents per share in 2001, as 3G spending kicks in. If those estimates hold up, the current drop in the share price will be considered a time when the market abandoned the stock for all the wrong reasons.
Jaffe writes about the markets for Business Week Online
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