Mobile Manufacturers Part I: Killer Competition

| About: Microsoft Corporation (MSFT)
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To understand whether financial success is a feasible result of a particular firm's fight in the marketplace requires some understanding of the difference between the winning strategies and the losing strategies already demonstrated in the hyper-competitive mobile hardware market. Factors historically viewed as crucial in the PC market may not drive success in the mobile market for reasons explained in Part One and Part Two of an earlier article on Google's position in the mobile platform war. (Spoiler: Google will gain share.) Hardware competition differs from platform competition in ways that impact product competitiveness, profitability and the market addressable by a manufacturer's particular hardware or hardware strategy. This article offers readers a view of the mobile battlefield not simply by focusing on platform differences, but by looking into the production of the physical product to examine which competitors are in a position to achieve acceptable results from some segment of the mobile gadget market.

Many makers of mobile hardware struggle for success in a crowded marketplace. The need to understand what the overall market promises its participants is especially crucial in a time of rapid change: Research In Motion's (RIMM) upcoming crop of hardware to run its QNX-based platform, Microsoft's (NASDAQ:MSFT) own hardware and that made by its OEM partners for its new platforms, and recent changes in the products and partner support in nearly every manufacturer's tablet. It's easy to conclude that commodity pricing will drive everyone's profit to zero, or to assume that current trends will continue forever and plot performance graphs to the moon.

Although this article seeks to discuss hardware rather than platforms, the connection of some hardware vendors to particular platforms prevents complete separation of the two. There is no market at all for mobile hardware without platform software. This article addresses hardware; the differences in margins and quality drive the competitive positions of the various market players, and the success or failure of the firms' mobile hardware businesses.

Today: Yesterday's Aftermath

When last we visited the mobile market, the mobile hardware war stood thus:

  • Apple Inc. (NASDAQ:AAPL) enjoyed a high-margin and high-growth mobile business vending smartphones and tablets to the high end of the global mobile market;
  • Samsung (OTC:SSNLF) had dwarfed Apple in unit volume to become the only other manufacturer to make a big profit in mobile hardware;
  • HTC Corp. (OTC:HTCKF) was eking out a thin profit as a pure hardware manufacturer, and did so without the cash safety net of a share-hungry platform vendor;
  • Research In Motion had begun posting accounting losses but announced it was on track to release a completely revised new BlackBerry 10 operating system and device family by year-end;
  • Nokia (NYSE:NOK), formerly the global mobile leader, launched a Microsoft-subsidized line of phones amidst mounting losses, hoping to raise Windows Phone global market share above the share enjoyed by Samsung's mostly-China "Bada" operating system in order to regain enough volume to break even again in its sagging phone business; and
  • Microsoft had re-entered the mobile hardware business with the Surface, which launched to "modest sales."

Ordinarily, handling and examining a physical product can give observers a Peter Lynch-style insight into its prospects, driven by such things as the feel of its quality, its price, and so forth. The interesting thing about the mobile hardware market is that examining a mobile product on its own merits without consideration for the cut-throat competition around it offers so little predictive value. The mobile market is dominated by cut-throat competition that longs to destroy participants.

Losing Money In Mobile Hardware

The mobile hardware business is tough. The descent of Palm Inc., maker of the once-dominant Palm Pilot device family, is an example both instructive and non-unique in how the fortunes of a hardware manufacturer can turn. Palm - bought by Hewlett-Packard (NYSE:HPQ) for its WebOS operating system and smartphone technology - is no longer valuable even as a hoard of intellectual property to the company that bought it. The ruins of Palm were spun out of HP as GRAM. Far from becoming a ubiquitous platform for everything from phones to printers, Palm's WebOS is now a volunteer project. Palm hardware, once the flagship of PDAs and the first PDA to include a phone, is no more.

Some hardware dies an early death, never reaching the lofty heights Palm once commanded. Microsoft once sold smartphone hardware it called the Kin. The Kin was derived from business acquired when Microsoft bought Danger. It's dead now.

Then, consider Motorola. Its pagers and cell phones not only sold well in the U.S., but gleaned huge share in the Japanese market despite protectionist legislation and domestic cartels. Eventually, Motorola became better at selling electronic devices to the Japanese than were the Japanese themselves. Times have changed. Motorola's fortunes have fallen until the money-losing (by GAAP accounting, even after the buyout was announced) business was bought by a bigger company in a different business: Google Inc. (NASDAQ:GOOG). In the wake of the Motorola purchase, Google cut 4,000 Motorola Mobility jobs and in a single quarter suffered a half-billion-dollar earnings kneecap due to Motorola's continued hardware losses. The plan is apparently to re-launch Motorola handsets next year as a high-end premium brand. If it is to succeed, it will take quite a bit of capital to accomplish: competition is tough.

How tough? Google's Motorola isn't the only hardware house hoping to pull up its crashing craft's nose-cone before falling to the earth. Research In Motion was once the king of smartphone manufacturers, but earlier this year it became clear its situation was serious. Increasing competition has prevented it from differentiating its products effectively in the mass market. Despite being able to retain enough old users that it could grow its subscriber base, falling unit sales and plummeting margins are killing profit. The result? RIMM's hardware business has consumed the non-hardware revenue that once was the cream of the company's operation. The company is presently in a rough competitive position, and pins its hopes on a generation of devices it will release (after some delay) in the month following the 2012 holiday shopping season. Whether gains in consumer sales will eclipse departing enterprise customers (including at Halliburton (NYSE:HAL), bring-your-own-device workplaces, and federal agencies such as NOAA and the ATF) and whether a new operating system will facilitate differentiation sufficient to hike margins, will be significant questions as Research In Motion's January 30 product release seeks to return profit to the once-dominant mobile hardware maker.

Another still-independent hardware manufacturer bears consideration. One would not expect one of the world's largest handset vendors to be in particularly dire straits, but the Guardian's chart of Nokia share (from IDC data) show Nokia's share of the smartphone market steadily sagging:

Smartphones v mobiles Q3 2012

Nokia's slumping sales slope isn't the whole story: business isn't just half or a third what it was, it's descended into the realm of nightmare. That's because profits aren't based on units, they're a function of both units and unit margin. As unit margin collapses under the dual burden of commodity pricing pressure and fixed costs that don't shrink with shrinking sales, even small changes in unit volume can result in outsized adjustments to the bottom line. (Ask Research In Motion about this.) Nearly two years ago, headlines about Nokia's battered bottom line was already being described with the word "again." Halfway through 2012, Nokia wasn't just suffering losses, it was suffering quadruple the loss of the comparable 2011 quarter, pushed by unit volumes declining "only" 34%. In the most recent quarter, Nokia racked up another more-than-a-billion loss. At this, a Canalys analyst finally remarked, "This is probably the first time that I have started to doubt the Nokia comeback story." Nokia's 5-year chart of earnings yield illustrates how volume loss impacts earnings in the hardware business:

According to the chart, Nokia is now losing each quarter more than five times the money it used to earn. This author once suggested Nokia as an attractive short, but avoided expressing much enthusiasm for shorting it only because Nokia was being supported by a heavy subsidy from Microsoft. You say - What? Microsoft subsidizing a hardware manufacturer? Although there may only be rumors of Microsoft subsidizing Windows 8 HTC phones to get placement with US carriers, there is well-documented news that Microsoft pays Nokia a billion dollars annually - from cash-producing business segments like Server and Tools - in order to ensure Microsoft has a client hardware platform for its money-losing smartphone business. Unlike smartphone hardware makers with an established profitable position, Nokia is losing money hand over fist despite a $1 billion annual subsidy from Microsoft: its latest operating cash flow was negative €429 million ($561 million U.S.) (link is an earnings release PDF) after Microsoft's quarter-billion-dollar quarterly subsidy. Nokia's year-on-year result has been a €1.5 billion ($1.96 million U.S.) decrease in net cash and other liquid assets, which stems from operational results and dividend payments "partially offset by cash flows related to the receipt of quarterly support payments from Microsoft" Other efforts to raise cash include abandoning an Australian outpost, selling off its Qt assets, peddling a patent portfolio, and even liquidating its global headquarters in Finland (to lease it back). Nevertheless: Nokia is down €1.5 billion cash on the year. How many billion-plus quarterly losses can it sustain? Hardware is a rough business, especially when trying to buy back lost sales share.

Microsoft's effort through Nokia (and to a lesser extent other handset makers) to succeed in smartphones isn't its only mobile effort: Microsoft launched a self-branded Surface tablet earlier this year. While reviews of it are easy enough to find - and advertisements - this author has not yet seen one in the wild. People watching advertising impressions haven't seen much of Surface either. Some of this relates to the device's newness, of course; and some relates to the limited number of distribution points for Microsoft's hardware (cell carriers don't offer it because no Surface model supports cellular data for non-WiFi connectedness). Microsoft's leader Ballmer described the Surface launch as "modest." Given Microsoft's experience with the defunct Kin, and the warranty-cost shocks that followed the high-volume sale of XBox hardware, perhaps a "modest" start is a wise move. Whether "modest" sales volumes are a strategic plan rather than the result of failure will remain (at least for a while) known for sure only in Redmond. The bottom line is: selling hardware is a hard business, and it can be expensive. The take-home story with Microsoft is that it has plenty of cash - produced by other business segments - to explore hardware competition until it strikes on a successful formula and a receptive target market. Microsoft may not make money in hardware soon, but it isn't disappearing soon, either.

The following chart depicts platforms in the U.S., but provides hardware insight as well: look at the U.S. share held by RIMM (9%), Nokia (0.3%+0.9%=1.2%), and Palm (0.6%+0.1%=0.7%). Backed by Google, Motorola retains double-digit market share among U.S. Android vendors (at 11%), but it's still losing money every quarter at those volumes. These once-giants' balance sheets are dying in the hardware market.

It's easy to lose money in mobile hardware in the current competitive environment. Big companies with recognized names and reputations for quality have failed, and more appear on the path to destruction. A few companies like HTC are at least not losing money, but most of the mobile hardware vendors are not able to produce significant profit from their operations.

High volumes isn't the secret to profit, or Nokia would not have drowned in so much red ink these last few years. Platform dominance isn't the secret to ultimate success, as most of the profit isn't in the leading platform. It's certainly possible that loss-leader strategies may lead to ultimate success after enough short-term profits are sacrificed to obtain whatever it is that puts meat on the mobile market segment pursued by a particular vendor, but without understanding what it is that makes firms profitable and mobile manufacturers succeed where higher-volume competitors have failed, it will be difficult to assess the strength of firms potentially clawing their way to financial success.

For an examination on what it takes to make money in mobile, read Part II on Samsung's success at actually making money in the mobile market. Then, continue to Part III, which addresses Apple's ability to profit in the immediate mobile environment and draws conclusions about the shape of competition to come.

Disclosure: I am long AAPL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.