Nokia's Roller-Coaster Report

Mixed results highlight strength at the top and bottom of the market and weakness in the mid-range, where Motorola and Samsung continue to gain

Is the glass half empty or half full? Mobile phone giant Nokia (NOK) reported third-quarter results Oct. 19 that contained both impressive growth and worrisome signs of weakness. Revenues rose 20%, to $12.7 billion, and handset shipments hit a record high of 88.5 million units in the quarter, up 33% from a year earlier. Nokia's market share also ticked up to just below 35%, according to market researcher IDC.

That's the good news. Net earnings fell 4.1%, to $1.06 billion, partly from charges for exiting the CDMA phone business. Worse, profitability slid across the board. Overall operating margins sagged 2.9 points, to 10.9%, meaning that on a $2.1 billion increase in quarterly revenues, Nokia was able to squeeze out only $61 million in additional profits. That negative news drove Nokia's New York-traded shares down 3% at midday.

What most worried investors was a stomach-churning drop in the average selling price of Nokia phones. Analysts had been expecting the continuation of a steady downward trend, driven by fierce competition among the top five handset makers and the steady shift in sales toward fast-growing emerging economies such as China and India, where prices tend to be lower.

Regional Differences

But rather than the €100 ($125) average the Street was predicting—down from €102 in the previous quarter and a year earlier—Nokia reported an unexpected plunge to €93 ($117). Only the sharp increase in volumes prevented revenues from stalling. In a conference call, CEO Olli-Pekka Kallasvuo cited softness in uptake for 3G handsets in Europe and a "tough" pricing environment overall.

Some of the blame for lower average prices falls on a rapidly changing geographical sales mix. The company's fastest-growing regions were China (up 47% year-over-year), Asia-Pacific, and Latin America—while the wealthier European and North American markets grew just 8% and 1%, respectively. But Nokia also apparently resorted to discounting in the quarter to maintain market share and keep factories humming.

Analysts say that may have been only a temporary tactic. Sandeep Malhotra of Merrill Lynch says in a report that he expects a "stronger portfolio" of products in upcoming quarters to "stabilize" average selling prices, though profit growth estimates may have to be adjusted downward by 3% to 5%.

Sales in Sound and Pictures

Indeed, despite higher revenues, Nokia couldn't escape a hit to profits. Its mass-market phones unit, which generates nearly three-fifths of total revenues, saw an actual decline in operating earnings, as did the networks division, which sells cellular equipment to carriers.

The troubled enterprise unit, which sells smartphones and other business-oriented devices, saw its losses increase to $81.5 million in the quarter, from $46 million a year earlier. What saved the day was Nokia's multimedia unit, which sells high-end music and camera phones. Revenues there soared 45%, to $2.6 billion, and operating earnings climbed almost 50%.

The mixed results highlight Nokia's strength at the top and bottom of the market—and its continued weakness in the mid-range, where rivals Motorola (MOT) and Samsung continue to make gains. Anticipation over Nokia's earnings had built after Motorola reported weaker than expected growth and a 45% decline in earnings the day before (see, 10/18/06, "Nokia and Motorola on Earnings Seesaw?"). And indeed, Nokia did outperform Motorola.

Optimistic Estimation

But the weaker profitability raises questions about whether Nokia can get back on a growth track. Gross margins in the third quarter fell from 2.6 to 8.7 percentage points in Nokia's four major divisions. And the combined operating earnings from Nokia's three handset units actually fell year-over-year, compared with a 38% increase for Motorola's mobile devices segment. That put the archrivals at nearly the same level of operating margins for the first time in years.

The picture is not all bleak for Nokia, though. The company raised its estimate for the 2006 global mobile phone market to 970 million units (some analysts are now saying it could even top 1 billion) and says it expects to hold share in the fourth quarter.

Analyst Albert Lin of American Technology Research in San Francisco, who has a buy recommendation on Nokia stock, notes that the company's sales grew faster in the third quarter than the market average in every region of the world. He figures Nokia will sell 105 million phones in the fourth quarter, another record.

Making Investors Smile

What's more, while earnings are under pressure, they're still headed upward. For 2006 as a whole, Merrill Lynch still figures profits will climb 15%, followed by 14% in 2007.

But quarters like the third don't exactly make investors happy. Two years ago, Nokia's price-earnings multiple was 22.5; now it's 15.8 and falling. Its shares are up 7.6% for the year, compared with 4.1% for Motorola. But to really win back investor enthusiasm, Nokia has to show that it can grow profits as quickly as unit sales.

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