Monday, August 08, 2005
Financial Times - August 8, 2005
Nokia is a perfect showcase for contrarian value investing. It is easy not to like Nokia stock, especially for US investors, as Nokia has not come up with a decent cell phone in the US for a while. Motorola has risen from the dead and offers a great portfolio. In addition, the latest quarter did little to provide comfort as margins in the mobile phone segment declined more than 3 per cent from 19.8 per cent to 16.2.
However, all these developments are widely known and more than priced into the stock, where many positive developments went unnoticed.
In the second quarter, Nokia's market share grew in the US sequentially, a miracle considering a below-average product range. Though 45 per cent of Nokia's shareholders live in the US and it is the single largest cell phone market, Nokia sales in the US represent only 8 per cent of its total sales - a considerable decline from 15 per cent last year. There is a lot more upside than downside in the US for Nokia.
Revenue in the second quarter grew 25 per cent and it was true organic growth, without acquisitions. An unfavourable product mix, a decline in the average selling price (ASP) of 5 per cent and intensified competition were responsible for margin erosion. The deterioration was due to explosive sales growth in emerging markets where sales are dominated by cheaper handsets.
The US situation is puzzling. Yogi Berra would describe it as Nokia making too many wrong mistakes. The company let Motorola take the lead in the US by missing the flip phone trend. Motorola deserves credit, as it did a wonderful job producing phones that US consumers wanted. Outside the US, Nokia is a dominant player owing to a strong brand and innovative products. Its problems in the US stemmed from its unwillingness to sacrifice manufacturing efficiency and to customise its phones to US carriers' specifications. Last year Nokia made needed modifications to its operating system that should have allowed customising phones on the software level without handicapping its manufacturing efficiencies.
Nokia is likely to approach the US market differently from the way it does the rest of the world. It will have to make phones just for the US - a significant shift in strategy. Nokia has all the ingredients to recapture the market, though I believe it will take some time. US will be the icing on the cake for Nokia as its overall success is not driven by its success in the US since it represents a small portion of its sales.
Nokia is by far the largest cell phone producer and it spends considerably more on research and development than its closest competitor Motorola. R&D is much needed to keep consumers in developed countries excited about new, feature-rich phones.
Nokia is also the low-cost producer, the Dell of cell phones, which is crucial as competition in the low end products is mostly price-driven. In the lower end phones in emerging markets, as long as features are comparable with other phones and the brand perceived to be of good quality, price is a deciding factor on a purchase. To put things in perspective, Nokia's record low operating margins are still much higher than Motorola's record high. The multimedia phone segment was a shining star for Nokia in the second quarter as it turned into a profitable (9.2 per cent margin) growth machine. Revenues were up 89 per cent. This segment was bleeding money in the past as it lacked much-needed scale. Nokia's portfolio in this segment is rich and it is likely to offset some margin compression in the mobile phone segment. Also, there is still room for margin expansion as its margins should be at least as high as - or higher than - mobile phone's 16.2 per cent. The company has virtually no debt and a $15bn cash stockpile in the bank (20 per cent of the market capitalisation) and has a great return on capital. The stock trades at 14.6 times 2004 free cash flows, and at 15 times - recently lowered but likely to be revised up - 2006 estimated earnings. The valuation is even more attractive if the cash stockpile is taken into consideration. In spite of falling ASPs and the difficulty in the US, Nokia's sales are likely to grow as the global market for cell phones is increasing rapidly.
The company expects to gain market share at the expense of the smaller players. Its margins are at record lows, thus their future movement is likely to be upward. Finally, Nokia pays a dividend yielding 2.4 per cent and is buying back stock (using its huge cash pile) as if it was going out of fashion.
The author is a portfolio manager with Denver-based Investment Management Associates and teaches equity research at the University of Colorado. His firm owns shares in Nokia.
Vitaliy N. Katsenelson, CFA Copyright Financial Times