By Jessi Hempel
October 22, 2009

The trouble with being number one in any industry is that you have nowhere to move but down. Few companies know this better than Nokia (NOK), the Finnish telecommunications giant that has dominated cell phones for so long that in some parts of the globe the brand itself has become synonymous with the device.

Nokia has long excelled at making beautiful phones, but in today’s competitive smartphone market, beauty is just a start. The devices that make consumers salivate are the ones that have great software, offer the most games and social networking features, get great service, and come attached to fast networks. Oh, and they have to be cheap.

One company has shaped this new competitive environment, and it’s not Nokia—nor was it even a telecommunications company until 2007 when it debuted the iPhone.

Apple (AAPL) is eating Nokia’s lunch.

With the iPhone, Apple created a consumer lust for smartphones by showing us we could browse the web from our palms and enjoy it. It launched a device so perfect in form that it has become the gold standard by which all other devices are measured. And it moved the global hub of telecommunications innovation from Asia, where form factors had previously trumped all else, to Silicon Valley, where software makers now race each other to come up with the coolest applications.

None of this has been good for Nokia, which had already lost substantial ground in the North American cell phone market (see “Nokia’s North America Problem”). Their struggle for market dominance in the age of the iPhone has been less about nailing an innovation strategy than playing a hardcore game of block and tackle.  Enter the latest move: on October 22, Nokia filed suit against Apple in a Delaware federal court claiming infringement on 10 patents it holds on the integration of several technologies at the heart of Apple’s iPhone.

As my colleague Philip Elmer-deWitt points out, you can’t blame Nokia for having its nose out of joint.  Apple, according to Nokia, has gotten a free ride since the iPhone launched—a very fast ride. Apple commands 22% of the smartphone market in the US, according to IDC. Globally, it holds 12% of the market, more than doubling its share from last year.

Meanwhile, despite its best efforts, Nokia has steadily lost ground. It holds 40% of the market, down from 43% last year, according to IDC. And in the competitive North American market, Nokia is barely holding its own with just 3%.

Recognizing that the North American market is more crucial than ever, Nokia has spent the last couple years retooling its strategy. It installed its chief financial officer in the U.S. It opened new offices in Atlanta to be close to AT&T Mobility (ATT) and in Parsippany, N.J., to be near Verizon Wireless (VZ). And it put several hundred product developers in its San Diego design center to work in collaboration with AT&T and Verizon Wireless on some new products.

The efforts have begun to yield dividends as North American carriers have started to support a slew of new cell phones—and even a couple of smartphones—but progress is slow going. “We’ve not been good at delivering promises in the past,” Niklas Savander, who heads up Nokia’s services division, told me recently, in describing Nokia’s relationships with the carriers. “It’s a trust thing and it doesn’t go away easily.”

Savander said he’s also stepping up the company’s efforts with its Ovi store by making strategic acquisitions, mostly as a way to hire new software development talent. In September, Nokia bought social networking company Plum Ventures and traveling startup Dopplr.

So far, these changes have not been enough to jumpstart Nokia’s smartphone growth. On October 15, the company reported a third-quarter loss of $836 million as sales fell 20% from a year earlier (in North America, sales dropped 25%). And as the Christmas season approaches, bringing a gaggle of gadgets for Santa to deliver, Nokia has a paltry smartphone offeri. It’s easy to understand why the telecommunications giant, explaining that it has sunk $60 billion into the research and development that has helped enable the devices to take off, might at least want Apple to share the wealth.

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