Region of the Day: Nokia Isn't Your Fine Finn Friend
David H.M. Baker, Columnist
Opportunity in infrastructure and eroding handset margins will see Nokia
scrambling to catch Ericsson.
In the rapidly evolving technology sector, the best companies must constantly reinvent themselves to stay one step ahead of the
competition. Today's hero can quickly become tomorrow's goat, and Finland's Nokia (Nasdaq:NOK - news) has set itself up
to become the next high-profile company to gain goat status.
Nokia has been arguably the ``favorite son'' of this sector over the past several years, richly rewarding many of its exuberant
investors. Much of Nokia's success has been built on the back of its handset business, which in the most recent quarter
accounted for 72% of total revenue.
Being so dependent on handset operations is a dangerous game and to date it has worked well for Nokia, but going forward
the environment will become much more competitive and place considerable pressure on profitability.
Nokia has a solid management team, strong technology and an excellent distribution network, but not one of these
characteristics can do anything about the increase in new competition and margin pressure the company will encounter.
Narrowing Margins
The issue here is the same that has faced all emerging technologies in the past, such as calculators and PCs: Consumer demand
for greater performance at ever-lower prices ultimately crushes the margin for these manufacturers. The margins can be
maintained if there is proprietary protected technology and few market players, but this is not the case with wireless devices.
Handset manufacturers are crowing about the opportunities for the next generation of handsets with more data-centric,
Internet-ready capabilities. There will be considerable demand for these units, but Nokia and other players won't be able to
sustain the profitability levels enjoyed on the initial generations of devices for several reasons.
First, the Asian manufacturers have all but been absent from the fray for wireless devices -- but they will emerge as major
players for the next round of devices, the so-called 3G-era. The likes of Matsushita Electric's (Nasdaq:MC - news) Panasonic,
Samsung, Hyundai, Toshiba and Sony (Nasdaq:SNE - news) will be close on the heels of leader Nokia. This means only one
thing: Nokia's rich 19.6% third-quarter operating margins are history. My guess is you are looking at least at a 30% haircut and
most likely, a 50% decrease from here.
Also, there is going to be a rapid convergence of the handheld wireless devices. Not only will Nokia have to contend with
emerging Asian competitors, but also they will now be going head to head with the likes of Palm (Nasdaq:PALM - news),
Handspring (Nasdaq:HAND - news) and other PDA manufacturers. The desire for an all-in-one unit will force Nokia to
increase its technology expenditure to maintain market share. And that will hurt profitability.
Turning Up Volume Won't Help
Nokia is trading at 45 times 2001 earnings-per-share (EPS) estimates, which seems expensive, as maintaining historic levels of
profitability will become increasingly more difficult and earnings will most certainly be revised downward. In fact, the
third-quarter operating margin of 19.6% was down from 25% in the second quarter. The drop was due to the launch of new
handsets and a strategic decision to increase sales volumes of handsets rather than protect profitability.
Many analysts are already reducing their future margin expectations and this is prior to the wave of cutthroat competition I
foresee on the horizon.
The bulls behind the stock are holding out the market-share gains and their belief is that volume gains will offset margin erosion
-- which is nearly impossible to achieve. The ramifications of Nokia's exposure to handsets may take several quarters to set in,
but when it does, investors will abandon these shares in the wake of weaker profitability.
Hand It to Ericsson
Nokia is well aware of this changing environment and is scrambling to build its network-infrastructure business, where real
opportunity lies. But it will need several years to gain significant momentum and show a demonstrable effect on profitability. The
company lacks the scope and breadth of Scandinavian neighbor Ericsson (Nasdaq:ERICY - news), which dominates the
sector.
Nokia is a great company, but it's a poor investment at current levels. For the company to capture a leading role in the lucrative
networking infrastructure business it will have to dramatically increase research and development expenditure as a percent of
revenue, which is currently at 8.6% -- half the level of Ericsson. Ultimately Nokia will be successful in migrating more business
to networks from handsets, but this will take time and most investors will not remain patient while this transition occurs.
My advice would be to swap your Nokia investment into Ericsson shares. Much of the upside in Nokia has already been
factored into the price and few investors are giving the necessary consideration to the profit erosion occurring in the company's
core handset business.
Ericsson is the mirror opposite of Nokia. Ericsson's networking unit comprises over 70% of its business, and the company is
phasing out lower-margin handsets. Further, the company has the broadest capability in the industry capable to deliver the
technology for all the disparate wireless technology platforms, including GPRS, CDMA, UMTS, TDMA and GSM.
Unlike Nokia, I would not be surprised to see Ericsson's earnings to be revised upwards, significantly improving its 40 times
2001 forward price/earnings ratio, as the impact of its restructuring, dominant infrastructure position and cost improvements fall
to the bottom line.
David H.M. Baker CFA is an analyst for worldlyinvestor.com and president of Rivendell Capital Management,
rivendellcapital.com a private-client money management firm, and a partner in Vision Investors LP, a
Boston-based hedge fund. His column covers stocks that he feels are undervalued relative to their peers. Clients of
Rivendell Capital Management own shares in Ericsson and purchases were made in the stock in the past month.
Positions may change at any time.
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