Handset Makers' Emerging-Markets Boost

Though profits may be squeezed by lower prices, S&P says some companies have nimbly struck a balance between developing and developed markets

Nokia (NOK; ranked 3 STARS, hold) surpassed the billion-unit mark in wireless handsets—106 million in the latest quarter—in part by marketing the equipment to the low-income masses in developing nations. In the U.S., Motorola (MOT; ranked 4 STARS, buy) is offering its KRZR mobile device at a deep discount—more than 75% off its launch price of between $400 to $500 last September.

Early entrants in emerging markets have been sacrificing margins in the hope they can reap benefits later. At the same time, they're fighting price wars in the developed world. But Standard & Poor's Equity Research thinks there are a few companies that have managed to make headway in both markets without allowing profits to erode severely. It's a balancing act, analysts say. Although both markets are intriguing, the paradox challenges mobile-device makers in their struggle to keep investors happy. To this end, S&P thinks the top handset companies have perhaps found their calling.

Mobile devices are already in the hands of more than 2.5 billion people worldwide. This base increases by more than a million new subscribers every day, according to data from Nokia.

Nokia's Efficiency

S&P raised its opinion on Nokia's stock to hold from sell on Jan. 26. S&P equity analyst Inger Soderbom says the Finland-based wireless company has likely found some equilibrium between both developing and developed regions, and she points to financial results. In the fourth quarter of 2006, Nokia sold nearly five times the number of handsets in China, the Middle East, and Africa than it did in North America (30.1 million vs. 5.9 million).

S&P was concerned that Nokia would be hurt by lower average pricing of its handsets because of its high concentration in low-end emerging markets. But this is not turning out to be the case. Even though North America handset sales have been weak, the largest global handset manufacturer has proven it can widen margins in its mobile-phone unit by improving production efficiency, which should carry over into 2007. Soderbom also raised her earnings estimate to $1.42 per American depositary receipt (ADR) from $1.36, citing wider margins and despite a forecast for only 5% sales growth in 2007.

No. 2 Motorola is in a similar situation, says S&P equity analyst Kenneth Leon. However, he believes the U.S. handset and communications equipment maker may be in fundamentally better shape. It sold nearly 68 million mobile units in the fourth quarter of 2006, and sales rose 47% in the period. That's in spite of an unfavorable product mix and pricing pressure. In 2006, revenues from wireless phones advanced 32% and accounted for more than two-thirds of total sales. On Dec. 8, Leon raised his opinion on Motorola shares to buy from hold, citing valuation.

Sony Ericsson's Growth

Looking ahead, Leon thinks Motorola can recover in 2007 with a handset unit turnaround and strong contributions from its other businesses. The domestic company can also use its free cash flow to retire long-term debt and repurchase common shares. "Despite our concerns about Motorola's ability to achieve 10%-plus operating margins for its handset unit, we believe the current share price is attractive, having corrected from its October high," he says.

The ability to dodge margin pressures also appears to belong to the fastest growing mobile-phone maker, Sony Ericsson. The joint venture between Sweden's LM Ericsson (ERIC; ranked 4 STARS, buy) and Japan's Sony (SNE; ranked 3 STARS, hold) sold 26 million phones in the fourth quarter, up a whopping 61% from 16.1 million in 2005—plus its profit more than tripled. Sony Ericsson made money by offering sub-$200 handsets and Walkman digital music phones. It increased year-over-year revenues faster than all the others at 64%, landing it in fourth place in terms of volume and sales.

Soderbom upgraded LM Ericsson's ADRs on Jan. 24 to buy from hold on the Swedish firm's strength in its network-systems unit.

The third-largest seller of mobile phones (by volume and sales) is Korea's Samsung (not ranked by S&P). Then comes Sony Ericsson, followed by another Korean company, LG Electronics (not ranked by S&P), which saw a decline in sales of 11% year over year.

Favored Service-Provider ADRs

As consumers in Brazil, Russia, India, and China—known as the BRICs in emerging-market parlance—begin shopping, talking, and "texting" at the current rate demonstrated by the Japanese, Europeans, and Americans, it's important for the companies to grab market share early. To get the handsets in all of these hands, a wireless service provider often subsidizes the price of the phones.

In this group, S&P favors the ADRs of Hutchison Telecom (HTX; ranked 5 STARS, strong buy), which primarily offers mobile services to customers in Hong Kong, India, Israel, and Thailand; China Mobile (CHL; ranked 4 STARS, buy), which provides a range of mobile telecom services in 21 service regions in China, encompassing 16 provinces; Tele Norte Participacoes (TNE; ranked 5 STARS, strong buy), which provides services in Brazil's Region I, accounting for two-thirds of the country's total geography, 41% of the country's GDP, and 55% of the country's total population; and TIM Participacoes (TSU; ranked 4 STARS, buy), the second-largest wireless service provider in Brazil with the only licenses to offer nationwide service coverage.

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