Ericsson's plans to seize leadership in multimedia cell phones suddenly seem in doubt. Some investors are raising questions about the Swedish phone giant's ability to fund its operations through next year, even after its just-completed $3.2 billion recapitalization. And the company announced a week ago Friday that the brutal operating climate could force a shutdown of its high-profile joint venture with Sony Corp. to develop inexpensive color-screen mobile phones.

Ericsson says its funding is sufficient to carry it through. But that's not the end of it. Beyond surviving the current technology downturn, Ericsson, Alcatel, Siemens and other big telecom-equipment makers face a further problem: They have limited chances to grow. At the end of last month, Nortel surprised investors by announcing third-quarter revenues would fall 10% below the preceding quarter, which shareholders had thought was rock bottom. And as the nearby chart shows (see accompanying illustration—WSJE Sept. 9, 2002), an upturn in spending on telecommunications equipment does not look imminent. To better their odds of surviving and thriving, gear makers need do more than wait it out. Success may lie in shrinking now to grow from a stronger base later.

That doesn't mean simply letting business atrophy. Consider the strategy put into play a decade ago by defense-industry giants such as General Dynamics. During the Cold War, General Dynamics had grown into a defense conglomerate. But the collapse of the Soviet Union brought fundamental changes—a rapid decline in demand in the early 1990s alongside a shift from cost-plus contracts to cost-competitive ones in which specialized scale mattered. So General Dynamics significantly cut back its portfolio to focus on armored vehicles and submarines—products where it could become the market leader.

Since then, General Dynamics' share price has grown more than fivefold, outperforming all of the other defense majors and the S&P 500. Its revenues have grown beyond Cold War highs, despite a much narrower product set. And its margins are among the best in the business.

Highly focused companies—those with a small number of strongly positioned businesses—fared much better than diversified companies over the last decade. Nokia's leadership in mobile handsets, for instance, resulted from the company's decision to shrink in order to grow from a refocused and stronger core. Founded as a pulp and paper mill on the Nokia River in Finland in 1865, the company grew into a conglomerate by expanding into rubber, energy and electronics before it zeroed in on the mobile-phone opportunity. In the 1980s, Nokia shed most of its businesses to focus on cellular phones, and continues to grow market share even in a global telecom recession.

The pressure on Ericsson to generate profits quickly from its joint venture with Sony highlights the importance of hewing closely to a strong core business. Ericsson is the world's leading supplier of wireless infrastructure for mobile phone networks, but it lags in handsets, wireline equipment and other markets. With its debt marked down to junk status, and negative cash flow weighing on its balance sheet, Ericsson will be hard-pressed to keep investing in a money-loser like Sony Ericsson Mobile Communications, unless its new phones take off.

For the Big Seven telecom-gear makers, three sweeping trends make General Dynamics' lesson worth learning: The equipment makers traditionally operated as national champions dominating their home markets. Paris-based Alcatel sold almost exclusively to France Telecom; Munich-based Siemens to Deutsche Telekom. As suppliers of choice to national customers, the companies enjoyed reliable margins and expanded their product portfolios well beyond their traditional base of central office switches into fiber optics, wireless infrastructure, mobile handsets and data products.

Country-specific equipment standards reinforced each vendor's grip on its account relationships. For example, the Japan-specific second-generation mobile PDC standard helped keep Nokia's handsets out of the Japanese market, allowing Matsushita and Mitsubishi to dominate there.

But the adoption of global standards for third-generation, or 3G, wireless will reduce the traditional barriers to market entry in Japan. As a result, the ultimate driver of winning strategies will be a shift to economics and away from traditional local customer relationships. Increasingly, high-cost new-product development is fixed, and new products, once developed, can be deployed world-wide, offering potentially huge margins to those with leading market position and global presence.

Concurrently, big shifts in strategy at telecom firms are forcing their equipment makers to restructure. Customers are larger, more focused and more sophisticated. For example, Vodafone now has operations spanning the globe; it purchases infrastructure and handsets for more than 104 million subscribers and had a capital expenditure this year of about GBP 4 billion, excluding 3G licenses.

And the telco marketplace is becoming more segmented. Vodafone is a mobile pure play. Former telecom monopolists BT, France Telecom and AT&T have spun off their wireless businesses. Those focused companies no longer need the vendors' full product portfolios. Moreover, the telcos are insisting on open standards instead of traditional proprietary systems. A decade ago, one or two companies owned 25% of the market for fixed-line infrastructure in developed countries. Today, open competition prevails. Those trends dilute the strategic rationale of the equipment-conglomerate approach.

But the strongest factor of all is demand shock. In the 1990s, telcos' spending on networks skyrocketed, stimulated by deregulation and a spate of new market entrants. Between 1996 and 2000, global telecom firms' capital outlays grew by 26%, far outstripping their underlying cash-flow growth of 8% to 12%. Yet world-wide revenues for suppliers of switches, wireless products and optical equipment dropped by 13% in 2001, and they are projected to fall another 15% in 2002, remaining stagnant at around $254 billion annually through 2004. One consequence, familiar to the defense sector in the 1990s: Capacity utilization at telecom-equipment manufacturers has fallen to 55% in 2002 from 82% in 2000. When spending will recover is anyone's guess—but we won't see the outlays of the late 1990s again for a long time.

The late 1990s were one of the most prosperous eras in recent business history, but only one out of 10 companies sustained profitable growth during that period, according to our decade-long research. The consistent growth leaders exhibit three clear characteristics: They reduce rather than extend the scope of their businesses; they find profitable opportunities within the boundaries of their current operations; they search constantly for ways to improve the performance of the core business.

The choices are not easy in the best of times. But for companies in distress, survival and growth depend on reinforcing the core.

—

Mr. Luzi is a director of Bain&Co. Inc. in London. Mr. Garstka is a Bain vice president in Tokyo.