Smartening up

Smartphones, netbooks and the data-hungry services they support are flourishing in the recession. But there are pitfalls for all involved

8 October, 2009

By Iain Morris, EIU (Economist Intelligence Unit)

Falling shipments of handsets, dwindling revenues from mainstream services and a dearth of capital for investments in next-generation networks. While the telecoms industry has not succumbed to the global recession anywhere near as badly as some manufacturing sectors, it is experiencing one of its toughest years ever.

Even in the more resilient mobile-phone business, the biggest players from all parts of the industry are struggling. Ericsson, the market-leading maker of wireless networks, would have seen a three per cent fall in second-quarter 2009 sales were it not for favourable currency movements, as network rollouts were put on hold. Globetrotting Vodafone could not prevent organic revenues from dropping by 4.4 per cent in recession-struck Europe over the same period. Most alarmingly, falling handset demand led to a 74 per cent drop in pre-tax profits at Nokia in the second quarter.

There are, however, some bright spots amid the gloom, as revealed in recent results from Apple. Buoyed by sales of its iPhone handset, the Cupertino-based trendsetter posted a 15 per cent increase in second-quarter net profit to $1,229m on a sales rise of 12 per cent to $8,337m. And even though handset makers have sold fewer mass-market devices this year than last, their smartphone units have already defied predictions from some well-regarded commentators that sales would increase only marginally this year.

In May 2009, market-research company Gartner published data showing that smartphone shipments were up by 12.7 per cent to 36.4 million units in the first quarter of 2009, when economists were at their gloomiest. Phone shipments that quarter slipped by 8.6 per cent to 269.1 million units.

The makers of netbooks - miniature, low-cost laptops designed for web surfing on the go - also appear to be flourishing. Taiwanese Acer shipped around 9.2 million PCs in the second quarter, up by an impressive 34 per cent on the same period 2008. The figure was bolstered by the company's focus on netbooks - a market it dominates along with local rival Acer - and compares with a 17 per cent slump in second-quarter PC shipments at Dell to 9.3 million units. Gartner expects 21 million netbooks to ship globally this year, and 30 million next.

Both developments are linked by the growing enthusiasm for mobile data services. While voice revenues in developed markets continue to decline, sales of mobile internet and other data services are on the rise. Research from Credit Suisse, a bank, shows that mobile voice revenues in Europe fell by 3.8 per cent in Q1 2009, but that data revenues grew by 11.2 per cent to form 25.3 per cent of the total, up from 22.7 per cent a year earlier.

Is it such a surprise these areas are doing so well in the slump? Smartphones are coming from nowhere, accounting for just 13.5 per cent of all phone shipments in Q1 2009, according to Gartner's figures. No doubt, their makers were never going to encounter the same problems as companies in more saturated luxury-goods markets. More importantly, devices are frequently being made freely available by operators hoping their generosity will pay off when customers start spending on usage.

Netbooks represent an even tinier fraction of PC shipments, meanwhile, and provide an alternative to costlier laptops at a time when household and corporate budgets are being trimmed. And the success of broadband in the fixed-line world has proven just how much value consumers attach to the internet experience: as mobile networks improve, and mobile devices become more user-friendly and attractive, there is no obvious reason why mobile broadband should not be even more successful.

Dumbing down

But there are dangers for all companies involved. With so many manufacturers crowding into the small smartphone space, even the most optimistic forecasts are unlikely to equal generous profits for many companies in the immediate future. And the sheer number of so-called 'apps stores' being developed for these devices is creating confusion for prospective customers and a headache for third-party software developers.

Operators are in an even more awkward position. Having subsidised the cost of iPhones and other expensive gadgets in a bid to woo new customers, they need their smartphone users to spend heavily on using their 'dumb pipes' and, effectively, pay them back. In the short term, however, their margins are under pressure. AT&T's wireless operating margin shrank to 23.8 per cent in Q2 2009, from 25.5 per cent a year earlier, largely because it has been offering the iPhone at a massive discount to its customers. Greater cost discipline allowed Verizon, its chief rival, to lift its own operating margin to 28.8 per cent from 28.6 per cent over the same period.

The question is whether customers of gadgets like the iPhone really generate enough revenue to justify the short-term squeeze. In the hugely competitive UK market, Telefónica is providing the device for nothing to customers who choose a £40 a month tariff. Ofcom, the UK regulator, says the average contract user in the country was spending £33.06 a month in 2007, up from £32.54 in 2006. The £7 difference sounds significant, but smartphone users are typically being offered unlimited data usage along with massive bundles of voice minutes. Operators are unlikely to earn much from usage over and above contractual limits, while the heaviest users are generating a huge amount of traffic, forcing operators to keep an eye on their investments in network capacity. If all their customers were smartphone users, they would undoubtedly have a problem on their hands. While talk of an impending 'capacity catastrophe' might be scaremongering, it is worth remembering that AT&T receives plenty of complaints from iPhone customers about the slow speed of its 3G network. Ignore them and AT&T may find some of those customers do not renew their contracts.

The growing popularity of netbooks and plug-in dongles presents a similar threat to operators. Much of the growth in mobile data traffic has been attributed to mobile-broadband offers based on such devices. Yet many operators are trying to compete with fixed-line broadband companies through flat-rate pricing - a dangerous ploy given the higher costs of running mobile broadband networks. One problem identified in December 2008 by Analysys Mason, a consulting company, is that operators have typically calculated the profitability of mobile broadband services on the basis of incremental cost. That may only be appropriate while those services require a small proportion of total capacity, says Amrish Kacker, a partner with the company. Yet even with just 8-12 per cent of all users taking up mobile broadband services, data capacity requirements would be likely to exceed those of voice.

Netbooks carry a risk for manufacturers, too. While smartphones are a move 'upmarket' for makers of ordinary phones, netbooks are an example of the opposite for most PC companies. Customers choosing them in preference to bigger machines may cause an upset - not only for the likes of Dell and Hewlett-Packard but also for Intel, whose low-cost Atom chips for netbooks generate less revenue (and possibly thinner margins) than its mainstream products. It is possible, of course, that consumers are choosing netbooks over bigger laptops because of the recession, and that the situation will reverse itself when economic prospects brighten. But that would be calamitous for companies that have chosen to shift resources to the netbooks area this year.

App, app and away

As data traffic revenues will not provide operators with the growth story they want to tell, many are trying to shake off their 'dumb pipes' label and sell more value-added services. But their efforts to make money here have not been a great success so far. Indeed, it is companies like Apple that have taken the lead in this area. Its smartphone apps store has been a hit with customers and the investment community alike, having generated about 1.5 billion downloads since it first opened just over a year ago. While most applications are free, Apple earns money from many others, keeping a generous 30 per cent share of sales where the application developer is a third party. The Royal Bank of Scotland (RBS) has estimated that apps-store revenues earned by Apple up to March 2009 were anything between $239m and $737m, depending on whether price-tagged applications accounted for just ten per cent of the total or as much as 30 per cent, and assuming an average application price of $2.99. At the time, RBS put gross profits at anything between $72m and $216m.

Operators are now getting in on the apps store act. Most significantly, Vodafone has revealed plans for a store that will work across any phone and operating system, potentially giving it a market of nearly 300 million users (Apple's target audience, including iPod Touch and iPhone customers, numbered 31 million in May). It also has the advantage of already having a direct billing relationship with its subscribers, while customers of Apple have to supply credit-card information when they register at its store. Vodafone has also promised to share with developers some of its network-access information, which would allow them to create 'location-sensitive' applications. These might, for example, alert customers to the presence of particular shops or restaurants in their immediate vicinity.

All store-developing operators are, however, being hotly pursued by software companies like Microsoft, and the lot may struggle to catch up with Apple. One emerging problem is persuading developers to spend time on developing applications for a store that is starting from scratch. Many will prefer to serve only Apple, which already has a base of loyal users and a business model that appears to work.

Longer term, there is even the possibility that apps stores lose out to increasingly powerful browsers. While it has launched an apps store of its own, Google thinks browsers will be more important in the future (it also launched its own internet browser earlier this year, dubbed Chrome) simply because they are more economical. New services are also appearing that let consumers access bundles of content over the internet, including music, games and video footage, for a set monthly fee. The question is whether consumers accustomed to getting their internet services for nothing will pay much for these offers, and even whether youngsters will be able to pay at all. The prevalence and acceptability of online piracy makes that question even harder to answer.

One thing's for certain: despite the recession, innovation in the telecoms sector is flourishing. Consumers are being treated to a feast of gadgets and services at affordable prices. For the industry, the challenge is in ensuring this innovation fuels profitable growth when the good times return.

Iain Morris is a Technology Editor for Industry Briefing & Forecasts, an Economist Intelligence Unit service that provides in-depth strategic analysis, five-year forecasts, special reports and profiles of the leading players. Visit www.eiu.com/industry for more information and to request a free trial.