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The Perils of Being Slim

Even by the standards of the volatile mobile handset business, the disastrous turnaround at Motorola Inc. (NYSE: MOT) -- which saw its profits fall 48 percent in the most recent quarter -- is remarkable.

On a two-year roll after the 2004 release of the popular RAZR device, which changed design standards for cellphones, Motorola saw its profits hit record highs and its share price climb above $26, a five-year high, in October of last year. Since then, margins have collapsed, profits have tumbled, and the stock has dropped by almost 30 percent. (See Motorola Profit Falls 48%.)

What happened? Paradoxically, in the runaway success of the RAZR lay the seeds of Motorola's downfall.

By all accounts, the booming sales of the RAZR, a slim, stylish device that sold 750,000 units in its first three months of availability and hit the 50 million mark last summer, caused Motorola CEO Ed Zander to believe that Motorola could, and should, overtake Nokia Corp. (NYSE: NOK) as the No. 1 supplier of handsets in the world. When asked how he would follow-up on the RAZR craze, Zander famously replied "More RAZRs."

"Motorola may have gotten caught up in striving to achieve their market share goals and profitability was sacrificed in the name of greater volume," says Todd Kort, principal analyst for wireless devices at Gartner Inc. "The tremendous success of the RAZR and the way Motorola continues to promote it, perhaps a bit to the detriment of other Motorola brands such as the SLVR, PEBL, Q, and KRZR," helped hasten Motorola's downturn, he adds.

The KRZR, in particular, was viewed as the successor device to the RAZR. Motorola was so confident in the newer devices' success that it let the price of the RAZR drop precipitously. From its $500 original price, the RAZR dropped in less than two years to effectively zero, available free online as part of two-year contracts with carriers. (See KRZR Burn.)

"The RAZR family was conceived of as a high-margin business," says Richard Windsor, Global Communications Equipment analyst at Nomura International . "The game plan was to bring out KRZR, which would allow them to cut the price of RAZR. They did that on purpose to keep volumes up."

Unfortunately, sales of the $200 KRZR did not take off like its predecessor.

"It is fairly clear that Motorola’s high-profile launch of the KRZR has been disappointing," wrote Citigroup analyst Daryl Armstrong in a research note. "So far, Motorola has failed repeatedly to replicate a hit in its new product portfolio."

Part of the problem was the rapidly shifting fashions in cellphones. Other companies quickly released similarly slender devices, like the "Chocolate" from LG Electronics Inc. (London: LGLD; Korea: 6657.KS) . Meanwhile, smartphone makers like BlackBerry began coming out with cut-rate, consumer-oriented devices like the Pearl. When its monopoly on cool, slim handsets evaporated, Motorola found itself in a contest it could no longer dominate -- and deficiencies in its products previously overlooked became more obvious.

"People bought the RAZR because it looked cool," says Windsor, "they didn't give two hoots about the user experience."

As a result, Motorola's strategy to rapidly gain market share in the high-end segment, with its corresponding rich user experience, is "fundamentally flawed," adds Windsor.

The upshot: Motorola found itself selling record volumes -- device shipments were up 47 percent to 65.7 million handsets in the fourth quarter -- at plummeting margins. The huge imbalance between margins at the high end, where the RAZR debuted, and low-end devices in emerging markets, where Motorola has been unable to compete with Nokia, propelled the company's results into a tailspin: "Motorola's inability to make decent margins on low-end devices lies at the heart of the problem," wrote Windsor in a research note last week.

Those looking for a quick turnaround in Motorola's fortunes may be disappointed. Sounding like President Bush defending his Iraq policy, Zander in a conference call said on Friday, "There's no change in strategy. There may be changes in tactics, but we're such a better-positioned company than we were a few years ago."

— Richard Martin, Senior Editor, Unstrung

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