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Macroeconomic Analysis of Logistical Costs to the Wireless Handset Industry and the
Consequences under Current Market Forces

by L. Pierre de Rochemont, Founder & CEO, GigaCircuits, Inc.
December 9th 2007
With over 1 billion units sold annually to more than 3 billion worldwide subscribers, the wireless handset has achieved a level of market penetration that is unprecedented in the history of consumer electronics. This phenomenal growth has precipitated the commoditization of these products earlier than many anticipated-a reality reflected in deteriorating average selling prices (ASPs) and profit margins to the mobile terminal OEM and throughout their supply chains.

Further complicating business risk analysis is the need for the wireless operators-(who actually buy the handsets in markets where the subsidy model is used)-to transition their business growth to the sale of enhanced services and content as their subscriber bases saturate. These feature-rich next generation mobile platforms will require more sophisticated microelectronic components that will actually add to the handset bill of materials (BOM) over the short term.

Recent market trends are pointing to a need to cut handset prices even more dramatically. In 2006, Verizon Wireless™ underwrote 68% of its subscriber base with video download-enabled phones, yet only 1% of these subsidized customers were willing to pay an additional $15 per month for the use of these new services. Further to the point, the mass consumer is clearly communicating that there are limits to the discretionary funds it is willing to apply to the new services when a media giant with the horsepower of Disney™ fails to launch a service like Mobile ESPN™.

Cuts will have to be made in the wireless industry's cost structure for it to continue to evolve. The most obvious target will likely be the amortized costs for the discounted handset that are factored into the mass consumer's monthly bill, i.e., mobile terminal costs must be driven down further.

This confluence of economic forces (skyrocketing production volumes, deteriorating handset ASPs, and a more sophisticated product platform) is unmasking the management of "logistical costs" as economic factors that make or break OEM profitability. The mobile wireless supply chain is an unwieldy, inefficient and unresponsive system due to the fact that these sophisticated products are made from too many discrete components. This introduces multiple levels of hidden costs (margin stacking and sub-assembly qualifications). The logistical costs of managing an inefficient supply chain and assembly process are difficult to determine as they are often "hidden" within the OEMs cost of goods sold (COGS) and BOM charges.

The tables below estimate these hidden costs and use recent market performance to drive home the need for handset OEMs to adopt new technology solutions that allow them to recover this lost value. 2005 market performance is used as a benchmark since it marks the onset of the wireless industry's strategic inflection point. Nokia's cost structure, well-known as the industry's most efficient, is mapped on to global handset revenues to provide a conservative estimate for an industry-wide COGS charge of $78,879 million.

The industry-wide BOM for semiconductor die ($31,460 million) is tabulated by multiplying the per unit ASP for all chip types (memory, processors, cameras, radios, etc.) with the number of handsets sold (using a weighted average chip set cost distributed across all air interfaces). The industry-wide value for non-semiconductor components is estimated to range between $30,214 million and $15,515 million by multiplying the total number of handsets sold with per unit costs of $37 for 3G handsets and $19 for 2G handsets as reported by JP Morgan.

Subtracting the total value of chipsets and non-semiconductor components from the conservatively estimated industry-wide COGS charge indicates that between $17,205 million and $31,904 million was absorbed by assembly and supply chain management activities within the industry. Converting these industry-wide values into unitized cost metrics indicates that economic value falling in the range between $20.67 and $39.07 of each handset (or 14% and 25% of their average selling price) were lost through supply chain management and assembly activities.

The future consequences of not adopting new technology solutions to recover economic value lost to inefficiencies in supply chain management and assembly processes can be forecast by applying these cost metrics forward under conditions of skyrocketing handset unit volumes and deteriorating handset prices.

The graph below projects industry-wide OEM profit margins by first calculating total projected revenues (tabulated by multiplying projected handset unit volumes with handset ASPs), and then subtracting operating costs, pure BOM, and supply chain management and assembly costs. Operating costs are estimated as 20% of total revenues (also consistent with Nokia's cost structure). The total values of the pure unitized BOM for semiconductor chipsets and non-semiconductor components are calculated as the number of units sold annually times the respective unit cost metrics.

The total value for the supply chain management and assembly costs is tabulated two ways using the most conservative cost metrics ($20.67 per unit or 14% of the handset sales price). In the first instance, the total number of handsets sold annually is multiplied by the $20.67 per unit charge; and, in the second instance, 14% of the handset ASP is multiplied by the total number of units sold. The resultant value (+ve/-ve) is divided by the total revenues to the industry and reported as an industry-wide profit/loss. As shown above, the industry rapidly moves towards insolvency if nothing is done to reduce the $20.67 per handset cost attributed to supply chain management and assembly costs.

As shown in the second instance where a percentage basis is used and handset OEMs are able to reduce these costs at the same rate as the price for their product deteriorates, insolvency is delayed, not avoided.

A comparison of the market performance of the two top handset OEMs provides data that is consistent with this analysis. (See the table immediately below). In the 2005-2006 period, both Nokia (ranked no. 1) and Motorola (ranked no. 2) experienced dramatic growth in unit sales and market share, with deteriorating average selling prices for their products. Signs of imminent danger during this period are evident when noting the growth in operating margins is roughly half the growth of unit sales for both companies.

More dramatic evidence for structural imbalance is found when making an annual comparison of the Q4 performance between 2005 and 2006, since both companies transacted roughly one-third (1/3) of their sales during that period. As noted, Motorola unit sales grew at close to 50%, in contrast to their operating earnings which declined by close to 50%.

For the previous 10 years and throughout 2006 Nokia aggressively attacked its supply chain management costs, sharply reducing the number of its suppliers and implementing cluster management techniques. It also shifted its market focus to the low-end phones supplied in emerging markets, which have minimal part counts and assembly costs. Growth in operating margins began to trend towards the positive by 2006Q4 as a result of these efforts.

As shown in the table immediately below, Motorola's slower reaction to this structural imbalance really impacted its bottom line throughout 2007, while Nokia's focus on a leaner and much sharply reduced/lower cost supply chain allowed it to return its profitability to historic levels.

Andrew Grove, the former Chairman and CEO of Intel Corp., popularized a strategic inflection point as "a time in the life of a business when its fundamentals are about to change. That change can mean an opportunity to rise to new heights. But it may just as likely signal the beginning of the end."¹ History has shown that the businesses that adopt new technologies or business practices that are responsive to the changing business fundamentals rise to new heights after a period of deteriorating profitability, while those that do not embrace technological change during this transition period often wind up on the trash heap of history.

History records the risk of a stagnating wireless industry is not wholly unrealistic. The last time a communications terminal was commoditized the world was shackled with the rotary dial phone for over 30 years!

The ability to apply nano-engineered ceramic laminates to fully integrate passive components and to develop novel radio solutions as GigaCircuits proposes to do, will establish direct value to the handset OEM's. Fully integrated microelectronic circuits will transform the unwieldy historic supply chain mentioned above into the more efficient Design Model common to the semiconductor industry. This transformed structure will maximize design-to-manufacture efficiencies and minimize lost economic value.

Our company estimates that the disruptive potential of GigaCircuits' integrated circuit and antenna solutions will cut the economic value lost in inefficient logistical cost management by 35%-50%. The chart below shows the economic impact this level of cost cutting will have on handset OEM profitability if it were to be phased in at 15%, 50% and 100% adoption rates industry-wide.

In summary, a compelling case has been presented that the wireless microelectronics industry is currently undergoing a transition that requires it to adopt new technologies and business practices. While transitioning out of structural imbalance, industry-wide cost benefits for adopting new technologies cannot always be determined using direct accounting methods. Fully integrated microelectronics and novel radio systems made possible using nano-engineered ceramic laminates is one such technology solution that promises to sustain the wireless revolution for decades to come.

¹ Andrew S. Grove, Former Chairman & CEO, Intel Corp.. in "Only the Paranoid Survive", ISBN: 0795327757. Publisher: RosettaBooks, LLC. December 1998

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