Operator vs. Handset Maker
Who will control the $42 billion in entertainment that mobile-phone users are expected to buy?
By Mark Halper, FORTUNE

(FORTUNE Magazine) - It seemed like a routine marketing ploy when Finnish mobile-phone giant Nokia (Charts) trumpeted a global survey in early June showing that two-thirds of handset users think music-playing phones will replace standalone MP3 devices like Apple's iPod.

After all, Nokia is hoping for a high-margin revenue stream from new computer-like telephony devices. Naturally, they'd promote any finding that buoys the cause.

But look between the lines of the survey results, and you see a ferocious tug of war breaking out between handset companies like Nokia, Motorola (Charts), and Sony Ericsson on one side and their longtime customers, mobile operators like Vodafone, Orange, and Verizon (Charts), on the other. They're grappling for control of the $42 billion worth of entertainment that Informa, a London market research firm, says mobile-phone consumers will purchase by 2010.

At issue: How will songs, videos, and games get to the phone? Will they travel through operator-controlled "portals" (called "decks" in the U.S.) and over the 3G networks that operators have paid dearly to build, or will they land on the phone through the many possible routes that bypass the operators, some of which can channel revenue directly to the handset vendor?

Even the operators' traditional voice business is threatened, as handset makers build devices that support VoIP (voice over Internet protocol) calls that skirt cellular networks. In May, Nokia added Google's Google Talk software to its 770 Internet Tablet, a handheld device that has no traditional cellular calling capability but, when used with Google Talk, supports free phone calls through Wi-Fi.

"Consumer mobile behavior is in the early days of changing, and how the operator vs. the handset vs. the media company benefits is up for grabs,'' says Frank Sixt, chief financial officer of Hong Kong's Hutchison Whampoa, which owns the 3 Group of 3G operators in Europe and Asia. "Who exactly plays what role in the value chain is not clear."

Indeed, the lines are blurring. As phones become MP3 players (Nokia's N91 and Sony Ericsson's W950 Walkman phone both store thousands of songs), consumers can load them with tracks in the same manner they do their iPods - by connecting to an Internet download site or to their own PC-based personal collection.

Handset vendors can potentially team with these sites. Nokia's not even ruling out starting its own music-download service. "We have never said we will not do it,'' says Anssi Vanjoki, Nokia's executive vice president of multimedia. Senior vice president of marketing Tapio Hedman is less circumspect: "It's under consideration."

That must alarm European operators that have spent more than $100 billion on spectrum licenses for 3G networks that are way behind schedule and have only recently attracted customers. Operators like Hutchison, Vodafone, and Orange have hoped that 3G networks will eventually pay off because the operators themselves will profit from selling entertainment and data services.

"It's a natural source of contention because these guys are deploying an agenda of their own," says Jens Schulte-Bockum, group director of terminals for Vodafone. But he plays down the threat, noting that handset vendors and operators have historically "debated" branding and the customer relationship. "It's the same old position dance as before," he says.

That's not quite true. Not only is $42 billion at stake, but the march of technology has given handset vendors many more opportunities to siphon entertainment revenue away from the operator. Many phones now have USB ports allowing users to transfer content to their phones from PCs that connect to the Internet and hold the user's own digital collection of songs, games, and videos. Handset vendors are also adding Wi-Fi to their cellular devices, potentially cutting traditional networks out of their Internet connections.

Even the operators' own 3G networks could work against them, since the faster speeds of the new networks make it easier for consumers to surf the Internet outside operator portals such as Vodafonelive and Orange World. That's why handset vendors, including Nokia and Motorola, have struck deals with Internet powerhouses Google (Charts) and Yahoo (Charts) in which they preload the popular Net portals onto phones.

While operators would still collect some "traffic" revenue when, say, a Google Internet session travels over their networks, they would have to give up the part of the pie they would otherwise receive by selling the content themselves.

Operators don't have to stock these phones, but Nokia and its handset rivals are free to sell them through independent channels, which are starting to account for a higher percentage of global sales. Nokia is even pushing into direct sales through its website and an expanding chain of branded retail stores.

Perhaps the most alarming part of the incursion onto turf that operators considered their own is the threat posed by VoIP. Companies, including Skype and Google, provide software for mobile phones that lets cheap or free VoIP calls travel over mobile networks. Nokia and Motorola have stated their intention to preload Skype onto some handsets, and chips that most handset vendors are starting to add will route VoIP calls around traditional mobile networks.

In a move that could further shake up operator economics, Google is rumored to be readying a handset that routes Internet calls and data over Wi-Fi (or even cellular networks) that are free to consumers who agree to receive advertising on their handsets.

The reality for mobile operators is that they'll have to lighten up on their intentions to control content and hope that music-playing mobile users will rely on their phones more for everything, including voice. Some are already heading in that direction. Pan-European operator Orange is selling phones that support Wi-Fi, and the 3 Group has struck a deal with Skype that will allow low-cost voice calling. No one knows yet if these decisions will be profitable, but they mark bold moves that are wiser than simply fighting against new technologies.

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