Shares digital

Mobile phone technology is big business and with next gen services round the corner the question is, which companies are primed to capitalise? Russ Mould checks the facts and makes the call

Eight years ago this month, 13 bidders were fighting over a quintet of third generation (3G) mobile phone licences in the UK. The five winners paid £22.5 billion between them, a price Vodafone (VOD), BT (BT.A), one2one, Orange and TIW – as they were known then – hindsight shows they would regret.

This may seem like ancient history, but Ofcom has just completed its fourth spectrum auction and is already planning another for 2009, which will see the UK communications industry regulator sell off the ultra high frequency (UHF) band released by the switch over from analogue to digital TV. Ofcom’s paper last December described this as ‘the highest quality spectrum likely to be released in the UK in the next ten or 20 years.’

America’s Federal Communications Commission (FCC) is in the process of selling five vital blocks of 700MHz bandwidth, freed up by US broadcasters also making the switch to digital. Over 200 bidders met the FCC’s strict criteria for the auction, which looks set to raise around $20 billion.

Rapid technological change, the latest auctions and Verizon (VZ:NYSE) Wireless’ launch of a price war in the USA in February all show the wireless communications industry remains every bit as unpredictable as it was back in 2000.

Shares has therefore tapped into the industry chatter from the recent Barcelona 3GSM and Hanover CeBIT communications and technology trade fairs to identify the wireless world’s key trends – and how investors can turn them into profits.

New services

‘There were two key strands to Barcelona,’ comments Charles Stanley telecoms analyst Michael Armitage. ‘Mobilising the enterprise, with the BlackBerry as just the first step in worker productivity, and also advertising moving to the mobile space.’

With three billion mobile phone users worldwide, against one billion fixed line internet surfers, the mobile advertising market’s potential is massive. Mobile upstart Blyk, which offers users free calls and messaging in return for accepting a number of directed adverts on to their handset each day, claimed click-through rate on advertising in excess of 30% during trials carried out late in 2007. This compares to less than 1% for web-based advertising and, in Michael Armitage’s words, is a potential gold-mine.

‘This is a huge opportunity for smaller companies to take on the big lumbering giants, who cannot interact with their customers or provide tailored services, as they do not want to cannibalise existing revenues,’ he says.

Mapping was also a hot topic in Barcelona, particularly after Nokia’s (NOK:NYSE) $8.1 billion swoop for digital mapping specialist NAVTEQ (NVT:NYSE). The Finnish mobile handset giant launched four Global Positioning System (GPS) enabled phones this spring, while British chip designer CSR (CSR) continues to invest heavily in GPS as well.

Evolution...

The other burning issue in Barcelona was 4G mobile technology. This may seem hard to believe, as Vodafone acknowledges capacity utilisation of its 3G network still averages around 20% in Europe.

However, a 4G technology standards battle looks set to break out between the rival Global Systems Mobile (GSM) and Code Division Multiple Access (CDMA) camps which have dominated the moves to 2G and 3G.

For the switch to 4G, the leading European network equipment vendors, Ericsson (ERICY:NYSE) and Nokia-Siemens Networks, have championed Long Term Evolution (LTE), which offers an easy upgrade path from 2.5G and 3G GSM-based technologies. Vodafone, Verizon and China Mobile (CHL:NYSE) have all backed the technology, and NTT DoCoMo will trial Ericsson-designed equipment later this year.

America’s Qualcomm (QCOM:NDQ), which was the driving force behind CDMA and CDMA-2000, has put forward Ultra Mobile Broadband (UMB) as an alternative.

...Or revolution?

LTE and UMB offer an evolutionary path from current 3G technologies. A more radical option is the IEEE 802.16 standard, known as Worldwide Interoperability for Microwave Access (WiMax). This, has been been championed by chip giant Intel (INTC:NDQ) and American telco Sprint Nextel (S:NYSE).

However, Sprint’s partnership with Clearwire (CLWR:NDQ) and plans to spend $5 billion on a US-wide WiMax network were shelved last November, as the operator struggled with the huge losses which resulted from its acquisition of Nextel.

A ‘soft’ WiMax launch is still expected from Sprint in 2008, but xGTechnology (XGT:AIM) may be the one to provide a real revolution. The Florida firm has developed a low-power, low-cost, long-range telecommunications technology called xG Flash Signal.

‘The nemesis of any network roll-out is the last mile. WiMax simply isn’t economically viable city wide and LTE is still extremely expensive,’ argues xG’s chief executive officer Rick Mooers. ‘What we are doing is rolling out a network on a profitable basis. It has not been done before and it’s only a matter of time before the market realises it.’

After extensive trials, xG is now shipping base stations in Maryland, Kansas, Florida and South Carolina. Mooers intends to run a mobile VoIP service first, branded as xMax, to prove the technology works, before moving onto more ambitious data-based services. A first generation of handsets should be available by May or June and Cambridge Consultants has struck a deal to design the second generation, which should be available by autumn.

January saw xG book its first profits, as a result of the 50-50 revenue sharing deal it has with operators who use its equipment, and positive cash flow is expected later in the first half. Mooers believes as momentum builds sceptics will have to convert to his cause.

‘WiMax has been two years away for the last seven years,’ he says. ‘I will be dismissive of WiMax as it’s not a 4G technology. xG will offer genuine 4G – as defined by the original ITU standards of 100 Megabits per second (Mbps) – by the fourth quarter of this year.’

Digital dividend

Mooers may be rude about WiMax’s economics but at an analyst meeting held earlier this month, Vodafone stated it is considering a feasibility study of the technology as an option for 4G.

Chief technical officer, Steve Pusey, also highlighted his firm’s portfolio of spectrum holdings across the 900MHz, 1800Hz and 2.1GHz bandwidths, which he argues will support any move to 4G. Pusey also acknowledged Vodafone will seek to ‘participate opportunistically’ in auctions of spectrum, in the UK and abroad.

Quite how the planned 2009 UK auction of spectrum released by the UK digital dividend will pan out is far from certain, although Ofcom is due to release a further paper this spring.

‘The picture is unclear, as Ofcom is laying no real foundation for what the spectrum can be used for. But it will encourage innovation and create opportunities, and I think telco operators will look to grab some of the spectrum,’ says Graham Rivers, chief executive of chief executive of interactive mobile information and entertainment expert WIN (WNN:AIM).

‘They really need to get higher capacity as 3G needs an overlay network to boost network capacity, and they don’t want to be making massive investments,’ he continues. ‘That’s why they are moving to HSDPA, as they need all the bandwidth they can. That’s why they will bid and they will bid hard – though not as hard as they did last time,’ he says.

Investors unplug sector in 2008

It is therefore unlikely spectrum bidders will overpay in 2009 as grossly as they did in 2000, and the auction’s impact is not likely to be immediate, as Vodafone does not expect it to be cleared for re-use until around 2012.

That lifts one potential cloud, but other threats mean the mobile telecommunications sector has fallen by 18% this year. This ranks it 42nd out of the 47 sectors which form the FTSE indices.

Firstly, prices remain under pressure. EU Competition Commissioner Neelie Kroes and Commissioner for Information, Society and Media, Viviane Reding, are keeping the pressure on prices for so-called ‘roamed’ calls and messages between countries. Verizon’s price cutting campaign in the USA elicited an immediate response from local rivals T-Mobile and AT&T (T:NYSE) in February, raising fears other geographies would see similar conflicts.

Secondly, a global economic slowdown could have an impact. Those with long memories will remember 2001 saw global mobile handset shipments actually fall from 410 million to 400 million, after the tech bubble burst.

Shares has therefore peered through the whole wireless food-chain to see where investors should seek to forge, or break, a connection.

WIRELESS FOOD-CHAIN

Operators

As the world’s largest mobile telecommunications company, Vodafone, with its £82 billion market cap and 252 million subscribers, bestrides the sector like a colossus. Chief executive Arun Sarin’s five-point strategic plan, outlined in 2006, has seen the company dump stakes in operators in mature markets such as Sweden and Switzerland, in favour of investments in emerging markets such as Turkey and India. This new found focus, coupled with booming data revenues, boosted Vodafone’s share price last year.

The US price war and a dispute with the Indian tax authorities have dragged the shares back in 2008, but the Newbury firm’s cellular technology is not the only game in town. Inmarsat’s (ISAT) network of global satellites offers mobile communications to voice and broadband data users on land or at sea or in the air, while Avanti Communications (AVN) intends to offer broadband and data services once its HYLAS satellite is launched in 2009.

Freedom4 Communications (FFC), formerly known as Pipex, has a further alternative to Vodafone’s well-established cellular technology. The proposed sale of its Hosting and Network Services divisions would leave its WiMax joint venture with Intel as its sole asset. Freedom4 owns a national licence to deploy WiMax in the 3.6GHz band and the service has already launched in Manchester and Milton Keynes.

Vyke Communications (VYKE:AIM) uses Voice over Internet Protocol (VoIP)-based callback and WiFi technology to bypass and undercut conventional cellular technologies and incumbent operators such as Vodafone in the international and long distance telephony markets. Calls using Vyke’s service can be made from mobile, wireline or WiFi handsets and a link-up with Nokia last autumn was a major strategic coup for chief executive Tommy Jensen’s firm.

Chief executive Tommy Jensen does not believe the EU’s plan to force the major mobile phone companies to cut the price of roamed international calls will hold up his firm’s progress, arguing the Vyke service is still 60-70% cheaper. Little wonder the £38 million cap exceeding its goal of grabbing 1.25 million new paid customers by the end of 2007. New account wins for the IP service more than trebled to 1.303 million.

Software platform providers

Many software platform vendors suffered terribly after 2005’s ‘Crazy Frog’ scandal of 2005. Subscribers who thought they had paid £3 to download one irritating ringtone had in fact found themselves paying for a whole series of them, as they had unwittingly subscribed to a premium rate service. Ofcom’s 2006 clampdown on such abuses hit many service and content providers’ revenues, but a few players have emerged wiser and stronger.

‘Our proposition is: operators are excellent at defining the one-size-fits-all application, whether its voice mail, video mail, mapping and so forth,’ explains WIN’s Graham Rivers.

‘But where they tend to have problems is niche markets – which for them could mean one or even two million subscribers. We are used to dealing with communities of say 50,000 to 100,000 subscribers, where it is difficult to develop one solution for all and the big players can’t respond quickly enough. We can move faster than they can.’

WIN and peers such as Velti (VEL:AIM) and 2 Ergo (RGO:AIM) provide services which enable operators to provide value-added content and boost their premium data traffic. All three are nicely profitable so it is perhaps not surprising the mobile telecom industry’s heaviest hitter of all, Nokia, is trying to muscle in. Ovi is the Finnish handset giant’s suite of internet services, designed to offer games, music downloading and mapping services to users of its handsets.

But WIN’s Rivers believes Nokia will not have things all its own way, despite a world-leading market share in mobile phones.

‘They will run up against the same problem [as the operators], that of sheer scale,’ he argues. ‘There are three billion mobile subscribers worldwide and they have a third of those, so that’s one billion subscribers across say 160 countries, and each of them has local needs, rights to develop and manage and so on. It’s a huge challenge and they risk becoming too gooey and slow to move.’

Mobile payment experts include Broca (BROC:AIM) and Monitise (MONI:AIM), although the share prices of both have performed appallingly since they came to the market. Technological innovations often take longer than hoped to gain traction – as Vodafone will testify with 3G – and Broca has fallen from 52p to 25p since it was spun out of 2 Ergo a year ago, while Monitise has slumped from 22p to 9.25p since it was demerged from Morse (MOR) last summer.

Hardware providers

Despite the huge addressable market and massive potential growth, it has not been all plain sailing for the makers of wireless network equipment or handsets, either. Sweden’s Ericsson, the world’s leading equipment maker, issued two monster profit warnings last autumn, and blamed network sharing between operators and emerging market uncertainty for its woes. This dragged down shares in network and handset testing experts Anite (AIE) and Spirent (SPT), although recent trading updates from both British firms were encouraging and both would benefit from the move to 4G networks over time.

America’s Motorola (MOT:NYSE) sacked its chief executive Ed Zander after horrendous market share losses in the mobile phone market last year. Another handset maker whose shares have suffered is ZTC Communications (ZTC:AIM), even though the Chinese firm has so far delivered everything it promised it would when it floated at 20p via a reverse takeover in 2006. ZTC focuses on the value, mid-to-low end of the mobile phone market in China, and has delivered excellent volume growth, although progress may have been held up by the local authorities’ dithering over which 3G technology to adopt.

ZTC’s shares have slipped to 10.5p, while i-mate’s (IMTE:AIM) languish at 27.25p, streets below their 12-month high of 95p at 27.25p, following its latest profit warning in January. The Dubai-based firm has found it hard to dislodge Research in Motion’s BlackBerry device from its strong position in smartphones.

But mobility is not just a consumer issue, tied to the ability to talk, listen to music or download the internet whenever you want, wherever you are.

Mobility is also a key issue for the enterprise as corporations seek to boost productivity and efficiency. Research in Motion’s BlackBerry may be the best known businessman’s gadget, but Psion (PON) is a leader in rugged, handheld devices with its Teklogix products, which specialise in wireless data collection. Rivals include Belgravium Technologies’ (BVM:AIM) mobile data capture and connectivity solutions, such as the Atlanta 8000 series of mobile computers.

Component providers

Recent profit warnings from major industry component providers such as ARM Holdings (ARM), CSR, RF Micro Devices (RFMD:NDQ) and Texas Instruments (TXN:NYSE) suggest the wireless handset foodchain is again seeing a slowdown in demand. Chip giant Texas Instruments noted its low-end products were selling well but demand from one customer – widely thought to be Nokia – had begun to flag for 3G product.

This alert looks particularly bad for ARM, as weakness in demand for 3G handsets would knock licensing income badly. ARM gets royalties of up to $0.30 per 3G phone, five times what it gets from 2G units, and Texas Instruments is its largest royalty paying customer.

CSR’s warning came after market share loss at Nokia, reportedly to Broadcom (BRCM:NDQ), while fellow chip designer Wolfson Microelectronics (WLF), which gets two-thirds of its sales from handsets or MP3 players, could be hit by an apparent slowdown in Chinese gadget demand.

Once 3G, and 4G, phones regather momentum, one beneficiary should be IQE (IQE:AIM), which prepares the discs, or wafers, of silicon from which key chips for handsets are manu-factured. The Cardiff firm now supplies product to six of the world’s seven leading wireless handset and equipment manufacturers, and specialises not in basic silicon chips, but wafers for more complex semi-conductors such as Gallium Arsenide (GaAs).

GaAs chips are used in mobile communications because of their superior power efficiency, which helps to increase functionality yet improve battery life at the same time.

CAP-XX (CPX:AIM) has addressed this trade-off between functionality and power consumption from a different angle, with its revolutionary supercapacitors, which enable mobile phones to use more powerful electric currents more safely. Negotiations with handset makers for a breakthrough large order are ongoing, but this has not stopped CAP-XX’s shares plunging from 93p to 32p since their 2006 flotation.

FOUR STOCKS TO SWITCH ON FOR 2008

2 Ergo (RGO:AIM) 181.5p

Lancashire-based 2 Ergo’s Multiserve platform provides content aggregation, delivery and billing capability to communications service providers who want to offer interactive, multi-channel content to their customers. A five-year deal with Telefonica’s (TEF:MC) O2 for its Multisend interactive messaging suite and February’s in-line trading update show the £56 million cap remains firmly in growth mode, despite the knock to sector sentiment caused by 2007’s phone-in competition scandals in the UK.

Anite (AIE) 44.75p

A reassuring trading statement earlier this month confounded the sceptics who were expecting a third profit warning in just six months. Handset testing remains weak, but encouraging commentary from Spirent and Agilent (A:NYSE) suggests the mobile network testing arm looks set for good growth, once 4G testing begins in earnest. The most powerful catalyst for share-price performance would be, however, a break-up of the firm’s unwieldy three-legged structure.

Intec Telecom Systems (ITL) 45.5p

The provider of billing software has generally failed to fulfil its potential but a new management team and a recent contract from Uruguay’s Antel for a convergent systems across fixed, broadband and wireless services suggests the firm may be back on track. A market capitalisation to sales ratio of barely 1x looks cheap compared to the 2-3x multiples paid by Ericsson (ERYC:NYSE) and Oracle (ORCL:NDQ) last year for LHS and Portal respectively.

WIN (WNN:AIM) 150p

New management arrived in November 2006 and refocused the mobile content expert on interactive mobile services, particularly for the enterprise. Selective acquisitions, such as music specialist Pocket and Switzerland’s Quattrocom, have filled in geographic gaps and broadened the service offering. A mid-single digit PE means WIN trades at around half the multiples of Velti and 2 Ergo and the firm even pays a 2p dividend.

AND ONE TO DISCONNECT

Research In Motion (RIMM:NDQ) $101

The BlackBerry handheld product is now well known and RIMM announced late last month it racked up around 2.1 million new subscribers in the fourth quarter of last year, 15-20% more than expected. But despite the higher subs number, management did not raise earnings guidance, which is concerning, as the prior quarter had shown gross margin erosion and signs of an inventory pile-up. Around two-thirds of new subscribers are still business users, and if the credit crisis leads to redundancies in the financial services industry, RIMM’s near 60x historic and 30x prospective PE could look exposed.