Last week, Gartner released some market data on worldwide cell phone sales. For anyone with a reasonable understanding of the mobile handset market, these data should not be viewed as surprising:

- 3rd quarter mobile handset sales growth was about 40% less than the year earlier.
- Gartner forecasts a 1% to 4% decline in handset sales in 2009.
- As reported by various sources, most of the growth worldwide has been driven by first-time buyers in emerging economies such as China, India, and throughout the Middle East.
- Gartner predicts weakness in the replacement market - especially in advanced economies.

So what are the implications of this report?

First of all, the demand characteristics of mobile subscriptions need to be separated from the demand for mobile handsets. Subscriptions are less economically sensitive than devices.

People all over the world continue to indicate that their mobile phones are essential to them in an economic downturn. This infers that a mobile subscription (not the phone) is non-discretionary, and may be categorized as a staple utility - right up there in priority with electricity and heat and water. This means that carriers such as Verizon (VZ-NYSE), AT&T (T-NYSE), and Rogers Communications (RG-NYSE) among others in North America should benefit from subscriber stickiness despite the recession.

However, as consumer budgets tighten, marginal usage may decline over the next 2 quarters, which could reduce earnings outlooks. Similarly, the conversion rate from the 2G network to the 3G network may not be as dramatic as forecasted earlier this year because people are more inclined to wait until their economic situations improve in order to upgrade their subscriptions. Although the phone is essential, the bling is not.

Carriers use device subsidies and bundling to switch and commit people to long-term data contracts in return for access to the latest and greatest devices. The threat of switching (also known as churn) drives the handset business. Based on the data from Gartner, most people may be inclined to hold on to their current subscriptions and devices for the next 2 quarters, including the Holiday season.

So what does this mean?

Innovators should gain ground. Only the most innovative handset manufacturers, which attract early adoptors with aggressive product release schedules, should benefit from the replacement market. This means that in North America, we should see innovators like Research in Motion (RIMM-Q), and Apple (APPL-Q) continue to grow market share in a declining segment, at the expense of all other smartphone and cell phone manufacturers. More than ever, in these markets, innovation matters.

Even the market leaders should see muted growth over the next two to three quarters:

- Smartphone upgrade delayed in emerging markets. In the remainder of the world, where Nokia (NOK-NYSE) is dominant, there should be significant delays in handset upgrade cycles in most emerging economies. As a result, Nokia should be able to protect its market share against the market entries by both RIM and Apple.

- Downchurning. There is a greater than 50% chance of significant increases in subscriber churn as carriers attempt to hang on to economically stressed subscribers in increasingly commoditized emerging markets. This should cause pricing pressure, which could compress margins for both handset manufacturers and carriers worldwide. Downchurning could benefit re-design leaders such as Samsung and LG, who are leaders at offering solid low-cost handset versions to emerging populations. We may see that trend occuring in advanced economies now as well.

- Crime. There is likely to emerge a gap between the essential utility of mobile subscriptions and the ability to pay for access in many economies. Considering that up to 85% of these subscribers are prepay users, there is significant organized crime risks related to prepaid phone cards, and subscriber fraud. Emerging secure payment networks should benefit from this increased risk. Look for electronic prepaid network providers such as Euronet (EEFT-Q), and Safeway's (SWY-NYSE) Blackhawk Network to benefit from the need for more transaction security, along with Canadian-listed Vendtek Systems (VSI-TSXV).

So the bottom line is this: Unless a carrier has utilized a lot of debt to upgrade its capacity, network providers should fare relatively well during a recession, although with reduced earnings potential. Handset manufacturers, which are reliant on subscription upgrades should see a few more choppy quarters. Innovators should exit this current economic downturn will better market positioning than followers.

In the end, it may be all about the Operating System. RIM, Apple, Nokia, Microsoft (MSFT-Q), Google (GOOG-Q), and Palm have all made significant efforts to open up their operating systems to independent application developers. Increasingly, handset manufacturers will be blurring value proposition between themselves and carriers.

I do not own shares of any of the Companies mentioned above, nor do I receive compensation from any of the Companies mentioned.

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