Costs of Mobile-Phone Licenses Mean Profits for Manufacturers

LONDON -- From the looks of most telecom shares, which have swooned from their highs, the spiraling costs of third-generation mobile phones appear ready to disconnect the entire industry.

Rather than connecting both the service providers and the equipment manufacturers with the same faulty wiring, as the market has done this week, it's worth remembering that one company's costs can be another's profits.

That message was lost on many investors after comments by Ericsson's (ERICY Quote - Cramer on ERICY - Stock Picks) President Kurt Hellstrom to a Swedish newspaper. He said the rising costs of third-generation licenses -- which will allow operators to offer data transmission services -- would likely dampen industry growth. Hellstrom's cautious words helped push shares of Ericsson, as well as competitor Nokia (NOK Quote - Cramer on NOK - Stock Picks), lower.

Both stocks are off about 14% this month as shares of mobile-equipment makers have followed those of service providers lower. Concerns for the sector range from the rising costs of third-generation licenses to uncertainty over the pace of the industry's consolidation. The S&P Telecommunications index is nearly 28% from its high.

On Friday, both Ericsson and Nokia recovered some of the week's earlier losses. Ericsson traded up 1 5/16, or 7%, to 20, while Nokia rose 1 3/4, or 3.6%, to 50.

An Ericsson spokesman, Mads Madsen, told TSC that Hellstrom's published comments were inaccurate. "We don't expect a slower market growth as a result of the license process," Madsen says.

The nearly 25% drop in Qualcomm's(QCOM Quote - Cramer on QCOM - Stock Picks) stock price over the last three weeks has been fueled by a different set of fears. The wireless communications technology provider announced a slowdown of chip sales in South Korea, its biggest customer, as well as a less certain future for its code division multiple access, or CDMA, technology in China. Qualcomm also has a 6.4% stake in the shaky satellite telecommunications company Globalstar(GSTRF Quote - Cramer on GSTRF - Stock Picks), which would cost Qualcomm $0.10 per share if Globalstar is forced to file for bankruptcy.

"Qualcomm's stock price will remain under pressure in the near term," says Chase H&Q equity analyst Edward Snyder, who says investors are waiting to see how forthcoming the company is about its future when it reports earnings next month. The price could be further hurt if Qualcomm is ambiguous, which could alarm investors, or overly rosy, which could spark disbelief and backlash. But if the company can offer an honest, less-than-dismal report of what the future holds, Snyder believes the stock price will rebound. "It's never going to return to its highs in this incarnation [of the company], but CDMA is not going away and growth will continue," he says. Qualcomm's stock price closed Friday at $60.

Motorola's (MOT Quote - Cramer on MOT - Stock Picks) stock price, down about 50% from March highs, has suffered because of declining margins on its handset sales. Snyder says that at current levels, the stock is undervalued. "It's an excellent buying opportunity [now]," he says, noting that Motorola's average handset selling prices are solid. If a company's average selling prices are declining faster than the industry overall, it's a key indication the company is in trouble, Snyder says. "With Motorola, that's not happening at all," he says. Motorola closed Friday $29 1/32.

Synder has a "hold" rating on Qualcomm and a "buy" rating on Motorola. Chase H&Q hasn't performed underwriting for either company.

There are good reasons why the growing costs at service providers like Vodafone Airtouch (VOD Quote - Cramer on VOD - Stock Picks) and Deutsche Telekom (DT Quote - Cramer on DT - Stock Picks) could mean money in the bank for the likes of equipment makers Ericsson and Nokia regardless of the ultimate returns generated from these licenses.

Service providers have come under pressure for the billions they will have to shell out to buy third-generation licenses and build the respective networks. Given the rapidly changing face of mobile communications from voice-only to a mixture of voice, data and services, it remains unclear whether these companies will ever be able to reap a return on these substantial upfront costs.

For instance, now that Vodafone has spent billions to buy a third-generation license in the U.K. it will have to begin building an infrastructure to support the new spectrum. Ericsson and Nokia are the companies that will be doing the dirty work and profiting all the while.

"There is a whole industry that comes on the back of third generation phones," says Rodrigo Parreira, an analyst with Cluster, a consulting firm specializing in telecom, technology and media companies. (Cluster has performed consulting for many companies mentioned in this story.) "There is no doubt the manufacturers will be making a lot of money out of this."

A large chunk of Ericsson's revenue -- 53% for the most recent quarter -- now comes from building mobile infrastructure. And some money managers are betting on that business.

"I don't know who will be the leading service provider in 10 years," says Scott Clemons, manager of the Brown Brothers Harriman's 59 Wall Street European Equity fund. "I do know that their network will be built by Nokia, Ericsson and Alcatel" Alsthom (ALA Quote - Cramer on ALA - Stock Picks), a French telecommunications company. Clemons says he's been using the weakness in these stocks this week to buy shares.

There are still uncertainties in this area. Service providers have yet to unveil how much they are willing to spend on this new infrastructure, so valuing future profits for these mobile-construction companies is still a guessing game. But it's less of a game than trying to determine when service providers will begin turning a profit on these next-generation services.

For that reason, Clemons says he's sticking with the companies building the networks, rather than the ones who will be operating them.

"That's where our fund has placed its money," Clemons says. "That's the bet we've made."