Will Ericsson Hang Up on Cell-Phones Altogether?

Outsourcing production may not be enough to stem its market-share loss in this cutthroat business

Talk about déjà vu. Back in January, 1988, when Swedish electronics giant Ericsson (ERICY ) sold its hemorrhaging personal-computer operations to Nokia Corp., the move coincided with a major shift in the global PC business: New players were entering the market, competition was becoming cutthroat, and Ericsson showed some fundamental weaknesses. An effort to grow too rapidly had spread its resources too thin, and investors' overly optimistic expectations had set the company up for a painful fall. As its PC sales nose-dived, Ericsson's stock price tanked.

Fast-forward a dozen years, and a remarkably similar story line is playing out. This time the drama stars Ericsson's money-losing cell-phone business. On Jan. 26, the company announced it would outsource production of its mobile phones to Singapore-based manufacturer Flextronics. Ericsson's efficiency should benefit, thanks to Flextronics' economies of scale, which should chop $1.6 billion in costs by 2002. This savings could return Ericsson's mobile-phones division, accounting for 20% of the company's $31.6 billion in sales last year, to profitability by the second quarter of 2001. That would be welcome relief over Ericsson's $300 million loss on $8.6 billion in sales in the final quarter of 2000 -- primarily due to losses on handsets, as the industry calls mobile phones.

But even after the outsourcing announcement, warning flags are still being hoisted over Ericsson's cell-phone business. Analysts predict that its worldwide mobile-phone share will drop about 30% this year. And they believe major changes at the company are just beginning.


  In fact, many analysts think Ericsson may put the cell-phone division on the block, echoing its earlier computer move. Wall Street is filled with rumors of a deal with Sony. Analysts think the Japanese company might want to co-brand Ericsson's phones or buy the division outright, a prospect neither company will confirm or deny. "We never comment on rumors," says Gunnar Liljegeren, Ericsson's director of business development. "Some of them are valid, and some of them are not." But a deal with Sony sounds logical in light of the deeper currents in the cell-phone market.

Japanese and Korean high-tech giants have recently mounted major campaigns to grab a share of the business, just as the market is maturing and sales are no longer growing as fast as before. The bulk of purchases is shifting toward replacement phones instead of new ones. In 2001, only 500 million phones will be bought worldwide, down from 550 million expected as recently as last fall, according to industry and analyst reports. Some see that number dropping as low as 450 million this year.

That will obviously crimp manufacturers' profit margins. And Ericsson could be especially hard hit because of some internal peculiarities: It takes a notoriously long time to bring products to market, has less standardized products than players like Nokia, and, consequently, suffers from high production costs. All these factors are pushing the company out of the game, says Sanford Bernstein analyst Paul Sagawa. But even producers that don't lose 70 cents on each $1 in handset sales, as Ericsson did in the past quarter, are in trouble. So analysts believe a shakeout is imminent.


  The current betting is that in three years, the list of top-tier mobile-phone players won't include most of the companies on it today. Market leader Nokia (NOK ), which has highly standardized products and enjoys significant economies of scale, will likely be the only top-three player to stick around and perhaps gain market share, analysts say. Motorola (MOT ) and Ericsson -- Nos. 2 and 3, according to Dataquest -- are expected to lose share this year and drop out of top three soon thereafter, says Yankee Group analyst Dan Downey. It could happen swiftly: According to a recent Morgan Stanley Dean Witter report, Ericsson could slip this year from a 10% share to a measly 7%.

The beneficiaries? Germany's Siemens, known for consumer-friendly designs, is expected to move up a notch to third place, at least temporarily. And Asian companies, such as Sony, Matsushita, Mitsubishi, and Kyocera -- all of which boast superior technologies, next-generation network expertise, and solid finances -- are likely to push their way into the top five handset makers within three years, says Jeff Kvaal of Lehman Brothers. Though the cell-phone market isn't growing as fast as expected, it's still huge, and many companies would like a piece of it.

The impending shakeout has become particularly apparent over the past month. Even Nokia cut its revenue targets, saying sales should grow 25% to 35% this year, down from 45% in 2000. On Feb. 1, the Finnish company announced plans to shift some of its U.S. manufacturing overseas in an attempt to cut costs. Meanwhile, Motorola said it would stop making mobile phones in its Harvard (Ill.) facility and would eliminate 2,500 jobs. That came after a December decision to outsource some of its cell-phone production to Canada-based contract manufacturer Celestica.


  Still, cost cutting isn't a panacea. As the market matures, all cell-phone players will have to adjust their growth expectations. Investors are already reducing theirs: The stocks of some of the largest handset players -- such as Motorola and Nokia -- have dropped to their lowest levels in more than a year. Ericsson's shares are hovering around $11, down from their recent high of $26.31 last March. And some analysts believe the company is still overvalued, because of the tightening cell-phone market.

Ericsson executives likely recognize the signs of a slimming market that decided the fate of their PC business back in 1988. The company has already shifted its focus to next-generation wireless systems and has won a major chunk of that market. And as it did with PCs, Ericsson will probably find a way to prevent the handset business from derailing its forward path. But the road ahead looks long and bumpy.

By Olga Kharif in New York

Before it's here, it's on the Bloomberg Terminal.