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Nokia Poised to Ring Investors' Bells

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Nokia is coming back in a big way...

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Editor's Note: This article was published in the August 8, 2005 edition of Financial Times. It is featured on Minyanville with permission for the benefit of our community.

Nokia (NOK) and I have had a love affair for awhile now. In fact, we fell in love when the stock got squashed into low teens in August last year. I declared my love by writing this piece.

This August the stock got sold off on what I thought was a good quarter performance, I renewed my vows to NOK again by writing the below article in the Financial Times.

Nokia lost its U.S. dominance a couple of years ago when it failed to bring clam-shell phones to the U.S. However, its market share in the U.S. stabilized and will likely start growing again with the introduction of new, exciting phones. Ironically the U.S. has very little impact on Nokia's bottom line since it accounts for a very small portion of its sales (see article), but a very large portion of NOK's investors reside in the U.S., thus forthcoming success of Nokia's products in the U.S. (caution: a major assumption) is likely to reinvigorate interest in the stock again.

Nokia is a perfect showcase for contrarian value investing.

It is easy not to like Nokia stock, especially for U.S. investors, as Nokia has not come up with a decent cell phone in the U.S. for a while. Motorola (MOT) 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 U.S. sequentially, a miracle considering a below-average product range. Though 45 per cent of Nokia's shareholders live in the U.S. and it is the single largest cell phone market, Nokia sales in the U.S. 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 U.S. for Nokia.

Revenue in the second quarter grew 25 per cent and it was true organic growth, without acquisitions. An unfavorable 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 U.S. situation is puzzling. Yogi Berra would describe it as Nokia making too many wrong mistakes. The company let Motorola take the lead in the U.S. by missing the flip phone trend. Motorola deserves credit, as it did a wonderful job producing phones that U.S. consumers wanted. Outside the U.S., Nokia is a dominant player owing to a strong brand and innovative products. Its problems in the U.S. stemmed from its unwillingness to sacrifice manufacturing efficiency and to customize its phones to U.S. carriers' specifications. Last year Nokia made needed modifications to its operating system that should have allowed customizing phones on the software level without handicapping its manufacturing efficiencies.

Nokia is likely to approach the U.S. market differently from the way it does the rest of the world. It will have to make phones just for the U.S. - a significant shift in strategy. Nokia has all the ingredients to recapture the market, though I believe it will take some time.

U.S. will be the icing on the cake for Nokia as its overall success is not driven by its success in the U.S. 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 capitalization) 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 U.S., 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.

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