Nokia: Head and Shoulders Above the Rest
By Ari Bensinger
Nokia Corp. (NOK ) has been the dominant supplier of handsets since the start of the wireless revolution. The Finland-based company commands 37% of the worldwide handset market (based on market share data from research firm Strategy Analytics), above its three largest competitors combined. During 2002, Nokia confirmed its ability to perform well an intensely challenging environment, translating core strengths of manufacturing scale and efficiency into good profitability.
So far this year, however, it's been a different story. The company disappointed investors by lowering its operating earnings guidance in its second quarter conference call. As of Aug. 22, the stock had significantly underperformed its industry benchmark, falling 7%, vs. a 28% gain for the S&P Communication Equipment Index. We believe that the lower guidance isn't as bad as most investors think, and view the stock as a compelling value at its current price.
Before we tackle the company's lower guidance, it's important to understand the basic dynamics of Nokia's end market, the wireless sector. While 20% of company sales are derived from wireless infrastructure or network products, we believe investors should focus on the company's core business of making mobile phones.
OUTPACING THE MARKET.
The wireless handset market is currently estimated to be the world's largest consumer electronics industry measured by units, with over 400 million handsets shipped in 2002, according to Nokia's estimates. To put this into perspective, 135 million personal computers were sold worldwide last year, according to research outfit International Data Corp.
Long-term industry prospects remain solid, in our opinion, with the potential for large replacement sales in Europe and new subscribers in low wireless penetration markets like China and India. Overall, we at S&P see the wireless handset market experiencing a long-term industry growth rate of about 10%. We expect Nokia's growth to continue to outpace overall market growth.
After modest volume growth in 2002, S&P expects the number of wireless handsets sold to rise 10% in 2003, to roughly 445 million units. With new subscriber growth beginning to falter, the replacement market is the key driver of industry growth. The handset replacement market accounted for approximately 50% of total units sold in 2002, and is expected to represent about 60% in 2003. On average, slightly more than a quarter of the global subscribers upgrade their handsets annually, which indicates a replacement cycle of about 2.5 years.
We believe the current rollout of data-enabled phones with multimedia messaging and color displays should help to spur the replacement cycle for the next couple of years. The European market, which is often on the cutting edge of technology, will likely be the vital growth region for replacement sales, in our opinion. With a dominant 50% market share in the European market, we think Nokia is best positioned to benefit from a technology progression to next-generation cell phones.
We expect Nokia's strong brand to act as a powerful tool in keeping the loyalty of consumers during this important mobile upgrade cycle. In a 2002 list of the world's top 100 brands ranked by U.S. dollar value, branding outfit Interbrand placed Nokia at No. 6, the highest place for a non-U.S. brand.
In a market where phones are becoming increasingly commoditized, the basis of competition has quickly shifted from quality to price. On average, handset prices fall 10% to 15% every year, and with industry competition intensifying, pricing pressure is as strong as ever. In our opinion, smaller handset makers that cannot produce in large volumes will have difficulty turning profits.
Unlike its peers, Nokia has consistently managed to increase its industry-leading handset operating margin, thanks to its large production. Nokia produces well over 500,000 phones per workday. This massive production volume helps Nokia enjoy economies of scale and substantial research and development (R&D) resources. It has also led to large international distribution channels and established relationships with all the major telephone companies. By Ari Bensinger Last month, the stock took a big hit -- skidding nearly 20% to $14.38 on July 17 -- when Nokia reported disappointing second-quarter handset average selling prices and cut its outlook for third-quarter handset operating margins. However, we would note that excluding the negative impact of currency, second-quarter average selling prices would have been flat from year-ago levels. In fact, we expect overall mobile phone average selling prices to firm in 2004, reflecting the added functionality and feature sets of next-generation phones.
Based on Nokia's third-quarter guidance, we believe handset operating margins could dip to 20%, from 23% in the second quarter. We largely attribute the margin decrease to higher operating expenses, as the company strategically decided to increase its R&D and sales and marketing spending to help position its new product portfolio for the ever important holiday season.
BEATING THE COMPETITION.
Looking back to mid-2001, we find a comparable occasion where Nokia increased its operating expenses in an effort to make over and energize its aging product portfolio. After a couple of quarters, operating expenses and profitability margins quickly trended back to the norm.
Similarly, we expect lower third-quarter handset profitability to be a temporary blip in the company earnings model. Even if margins fail to rebound, our forecasted 20% operating margin for the third quarter of 2003 -- a level that some analysts consider "disappointing" -- is head and shoulders above the competition. For comparison, rival Motorola (MOT ) reported second-quarter operating margins of under 4% in its personal communication handset segment.
Most importantly, Nokia's increased product investment in 2001 helped fuel a dramatic increase in its global market share. As the industry shifts to next-generation data phones, we believe it's a good time to again increase investment in research and marketing. The company plans to introduce 35 new phones during 2003, including the N-Gage gaming platform, the 3300 MP3 player, and the 6600 business imaging device. These innovative concept phones require added marketing resources to educate consumers about new wireless data applications. We believe that a temporary increase in operating expenses will prove to be a wise long-term investment for the company.
Nokia shares, which closed at $16.31 on Aug. 27, trade at a price-to-earnings multiple of approximately 17 times our 2004 translated U.S. EPS estimate of 95 cents, below the peer average. At 2.6 times our 2003 sales estimate, the stock was above the industry average. However, we believe this premium sales valuation is warranted, based on Nokia's industry leading profit margins, which are over four times those of peers. The company produces strong cash flow generation at an average clip of 1 billion euros per quarter (or over $1.2 billion).
Applying a blend of average group forward p-e and price-to-sales ratios, we derive a 12-month target price of $20. This target is further supported by our discounted cash flow analysis (DCF), which indicates a fair value of just under $20. Our DCF model assumes a weighted average cost of capital of 12.2% and a conservative terminal growth rate for free cash flows of 3%. We have assigned the stock our highest investment ranking of 5 STARS (buy), and view Nokia as a core holding for investors that want exposure in an improving wireless handset market.
Analyst Bensinger follows telecommunications equipment stocks for Standard & Poor's