April 22, 2010 Quick Thoughts: Lower Subsidies Will Delay Handset Recovery

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1Q10 results and forward guidance from players on the wireless value chain have been largely uninspiring.  While we are very bullish about the future of wireless technology, and in particular, the promise of 4G, we are more sanguine about the near term prospects for an immediate recovery in global demand.  Replacement sales to existing subscribers make up more than 85% of the global device market.  These sales are extremely sensitive to the subsidies that are provided by carriers – drops in subsidies cause users to hold onto their phones longer and to choose cheaper devices when they do replace.  Global mobile device demand was very slow to recover from the 2001 recession, largely, because carriers were cautious in returning subsidies to pre-recession levels.  We believe that carriers, facing sluggish industry subscription growth, will remain conservative on device subsidies and that recovery in mobile demand may lag the overall economy by more than a quarter or two.

The U.S. market has remained somewhat more robust, with a sharp shift toward smartphones, and in particular, iPhones and Google Android models, driving brisk replacement.  Even here, there are some signs of concern, as carrier net subscriber additions have decelerated sharply and could portend a pull back in subsidy levels to refocus on profitability.

Subsidies and promotional spending on handsets are not reported by wireless carriers nor are they tracked by the various industry consultants publishing market data and projections.  As such, they are typically ignored as a driver of mobile device sales, despite the fact that we estimate that carrier subsidies account for well more than half of spending on mobile devices worldwide, and in many markets, have consumers expecting free mobiles at the end of each contract.  The effect of lower subsidies is felt both in weaker volumes and in lower average selling prices, as users trade down to account for the lower subsidy level.

Global mobile phone volumes were stagnant from 1999 to 2002 – and pronounced dead by many analysts – before reaccelerating to double digit growth in every year from 2003 to 2008.  The millennial malaise coincided with a period of excessive leverage and inadequate cash flows at carriers that precipitated the 2001 recession and resulted in a significant reigning in of subsidies in the name of cash preservation.  We believe the current focus of carriers is again on free cash flows to support dividends, and that most will resist the temptation to use subsidies to chase market share in the near term.  Thus, we prefer to wait on the sidelines for stocks that are highly dependent on global handset volumes and average prices.

While carriers may be exercising restraint now, the connection between subsidies and market share has been well established and the lure to break ranks and crank up the level to draw subscribers is too strong to be ignored for long.  We believe that we should see a return to more vigorous competition by 2011 and with it, higher subsidies and a reacceleration in the device market.  Longer term, we believe 4G will catalyze growth and growing ASPs by 2013.  Moreover, valuations in the wireless sector appear to be quite depressed, particularly in the wake of the poor 1Q10 results.  Nonetheless, the near term prognosis is not promising for overeager investors and we recommend that investors wait until the news flow is unambiguously encouraging for handset-related stocks.

Member: FINRA / SIPC 

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