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Originally published Monday, January 15, 2007 at 12:00 AM

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Handset sales going up, but not profit

For traditional manufacturers of wireless phones, the squeeze is on. Faced with stiff competition, changing consumer patterns and a shift...

MarketWatch

WASHINGTON — For traditional manufacturers of wireless phones, the squeeze is on.

Faced with stiff competition, changing consumer patterns and a shift in demand to developing nations, handset makers find it harder and harder to maintain profit margins. The entry of Apple into the market with its iPhone won't help matters, either.

While global handset sales will continue to rise — 1 billion phones are expected to be sold in 2007 — profit margins are unlikely to follow suit. Indeed, Nokia, Motorola and other manufacturers will be hard-pressed to maintain them at current levels.

Margins in Motorola's handset business could fall to as low as 5 percent in the fourth quarter from 11.9 percent in the third quarter when the company reports results this week. Motorola warned recently that sales and profits would be lower than projected.

Nokia saw the operating margin in its handset division slip to 13.1 percent in its third quarter from 16.9 percent a year earlier — well below a rate of nearly 24 percent in the glory days of the late 1990s.

The upshot for investors: Don't look for major moves in handset stocks similar to what Motorola saw in 2005, when its shares surged 31 percent owing to sizzling sales of the company's premium-priced Razr phones. A huge hit like the Razr is going to be harder to duplicate, analysts say.

"The glory days of the big premium on handsets is over," said Jane Zweig, chief executive of The Shosteck Group, a wireless consultancy. "It's a tough industry."

To some extent, the industry is a victim of its own success.

Manufacturers made wireless phones "cool" by introducing a number of innovative features and designs, but handset makers and network operators also pushed prices lower to stoke demand. In many cases, carriers give away phones when customers sign up for long-term contracts.

The result: Consumers, especially in the U.S., have become more resistant to high handset prices. They also realize prices will fall if they bide their time. As many as four of every five handsets sold in the U.S. is purchased for less than $100, market research shows.

Take Motorola's Razr, which broke new ground with its ultrathin body when it was introduced two years ago. The device initially sold for $500, but customers can now find newer versions for $50 or less.

Falling prices have helped Motorola to sell more than 50 million Razrs worldwide.

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Analysts say the sharply lower cost of the Razr has undercut sales of the phone intended to replace it, the $200 Krzr, and contributed to the plunge in Motorola's profit margin during the fourth quarter.

"Price is consistently the most important factor when people purchase a phone," said Miro Kazakoff, director of wireless research at Compete Inc. "In the U.S., you can get great phones for free."

Global push

Another trend driving margins lower is the push by big handset makers into developing countries such as India and China, where the use of wireless phones is exploding.

Global market leader Nokia jumped in first, but Motorola is trying to catch up.

Yet prices are much lower in developing countries, where per-capita income is far less. A phone that sells for the equivalent of $40 in China or India would sell for around $85 in the U.S., according to The Shosteck Group.

Because most people in the U.S., Europe or Japan already have wireless phones, developing markets are expected to generate the bulk of handset sales in the future.

Analysts say the main way manufacturers can boost margins in those markets is by making already-lean operations even more efficient — no easy task.

High-end battle

Even if they succeed, ferocious competition will continue to put pressure on profits, particularly at the high end of the market where margins are widest.

Nokia, Motorola, Samsung, LG Electronics, Sony Ericsson, Research In Motion and Palm all continue to battle for the allegiance of lucrative business customers or high-end consumers willing to splurge on a feature-laden mobile device.

And soon they will be joined by Apple, whose new iPhone is already generating a tidal wave of publicity leading up to an expected debut in June.

The Apple device, like other so-called smart phones, can perform a range of duties: make calls, send e-mail, surf the Web, snap photos, play music, watch videos.

And like the Razr, the iPhone breaks new ground. The device uses a fully touchscreen-based design — the first of its kind — and relies on intelligent motion sensors to make the phone easy to use.

Indeed, the advent of the iPhone is sure to spur other manufacturers to unveil rival touchscreen-based phones, especially since Apple's device won't become available until mid-2007.

The initial price of the iPhone, however, is unlikely to turn the device into a mass-market hit like the Razr. The phones will sell for $500 to $600 and will only be available from Cingular Wireless. Some prospective customers could also face termination charges of up to $200 if they tried to break an existing wireless contract and switch to Cingular.

"Does it have the ability to upend the market overnight? No," said Compete's Kazakoff. "At this price, it can't be a Razr."

Even at its listed price, though, Apple's iPhone could prove a tough competitor to the smart phones of niche developers such as RIM and Palm. Shares of both companies fell last week after Apple unveiled the iPhone.

One other factor that could limit demand for expensive handsets is the cost and complexity of monthly phone plans.

Wireless carriers offer a number of plans, but sorting through them can be confusing.

"You need an Internet plan and an e-mail plan and a phone plan," griped wireless analyst Maribel Lopez of Forrester Research.

Wireless carriers have not offered simple flat-rate plans because of network capacity constraints.

Plans based on how much capacity a customer uses keep networks from getting congested. And they are more profitable to boot.

Yet they also represent an obstacle to customers looking to purchase a high-end phone that can perform a number of duties.

Said Lopez: "The plans aren't very friendly."

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