Brains vs. Beauty in Cell-Phone Market <By Tero Kuittinen, RealMoney.com Contributor>
Motorola (MOT:NYSE) and Nokia (NOK:NYSE ADR) have chosen nearly opposite product strategies for 2006, which makes them a highly volatile pair to watch.
Nokia is going with a smartphone strategy that emphasizes new features for midpriced products; Motorola is emphasizing design and radically extending the Razr brand. Both stocks are likely to head south over the next two months, though Motorola may well continue to outperform Nokia for a month or two.
Nokia Awaits Lift From Smartphones
Motorola shares strongly outperformed Nokia over the summer, but in the month ahead of third-quarter results, Motorola fell more than 15% while Nokia shares were stable. Now Motorola is seeing a bounce. The reason for the volatility is the product transitions both companies are facing this winter.
Nokia managed to beat the EPS consensus by a euro cent, but its volume growth didn't dazzle like the numbers reported by Motorola, Sony Ericsson and LG just days earlier. The big problem most probably was in the low-end portfolio, where the old workhorse 1100 is aging rapidly.
This cheap blockbuster is selling significantly more than 10 million units per quarter, but it's being replaced by a follow-up model, the 1110. Nokia's year-on-year revenue growth of 15% in its bread-and-butter mobile phones unit implies that the transition is not taking place as rapidly as it should. The price erosion of the 1100 may loom larger for some time than the better average price that the new 1110 delivers.
For 2006, the 1110 is a key phone for Nokia. At 80 grams, it's extremely light for a cheap phone and incorporates fewer components, resulting in better margins. However, if the replacement of the 1100 by the 1110 is going slower than anticipated, it's hard to gauge whether the situation will be resolved in the fourth quarter. This is something investors are likely to get nervous about over the next two months.
In the high-end segment, Nokia is seeing strong results from smartphones -- the operating margin of the smartphone unit soared from 10% to 16.9% in a year. At the same time, smartphone revenue grew by 55% year-on-year. The key dilemma here is when the robust profitability and hot revenue growth of the smartphone unit will begin to offset the falling ASPs of the plain-vanilla mobile phones unit.
At the moment, the revenue score is 5.2 billion euros from mobile phones and 1.4 billion euros from smartphones. A year ago, the ratio was 4.5 billion to 0.9 billion. So the smartphone unit is rapidly becoming an important new product segment, but in the third quarter, the positive impact was still overshadowed by the price erosion of the cheap, basic phones.
Nokia is bringing out a new range of smartphones in the 350-450 euro range in 2006, radically undercutting its major rivals, whose smartphones are priced at 600-800 euros. This should enable Nokia to grow its smartphone unit into a size that is perhaps as big as half the size of its mobile phones unit by the third quarter of 2006. But at what stage will we see a substantial ASP and margin impact? It's a difficult question, and the transition from the 1100 to the 1110 is obviously postponing the point at which Nokia's smartphones will start having a substantial impact on the overall company performance.
However, one thing is becoming evident -- Nokia is the only vendor positioning itself seriously for a smartphone boom in 2006. The smartphone market grew to some 45 million units in 2005 and is projected to expand to 80 million to 90 million units in 2006. Only Nokia has announced a wide selection of smartphones with prices starting from roughly 350 euros -- its rivals see smartphones as a relatively small luxury niche (witness Sony Ericsson with its single new high-end smartphone, priced around 800 euros). Motorola on a Razr's Edge
Motorola certainly isn't betting on smartphones. Its most visible new model, the Motorola Q, won't debut until December and is expected to be a high-priced luxury unit. Instead of creating phones using sophisticated operating systems and lots of new features, Motorola is focusing on models with strong design and often remarkably thin chassis.
Motorola's Razr phones debuted in the autumn of 2004 and captivated consumers; Motorola is likely to sell more than 10 million units of Razr models and related spinoff phones in the fourth quarter this year. The demand for Razr phones has been running extremely high, powering Motorola to double-digit volume growth from the second to the third quarter. But its decision to expand the Razr family so widely and launch so many spinoff models is almost unprecedented. Many of the new Razr spinoffs are technically unimpressive -- they possess the same eye-catching design, but they don't add the same amount of new features that its biggest rivals are offering.
This is a strategy that has worked well for Motorola over the past four quarters. It's also a high-risk gamble. Phone vendors usually try to minimize their exposure to a single product platform, particularly one that is more than a year old. Motorola is either cannily extracting every ounce of value from the Razr or going out on a plank.
Concerns over this strategy sent shares tumbling from $24 to $20 ahead of earnings. And despite its stellar third-quarter numbers, Motorola didn't regain $24 after they were announced.
I think the markets will get nervous about the Razr extension outlook. Motorola has started shipping spinoffs like Pebl and should get key 3G models like V3x out during this quarter, but these models are not yet showing up in meaningful quantities in major markets.
We still don't know whether Pebl, Slvr, A1010 and V3x are going to hit substantial production volumes this quarter. The timetable is considerably hazier than Sony Ericsson's, which is clearly hitting on all cylinders already with crucial holiday season models like the K750 and W800. Features vs. Design
Five years ago, Nokia depended heavily on design and Motorola was an engineering-driven company focusing on richly-featured phones. These roles have now neatly been reversed.
What will consumers crave this winter? Phones with features like 2-megapixel cameras, a new generation of color displays, an operating system offering a variety of applications? Or phones with exciting designs, thin builds and the buzz that the Razr family offers?
I remain convinced that we are edging into a period in which features trump design. No platform has been extended further than Motorola is now extending Razr. The company could pull it off, but the risk of consumer boredom is increasing.
Sony Ericsson's results show consumers are flocking to models with new-generation features, including 2-megapixel cameras. Nokia is better positioned to meet this demand in the first quarter of 2006. Its new strategy of pitting 400-euro smartphone devices against rival vendors' 700-euro models is vitally important -- the latest smartphone sales snapshot from the second quarter showed 200% year-on-year volume growth in this product category. It still looks to be the key battleground of 2006.
I think the phone vendors will be defined in 2006 by how they prepared for the new era of phones with rich software and hardware features, and those that refused to invest massively in R&D from 2003-2005 will find the catch-up game hard to play.
I wouldn't make little of the rough patch that Nokia's low-end portfolio is going through; U.S. investors don't really believe in the importance of the smartphone market and they don't buy Nokia's focus on this category. The European/Asian smartphone boom is still largely invisible in North America.
I think Nokia is headed back to $13 to $14 a share as investors fret over how badly the 1100 is eroding before the 1110 takes up the volume mantle. For Motorola, the $24 level the company flirted with a month ago was probably the cycle peak -- the moment before investors began worrying about the growing reliance on Razr and the still semi-obscure production ramp-ups of the new fourth-quarter models.
The valuation swings of Nokia and Motorola tend to be strong. The latest leg began around May as Motorola snapped Nokia's outperformance streak of the first half of 2005 and began outpacing its rival. Motorola's performance is likely to continue to be relatively stronger as both decline over the next month or two, but I think the pendulum will begin its inevitable swing back to Nokia's favor around December or January.
For Motorola, 11% phone margins are a peak phenomenon; for Nokia, 15% has been the bottom-out phase.
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