The Call on Nokia: Buy

S&P likes the wireless phone giant's dominant market position, strong cash flow, and attractive valuation

By Ari Bensinger

Nokia has been the dominant supplier of wireless-phone handsets since the start of the wireless revolution. In terms of market share, it is twice the size of Motorola, its nearest competitor. And that dominance was confirmed yet again in 2002, when the Finland-based company performed well in an intensely challenging environment, translating its core strengths, enormous manufacturing scale, and efficiency into solid profitability.

We at Standard & Poor's have assigned Nokia our highest investment ranking, 5 STARS (buy), and view it (NOK ) as a core holding for investors who want exposure to an improving wireless-handset market.


  Estimates put wireless handsets as the world's largest consumer electronics industry as measured by units of sale, with around 400 million units shipped in 2002. By contrast, the personal computer industry is estimated to have sold approximately 135 million units worldwide during 2002.

The wireless-handset market bounced back somewhat in 2002, with an estimated 5% increase after experiencing its first unit-volume decline the previous year. Growth in European markets slowed in 2002 while the Asia/Pacific region -- especially China -- was expected to once again report strong demand in 2002. Overall, we expect the wireless-handset market to experience a solid long-term industry growth rate of 10% to 15%.

With new-subscriber growth beginning to wane, the replacement market is the key driver of industry growth. Replacements accounted for approximately 45% of total units sold in 2001, and that figure is likely to have topped 50% in 2002. On average, slightly more than a quarter of wireless subscribers worldwide upgrade their handsets annually.

Looking ahead, the rollout of data-enabled phones with color displays and multimedia messaging (MMS) -- which includes digital photo, video, and audio capability along with text -- should help to fuel the replacement cycle. The European market, which is often on the cutting edge of technology, will likely be the vital growth region for replacement sales. With a dominant 50% market share in Europe, Nokia is the manufacturer best positioned to benefit from a technology progression to next-generation cell phones.


  In a market where phones are increasingly becoming a commodity, Nokia has established a powerful brand image. In a 2002 list of the world's top 100 brands -- ranked by U.S. dollar brand value -- consulting outfit Interbrand placed Nokia at No. 6., the highest ranking for a non-U.S. label. In Europe, Nokia was rated the No. 1 brand by a recent Reader's Digest brand-preference study, which also showed that brand loyalty in mobile phones is higher than in any other product category.

Nokia has become the industry benchmark for handset design, primarily due to its philosophy that handsets are a stylish fashion accessory rather than a mere communication tool. The company's research team aims to segment the market and target specific demographic groups. For example, Nokia's current handset lineup consists of six product categories: classic, basic, active, expression, fashion, and premium. Its focus on developing handsets that appeal to the mass market has enabled the company to predict and satisfy the market's needs and preferences ahead of the competition.

Standard & Poor's expects a new product cycle toward next-generation phones will start this year. Nokia plans to introduce a plethora of new models early in the year, with an emphasis on new features such as color screens and MMS. The company expects more than half of all the phones it offers for sale to be MMS-enabled in 2003.


  As befits an outfit with a nearly 40% share of the global wireless-handset market -- greater than its three nearest competitors combined -- Nokia's production capability is enormous. It produces some 560,000 phones per workday. This massive production volume helps Nokia enjoy economies of scale and deploy substantial research and development resources. It has also allowed the creation of large international distribution channels and established relationships with all the major telephone companies.

By continually producing the largest volume of phones in the industry and introducing newer and higher-priced product lines, Nokia has been able to counter fierce pricing pressure. The operating margin for its handset business increased to 22% in the third quarter of 2002, compared to 9% for Motorola (MOT ), its closest competitor. In contrast, wireless-handset vendors that can't produce in large volumes in order to gain economies of scale will have difficulty turning profits. Indeed, smaller phone makers Philips (PHG ) and Alcatel (ALA ) are seeking to exit the business.

At a price-to-earnings (p-e) multiple of about 20 times our 2003 earnings-per-share estimate of 81 cents, Nokia is trading near its lowest valuation in more than five years. In relation to sales, the shares are trading at under 2.6 times our 2003 estimate, above the industry average. However, we believe this premium is warranted given Nokia's industry-leading profit margins, which are roughly three times the average of its industry peers.

On an S&P Core Earnings basis, we deem Nokia's earnings quality as high. Stock-based compensation (option) expense would have lowered 2001 operating EPS by 17%, vs. an average decline of 45% for the communication equipment companies that we cover. Pension expense during 2001 was negligible.


  Nokia's balance sheet is strong, with more than 8 billion euros in cash and available-for-sale investments. Nokia has minimal long-term debt and enjoys a strong current ratio of nearly 3-1. Its industry-leading operating margins help produce strong cash-flow generation at an average clip of 1 billion euros per quarter. S&P's discounted cash-flow model implies an intrinsic value of around $20 a share.

In light of its leading market position, strong cash-flow generation, and relatively low valuation, we believe the stock is poised to reach our 12-month target of $19, which would represent an approximate 15% increase from the current quote.

Analyst Bensinger follows communications equipment stocks for Standard & Poor's

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