Sunday, June 20, 2010 4 comments

Added to watchlist: Nokia (NOK)

I remember a time, perhaps not even 2 years ago, when I was looking at Motorola (MOT) as an investment opportunity, and wondered if Nokia (NOK) is the type of company that would never "get cheap." At that time, and even to this day, Motorola was going through serious problems in their mobile phone division. In contrast, Nokia seemed to be sailing smoothly, gaining market share throughout the world.

My, how things have changed. Nokia's shares hit a decade-low this week, after Nokia's guidance came in weaker than expectations. In particular, the market appears to have voted that Nokia is going to lose the smart phone market. Given how smart phones are forecast to be the ubiquitous mobile phones in a decade, this is a big deal for Nokia.

Given the big decline in share price over the last few years, I felt this was a good contrarian opportunity to investigate. Here is my very preliminary, early, look at the company. My goal has been to avoid investing in mega-caps (since upside is smaller and they are correlated too much to the broad market) but I may make an exception here.

Current State of Affairs

Nokia (NOK) as many of you may know, is a mobile phone manufacturer from Finland. It is the largest mobile phone handset company in the world. Living in North America, it's not obvious that Nokia is the most dominant company. This is mainly because Nokia's smart phone penetration is North America is very low. Brands like iPhone and Blackberry have more powerful brands in North America. From limited reading I have done, it appears that Nokia's brand (not necessarily in smart phones) is pretty strong in emerging markets.

I'm not an expert in the mobile phone market but what appears to be happening is that the dominant incumbent, Nokia, which dominated mobile phones in the early 2000's, is having problems adapting to the newer technology, smart phones. Presently Nokia maintains a dominant position with lower-end mobile phones which have low margins but higher volume. One of the reasons the stock sold off last week was because the product mix is appears to shift towards the lower-end products with lower margins.

Share Price Performance

Nokia's share price is down around 66% from its peak in 2008 and around 33% from the beginning of the year. It's one of the few stocks that is trading close to the price hit near the March/April 2009 bottom. So this makes it a good contrarian opportunity.

Just because the stock price is down doesn't mean it's cheaper than before. In many cases, the market marks down the price due to changes in the underlying business. This is partly the case here. Nokia used to dominate the mobile handset market and the market awarded it a really high valuation a few years ago. In 2007, it had a market cap of $157 billion, whereas it is now down to $33 billion. The market has been marking down the P/E ratio from the low 20's to low 10's (abnormal earnings in the last year so it's kind of confusing to rely on P/E ratios.)

The question for potential investors is whether the market has marked it down too much. Or another way to think about it, ignoring market prices, is whether you would be satisfied owning a company with the given normalized earnings (I haven't done any work on figuring out the normalized earnings yet.)

Look at 10 Year Financials

I pulled some key 10 year data from a Morningstar report for Nokia below (click for larger pic):

Some of the things that jump out at me are the following:
  • It's amazing how much the market cap has changed in a decade. From a TMT-bubble peak of around $202 billion; down to trough of $73 billion in 2004; to a near-term high of $157 billion in 2007; and to the current trough of $33 billion. The market cap is still somewhat high—there aren't too many companies out there sporting a cap of $33 billion—and this is one thing I don't like about this stock. The stock will be highly correlated with the broad market. In some of the European indexes, it is probably one of the largest constituents. The question to figure out is if the underlying business will continually deteriorate or not.
  • One other nice thing about this company is that their share count has been declining for years. In the last 5 years, share count dropped around 20%. Management obviously bought back shares at prices far higher than the current price (definitely not a good thing) but at least it does show that management is comitted to reducing shares, as opposed to some technology companies that keep issuing new shares. If I'm not mistaken, the company decided last year (?) not to re-new its share re-purchase plan  but if the company does turn the corner, it'll likely reduce the share count in the future.
  • Another thing to note is that Nokia is one of the few tech companies that pays a dividend. I believe it's set by a formula and is likely to be cut going forward, but at least you'll get paid for waiting—if you can tolerate a few percent per year for typing up your capital.
  • In terms of earnings and cash flow, I have to do more work to figure out what normalized numbers are (the is really tough and the key element of investing, especially for a technology company whose product life cycles are short.) The 2009 earnings number is really low and is likely not representative of normal times. My guess is that Nokia should be able to post net income of around $3 billion. In terms of free cash flow, I think it can earn around $3 billion. Given the current market cap of around $33 billion, if Nokia earns FCF of around $3.3 billion, its FCF multiple would be around 10. If earnings was around $3.3 billion, the P/E ratio would be 10 too. I find those numbers highly attractive for a company with a moat (albeit a small and deteriorating moat.) I have to do more homework to figure out how rosy these earnings are. Nokia is also apparently getting hit by the declining Euro—not sure if this is management excuse or is actually a big deal—so there are some confusing currency effects embedded in the earnings as well.
  • Given the poor performance in smart phones, which have higher margins, Nokia's margins are weakening. This is obviously not good news. Investors need to figure out how low the margins can be. If margins continuously decline, it may not be worth investing in this company; it can easily go bankrupt or fall off a cliff like Palm, which used to dominate PDAs at one time.
  • The P/E ratio has been contracting over the last 10 years. This makes sense given the deteriorating business. When Nokia was growing rapidly and was at the top of the game, it's P/E was 18 to 20. Since it failed to maintain dominance with smart phones, the market has been marking down the P/E ratio, which may be as low as 11 right now based on normalized earnings (hard to say though.) The cash flow multiple has similarly declined to attractive levels.
Final Thoughts...for Now

It is uncommon to find companies like these at low valuations so that's one reason I'm looking at it. I would have no problem investing in Nokia at normalized P/E ratio of around 10 to 12. I need to figure out what normalized earnings are. In particular, there is great risk that earnings can fall off a cliff in 5 or 6 years if Nokia doesn't gain traction in the smart phone market (or if some new futuristic technology replaces mobile phones.)

Nokia spends around $8 bilion on R&D each year—it's one of the biggest R&D spenders in $ terms—so it's bound to stay in the game longer than many smaller companies, even if the battle gets rough. Although R&D is an expense and deducts from earnings, I like to follow Warren Buffett's thinking that it should be considered as an asset (assuming it isn't wasted outright.) Hopefully Nokia is improving its moat and developing some new technology asset that can be used in the future.

The main risk here is the possibility that Nokia may be completely shut out of the smart phone business and not recover. I'm not as concerned with that risk because selling lower-end phones is not a bad business. Sure, you don't get the hype and glory of an Apple, but the vast majority of people can't afford those products. For instance, majority of the citizens in developing countries can't afford a smart phone yet. Nokia can capitalize on the lower cost products in those countries (although there are other problem in those countries such as pirated/fake/clone phones, and the like.)

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4 Response to Added to watchlist: Nokia (NOK)

Ashish Gupta
June 26, 2010 at 1:53 AM

Very good analysis. I agree.

Nokia and Rimm are both down. Mot has been down for years. Apple is one player and obvious leader in smart phone market. There are ususally always other players who do well. Nokia is best positioned to be the other dominant player. If Nokia comes up with good smart phone, it might take market share from RIMM.

Sivaram Velauthapillai
June 26, 2010 at 2:08 AM

It's really tough to say which one is going to survive...there's a reason Warren Buffett avoids these industries. It's like automobiles in the 1930's, when we had upwards of 20 or 30 manufacturers but only a few remained by the 1950's.

My feeling is that Motorola may not make it. YOu suggested that RIM might lose market share but I'm not so sure. The advantage RIM has is that its corporate e-mail platform is superior. None of the others, even the iPhone, come close and many businesses are unlikely to switch.

Unlike some who imply that mobile phones are a 'winner takes all' business, I think there is room for several. It's not like Internet businesses where the winner does totally dominate due to networking effects and scale. I can see some company dominating the top (Apple now but who knows in the future) while a few battle it out in the mid to low-end market.

The problem for Nokia is that, even if it maintains market share in the low to medium market, its margins are likely to contract. As the industry matures, the high margins it earned 5 years ago will decline. The question is where it will stabilize.

Furthermore, I looked at some of their corporate presentations in the last few years and two things stand out--and they are not good:

(i) Management wasted a lot of money on useless projects and buyouts (buyout of Symbian OS was largely useless now that management says the high-end phones will be based on the MeeGo OS)

(ii) No coherent strategic vision. I can't tell what they are aiming for. Are they going for the high-end? Low-end? Business customer? Consumer? Focus on carriers? Emerging markets? Developed world?

Now that they have lost their dominant position, I think management needs to focus their business and prune their products. Nokia appears to have as many as 30 or 40 mobile phones, whereas Apple has 2 or 3 and RIM probably has less than 15.

Ashish Gupta
June 4, 2011 at 5:03 PM

Did u revisit Nokia recently?

Sivaram Velauthapillai
June 4, 2011 at 5:54 PM

Wow, reading my comment above, it's interesting how much has changed. New CEO... alliance with Microsoft... huge stock sell-off... etc...

To answer you question, yes, I'm watching Nokia closely. It's actually near the top of my list.

The stock has sold off sharply but it actually isn't that surprising to me. I was expecting Nokia to face a tough few years while it transitions to a new OS (I didn't know they would pick Windows Phone last year but it isn't entirely surprising since their internal OS, Meego, was nowhere to be seen last year). My opinion of Nokia hasn't changed much given the events that are unfolding. The loss of market share presently is a bit worse than I thought but it's too early to say.

I think Nokia is way more interesting right now and is starting to hit levels that make it an attractive purchase. I'm trying to figure out the break-up value of Nokia (in the worst case--I hope they don't split the company) and shares seem to be trading below it. However, this is the type of situation where the stock may sit at a bottom for an year or longer. The shares may also sell off further if the broad market sells off, which it appears to be doing.

Nokia is also a turnaround situation and as Warren Buffett quipped once, turnarounds seldom turn. So you have to be sure that their future Windows phones will sell reasonably well for you to invest.

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