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Nokia's Disconnect

By Andy Reinhardt Nokia is a victim of its own success. The Finnish cell-phone giant, which has one-third of the global market for handsets and is a top-ranked seller of wireless networks, has done more than any other company to democratize mobile telephony -- especially in the developing world. Wireless phones have become so ubiquitous that researcher Gartner now forecasts sales will approach 780 million units this year and more than 1 billion worldwide in 2009.

The problem for Nokia (NOK), as evidenced by its poorly received second-quarter earnings announcement on July 21, is that the more phones it sells in developing countries, the lower the average price and profits per unit. No phonemaker in the world is better equipped to handle these massive volumes. Nokia should sell more than 250 million phones this year alone, and even with a shift to lower-cost models, it still commands operating margins of 12.5% -- higher than the 11.1% posted by archrival Motorola (MOT).

But sagging prices and profit pressures keep a lid on Nokia's results. The company announced an eye-popping 25% rise in revenues vs. last year's second quarter, its best quarterly showing in five years. But profits grew only 15% -- a sign of the fierce price competition raging in the low end of the market (phones selling for $150 or less), and a shift in units from richer Western and Asian countries to more price-sensitive emerging markets such as China, India, Russia, and Latin America. That drove Nokia's average selling price to $128, down from $138 a year earlier.

The weaker-than-expected showing, coupled with cautious guidance for the third quarter, sent Nokia shares down 10% or more on bourses in Helsinki, Stockholm, and New York.

MIGHTY MOTO. Of course, 15% profit growth is nothing to sneeze at. Nokia still spins out quarterly cash flow of about $1 billion -- though this quarter it sagged to $617 million because of a big jump in working capital and slower collections from customers in the developing world. It's buying back billions of dollars worth of shares and pays a solid 2.5% dividend. But investors smell slow growth and renewed competition from a revitalized Motorola, which announced blowout results on July 19.

Analysts are plainly concerned. Jari Honko, who covers Nokia for eQBank in Helsinki, worries that the third quarter will be a "disaster" and cut his rating on the stock from buy to reduce. Richard Windsor of Nomura International in London, who rates Nokia neutral, frets that increasing competition at the low end, especially from Motorola, has "put a permanent dent in mobile margins." Windsor is especially alarmed that Nokia's mass-market mobile-phone unit, which still generates 60% of revenues despite a concerted diversification effort, saw operating margins fall to 16.2% in the second quarter from nearly 20% a year earlier.

To get out of a commodity trap, Nokia is counting on uptake of potentially more profitable multimedia and professional devices. Its multimedia unit, which sells camera phones, music players, and handheld game machines, now contributes 17% of revenues (up from 11% in the same period last year) and nearly 10% operating margins. Gross margins on multimedia devices are actually higher than for mass-market phones, but Nokia's R&D and marketing expenses for the new division are also higher, holding down operating profits.

HANDHELD HELL. The New York-based enterprise solutions unit, meanwhile, continues to bleed money. It saw sales of its personal organizers and Internet gear creep up just 7% year-over-year, to $240 million, and operating losses of $46.5 million actually mounted from a year ago. In a conference call with equity analysts, Nokia CEO Jorma Ollila blamed overreliance on a small portfolio of products, such as the Communicator handhelds, and promised more devices to juice up growth.

One saving grace was Nokia's networks division, which sells the radio equipment and switches that power mobile-phone networks. It saw a 6% sales gain and made operating profits of 12.9%. Still, that was far less than the impressive 18% revenue gain notched by No. 1 mobile networks seller Ericsson (ERICY). Some analysts worry that growth in networks will slow in coming years, as the worldwide upgrade to third-generation (3G) networks starts to tail off.

Is Nokia in trouble? Hardly. It still runs circles around its competitors in operating efficiency and scale, not to mention absolute profits. If the shift to lower-price phones is permanent, Nokia is likely better prepared than most rivals to weather the transition and squeeze out earnings from cheaper handsets. For instance, it's building a huge new factory in India to take advantage of lower labor costs and better serve one of its biggest and fastest-growing markets. And in the second quarter, it reinforced its strong No. 1 market share position in China.

NECK AND NECK. But the threat of a resurgent Motorola can't be ignored. Nokia likely gained several points of market share in the second quarter, putting it back almost in the position it enjoyed before a disastrous first half in 2004 whacked six points from its hard-won share and drove it below 30% for the first time in years. But Motorola also gained in the quarter, reaching nearly 20% of the market, its best showing in years.

The Illinois company is winning plaudits for its slick design and newly aggressive pursuit of the low end. And Motorola's strong showing is taking a toll on weaker rivals. Some companies are bailing out of mobile phones entirely because the fight is too fierce: No.4-ranked Siemens, for instance, is spinning off its handset group to Taiwan's BenQ. Even Korean star Samsung, which has climbed in recent years to a strong No. 3, saw a slight share decline in the second quarter.

The mobile-phone business is looking increasingly like a race among a handful of giants. Nokia is still far ahead, but the battleground keeps shifting. Keeping investors happy is only one of the challenges Ollila & Co. will face the rest of this year. Reinhardt is a correspondent in BusinessWeek's Paris bureau

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