Fair Value Estimate: EUR 11 ¦ Fair Value Uncertainty: High ¦ Economic Moat: None
Thesis
In terms of the total number of units sold, Nokia still dominates the global mobile phone business, but we believe that the firm's inability to be a major player in high-end smartphones demonstrates that the competitive advantages that helped it dig an economic moat in the 1990s and 2000s have become less relevant to today's market.
Nokia's biggest competitive advantage is scale, as it commands roughly a third of the worldwide market for handset devices. Manufacturing products in 10 countries across Europe, Latin America, and Asia gives Nokia a lot of flexibility. It can react to changes in the mix of products demanded by its customers by shifting production to different facilities. It can also shift production to regions where component prices (and exchange rates) are most favourable to Nokia's cost structure, and it can quickly switch suppliers in order to get the best possible pricing.
Nokia's other key advantage, in our opinion, is its deep distribution channels in most parts of the world, including rapidly growing markets such as China and India. While it is not yet clear whether this is a real long-term advantage, Nokia has recently demonstrated a notable advantage in markets where consumers demand entry-level (below EUR 50) phones. In such markets, the firm holds roughly 50% share and still earns decent margins. We expect sales volumes in emerging markets to continue to surge, but we think that emerging competition from the major Asian handset makers, along with smaller niche companies targeting specific local markets using custom-built (and sometimes even counterfeit) phones could weigh further on prices.
The higher end of the handset market is much more of a challenge. Smartphones (or as Nokia terms them, "convergence devices") are an increasingly important segment of the market, and we believe that growth in smartphones is putting the squeeze on the market for mid-range feature phones in developed markets. Nokia has spent heavily to develop new high-end devices and acquire software and services to take advantage of those devices, but the firm's share of the high-end market has been eroding rapidly. Firms with deep software and hardware expertise, including Apple and Research in Motion, have taken a big chunk of the high-end market and are positioned to continue to gain share at Nokia's expense, in our opinion.
Nokia has dominated the mobile phone business for nearly as long as that market has been in existence, but its returns on invested capital have been falling and we expect a continued decline. Even if Nokia is able to expand its dominance in emerging markets, pricing pressure on low-end phones could thwart attempts to return margins to their historical highs. At the high end of the market, we see Nokia as being on the defensive against Apple and RIM. We expect Nokia to remain a powerful player in the mobile handset industry far into the future, but if the industry continues to develop in the direction we expect, we think that its days of reaping massive returns on invested capital are numbered.
Valuation
We are cutting our fair value estimate for Nokia to EUR 11 from EUR 13 due to our belief that Nokia's long-term competitive problems are hitting the firm's financial statements more quickly than we had anticipated.
Our five-year revenue forecast for Nokia now calls for a 3% compounded annual growth rate, rather than our previous 4% estimate. Much of this is due to the fact that we now expect a slight revenue decline in 2010, rather than low single-digit growth. We continue to believe that increasing competition across the wireless device market will eat into Nokia's market share over time and cause the firm's sales mix to shift more heavily toward the lower end of the market, where margins are lowest and competition is increasing. We expect selling prices at the low end will continue to decline due to these competitive pressures but that Nokia will be able to still improve margins moderately due to cost-cutting efforts.
The Nokia Siemens Network and NAVTEQ businesses are immaterial to our valuation.
Risk
Average selling prices in the mobile device industry have been falling for the past several years, as sales in high-growth emerging markets are weighted toward entry-level phones. Competition at the low end of the market has driven prices down to the point where we think there is little profit. If Nokia is unable to gain market share in high-margin phones while its margins at the low end continue to fall, the firm could have a hard time generating reasonable economic returns for shareholders.
Management & Stewardship
Nokia's management team includes several executives with deep experience at the company. CEO Olli-Pekka Kallasvuo began his career with Nokia in 1980 as corporate counsel. Since then, his tour of duty has included various operational and functional assignments that included the roles of CFO and COO, eventually leading him into Nokia's top seat in June 2006. Kallasvuo's compensation is reasonable, especially given Nokia's size, and has shown considerable variability based on the firm's performance. Other senior positions within the firm are filled with officers exhibiting similar operational experience both inside and outside the firm.
Overview
Growth: We expect the firm to generate low-single digit revenue growth over the next five years, with a modest decline in 2010.
Profitability: The global economic downturn and growing competition haven't been kind to Nokia's margins. After consistently reporting operating margins around 15% for several years, this figure dropped below 10% in 2008, 3% in 2009, and 2010 looks only a little better.
Financial Health: Nokia is in solid financial shape. The firm is sitting on around EUR 9 billion in cash and investments versus around EUR 3 billion in debt. Despite the extreme drop in demand for its products, Nokia continues to generate positive cash flow.
Profile: Nokia is the world's largest manufacturer of mobile devices and a leader in mobile network equipment and software. The company's mobile phones provide consumers with experiences in voice, video, gaming, navigation, imaging, and music. Through its 50%-owned Nokia Siemens Networks joint venture, the company provides equipment and services to network operators, service providers, and corporations.
Strategy: Nokia has developed or acquired several technologies over the past few years, hoping to capitalise on the convergence of traditional wireless calling, messaging, Internet access, media consumption, and other information technology applications. The firm's acquisition pace will likely slow, but we expect the firm to continue pushing into areas deemed necessary to defend its dominant position in the wireless handset market.
Bulls Say
1. Nokia's advantages in the wireless handset market, including massive scale and extremely broad distribution, are still formidable. If management can leverage those strengths in the high-end of the handset market, there is still the chance that Nokia could be a big smartphone player.
2. Nokia's balance sheet is in great shape, and the firm has a solid technology portfolio and strong R&D capabilities. Developing new products should not pose a problem for the firm.
3. Nokia Siemens Networks is still an important player in the wireless equipment market.
Bears Say
1. Nokia is losing ground in the smartphone market and has shown no sign of sorting out its operating system or application store roadmaps. We think both of these are key to developing a smartphone platform that will resonate with consumers in the same way that the iPhone and BlackBerry platforms have.
2. With a declining market share at the high-end of the market, and an operating system and development tools that lag those of the competition, Nokia is rapidly losing its relevance among developers of smartphone applications.
