Crunch Time for Nokia

Motorola's disappointing fourth-quarter earnings warning underscores the challenges facing global handset makers

When Motorola warned late on Jan. 4 that its fourth-quarter revenues and profits would fall well below Wall Street expectations, the shock waves rippled around the world. Among the hardest-hit was No. 1 mobile-phone maker Nokia, whose shares fell 4.15% in Helsinki trading, to €15.26 ($19.84), and plunged by more than 5% in New York by mid-afternoon on Jan. 5.

It's no wonder investors were spooked. The market forces that Motorola (MOT) cited for its woes—especially a shift in sales towards emerging economies—apply equally to Nokia (NOK).

The Finnish giant disappointed investors in the third quarter, when, despite a 20% revenue increase, its net profits fell 4.1%. At the time, Nokia pinned part of the blame on fast growth in markets such as China and India that tend to buy cheaper and less-profitable phones (see, 10/19/06, "Nokia's Roller-Coaster Report").

That trend appears to have continued in the fourth quarter, as the top two handset makers waged a fierce market share battle in the developing world. Motorola says it sold a record 66 million units in the last three months of 2006, up 48% from a year earlier. But an 8% decline in the average selling price per unit vs. the previous quarter, to an estimated $121, helped limit revenue growth to between 11% and 13% for the company as a whole.

Prices on the Way Down

"It's déjà vu again," says analyst Jussi Hyoty with FIM Securities in Helsinki. "Volumes are good, prices are under pressure, and margins are coming down. That was the story last quarter from Nokia, and now it's Motorola's turn to sing the same song."

As investors digested Motorola's earnings pre-announcement, they couldn't help but wonder how badly the same forces will affect Nokia when it reports fourth-quarter results on Jan. 25. Analysts figure the company sold north of 100 million handsets in the last three months of 2006, up more than 25% from the same period a year earlier.

But on Jan. 5 brokerage Credit Suisse issued a report predicting that Nokia's average selling prices slipped to €87 ($113)—down from the €94 average it logged in the third quarter and 13% below the level a year earlier. That means Nokia's sizzling unit growth could translate into just a 12.4% gain in revenues.

Keeping a Lid on Costs

The impact of lower prices also falls right to the bottom line. Credit Suisse now figures Nokia's operating margins for handsets in 2006 were 14.6%, vs. 15.1% a year earlier. And 2006 net income, though up 12.5%, to €4.07 billion ($5.3 billion), will lag far behind revenue growth of 20%. Nokia was unable to comment due to its pre-earnings quiet period.

Still, most analysts think Nokia remains better placed than its resurgent American rival. Its market share remains around 35%, and it takes home more than half the profits earned in the entire mobile-phone industry. What's more, Nokia's huge production volumes give it an edge in keeping a lid on costs. Analyst Paul Sagawa of brokerage Sanford Bernstein figures Nokia enjoys a 3%-to-4% cost advantage in manufacturing and distribution over Motorola.

Aware of Nokia's economy of scale advantages, Motorola has scrambled in the past two years under new Chief Executive Ed Zander to grab market share and boost volumes. Thanks in part to the huge success of the sleek RAZR flip-phone, Motorola's share has climbed 8 percentage points since 2003, to an estimated 22% in 2006.

But in recent quarters, analysts say, the company has resorted to aggressive price-cutting to maintain or increase share—at the expense of margins. Morgan Stanley (MS) figures Motorola's operating margins for handsets fell by almost half in the fourth quarter, to 5%.

Staying Above the Fray

At the same time, both companies are facing an inexorable change in the nature of the mobile-phone market.

There's no sign of slacking demand overall, notes analyst Carolina Milenesi of market researcher Gartner. Indeed, sales in 2006 may have topped 1 billion units.

But as customers in developing economies snap up millions of low-cost phones, sales of high-end models tricked up with cameras, MP3 music players, and support for speedy next-generation 3G networks aren't growing fast enough to compensate.

Some companies are managing to stay above the fray by concentrating on the mid-tier and high-end segments of the market. Sony Ericsson, the 50/50 joint venture of Sony (SNE) and Ericsson (ERIC), enjoys the highest average selling prices in the industry and is gaining market share, especially in Western Europe, thanks to its popular Walkman music phones and Cybershot camera phones.

Korean giants Samsung and LG Electronics also lean to the high end, with products such as LG's hit Chocolate phone. Samsung's market share has been relatively flat for three years, and both companies had a difficult time in the first half of 2006 because of stiff competition.

But the LG Chocolate and Samsung's new Ultra line are helping to spark turnarounds. Samsung figures its unit sales will grow 10% in 2007, to 130 million units, while LG anticipates nearly 22% growth, to 78 million.

Heavy Investments in Design

Where does this leave Nokia? Despite tough market conditions and continued concerns about prices and margins, most analysts believe the Finnish giant will continue to outpace rivals.

"Nokia can handle the price competition better," says analyst Jari Honko with Helsinki-based brokerage eQBank. "When problems hit, they hit Motorola harder."

In part, that's due to Nokia's formidable scale. "It has a broader product line and better geographical mix than Motorola does," says analyst Hyoty of FIM Securities. Nokia also invested earlier and more aggressively in emerging markets from China to India to Latin America, which gives it "enormous volume and distribution advantages," Hyoty adds.

Nokia is also investing more heavily in design to make its phones more appealing, and scrambling to fill out the weak mid-section of its product portfolio (see, 12/26/06, "Nokia's Grand Plans for 2007").

No doubt, growth and profits will get harder to squeeze out of a business that is rapidly commoditizing around the world. But the Nokia shareholders who pressed the sell button on Jan. 5 may have jumped the gun.

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