Handset vendors face rising costs as margins decline - Top five vendors look to cut R&D and marketing; average margin shrinks to 4% in 1Q09

New research from GSMA Intelligence has revealed that the world's largest mobile handset vendors are facing severe financial pressures as they continue to invest in their product portfolios during the market slowdown. We estimate that the average operating margin at the top five vendors - Nokia, Samsung, Sony Ericsson, Motorola and LG - declined to around 4 percent in 1Q09, down from an average of 13 percent a year ago. However, as our data shows, vendor expenditure in areas such as research and development (R&D) and marketing has increased; R&D expenses are estimated to have risen from 10 percent in 1Q08 to 12 percent in 1Q09, while marketing costs have risen from 9 percent to 10 percent over the same period. The figures highlight the predicament faced by handset vendors as they continue to invest in markets where demand is slowing and margins are shrinking, and we predict that vendors will look to cut costs in 2009.

In the first quarter of the year, the top five vendors shipped 191 million devices worldwide compared to 236 million a year ago, a 19 percent decline. Many vendors – including market-leader Nokia - are predicting a further 10 percent decline in shipments during the current calendar year. Shipments for the current quarter are expected to be flat sequentially and down year-on-year. Nokia, Sony Ericsson and Motorola all reported an annual decline in revenues in 1Q09, while only Samsung and LG, the two South Korean vendors, reported positive revenue growth. As a consequence, profits have dropped significantly at most vendors. Alongside the market slowdown, margins in the sector have also been negatively affected by a high-level of product inventories, fierce price competition, and a decline in the Average Selling Price (ASP) of devices. Handset vendors are now simplifying their portfolio of devices, focusing on high-margin segments and embracing content/media services, which has seen the battle in the handset space shift from a pure hardware play to a software-centric strategy.

As operating margins shrink dramatically, vendors are expected to significantly reduce expenditure in 2009 to remain profitable. It is likely that cost savings could be made in R&D as vendors look to streamline their portfolio of devices. In most cases, vendors are planning a two pronged strategy, looking to smartphones to generate high- margins and lower-tier devices to generate high volumes and maintain market share. However, a scaling back of R&D is risky considering that the average lifecycle of a device is six to nine months, which requires vendors to either revamp devices or launch new ones every six months while maintaining a balanced portfolio mix. In some cases, vendors will also need to develop costly new hardware and software platforms, most notably for the various new Android-based devices planned for launch later this year by most vendors.

Many of the US and European vendors have already outlined cost cutting strategies. Sony Ericsson has announced a cost saving plan that will reduce operating expenses by EUR300 million during 1H09 and by a further EUR400 million by mid-2010; Nokia has announced the streamlining of its R&D operations starting with the closure of its R&D facility in Jyväskylä and the downsizing of its mobile device manufacturing facility in Salo (both in Finland), and is targeting opex savings of EUR700 million in its devices unit by the end of 2010; Motorola, which is implementing arguably the most severe cost-cutting programme, is targeting cost savings of US$1.2 billion this year at its beleaguered handset unit.

Such cost cutting measures should result in a number of trends emerging in 2009. Alongside the reduction in handset portfolios, we expect an increase in joint-marketing campaigns with mobile operators and distributors, and the outsourcing of more products to Original Design Manufacturers (ODMs) such as HTC, Compal, Foxconn or Asustek.

Joss Gillet, Senior Analyst, GSMA Intelligence:

The current pressures we are seeing in the handset market have been caused mainly by the high level of maturity in developed markets, though the economic downturn has also played a part with regards to unfavourable currency fluctuations. In 2009, vendors (as well as mobile operators) are streamlining their device portfolios to focus on high-end consumer segments to generate high- operators) are streamlining their device portfolios to focus on high-end consumer segments to generate high- margins, and lower-tier devices as a volume and market share play. Vendors are expected to concentrate less on devices in the mid-tier segment (with an ASP of between EUR170 and EUR290) in the medium-term, focusing their R&D on high-end devices and outsourcing more lower-tier devices to Asia-based ODMs. Depending on the level of subsidies and how fast the bill-of-materials (BOM) for smartphones declines, handset vendors will have to carefully monitor price elasticity and device price erosion. Vendors that do not have a compelling and competitively-priced portfolio of devices ready to ship in time for the crucial last quarter of the year are likely to be in for a rocky ride in 2010.