HQ:Trading 3Q:00 Handset Op Margins for Market Share,BUY
Excerpts from Chase H&Q follow:
Date: 7/28/00
1 of 3 NOK: Trading 3Q:00 Handset Operating Margins for Market Share : BUY.
* Nokia reported Q4:99 results of Eu 7.0 / 0.20, essentially in-line with our
estimates of >Eu 7.1 / 2.0.
* Unit volumes and revenues were flat sequentially, but Nokia retained its 30%
market share in phones.
* Nokia will cut prices on its 6100 series handsets in 3Q to accelerate market
share gains and exploit severe production problems at Ericsson and product
transition at Motorola.
* Expect sequential increase in revenue and market share in 3Q:00.
* Price cuts will re-position the 6100 series toward the entry-level segment,
which, if successful, could add many new loyal Nokia customers and spur
upgrade sales in 2001. The 6100 series will be discontinued in 2H:00.
* We believe yesterday's 25% sell-off is an overreaction and presents a buying
opportunity. Reiterate BUY.
Nokia reported 2Q:00 results of Eu 7.0 / 0.20, essentially in-line with
our estimates of
Eu 7.1 / 2.0. R&D expenses were higher than forecasted on increased
investment in GPRS and 3G product development, but were offset by lower SG&A
and higher gross margins. Network systems exceeded our revenue expectations
slightly, while consumer products came in just under our forecast.
Ericsson''s inability to ship product in 2Q and Motorola''s decision to
discontinue certain low-end handset likely resulted in increased sales to the
low-end segment for Nokia last quarter. Higher sales to the low-end market
would result in lower blended ASP and lighter-than-forecasted revenue. We
expect R&D to remain above 9% of sales as the company continues to invest in
3G development for both systems and handsets.
Unit volumes and revenues were flat sequentially, but Nokia retained its
30% market share in phones. The company reported a 1% q/q growth in unit
volumes, which, coupled with a 2% increase in ASP over the last 12 months,
indicates that Nokia has chosen profits over large unit share gains. The
company plans to cut ASP by 10-15% sequentially to spur substantial unit
growth. We expect the price cuts to decrease 3Q operating margins to about 16%.
Table 1: Year-to-Year and Actual-vs-Estimate Variance
( EUR Millions) Q2FY00 Q2FY99 %Chg. Q2FY00E Variance
Revenue 6,980 4,493 55.4% 7,101 -1.7%
Operating Income 1,412 881 60.3% 1,407 0.4%
Income Before Taxes 1,389 861 61.3% 1,399 -0.7%
Net Income 951 581 63.7% 958 -0.7%
EPS 0.20 0.12 61.9% 0.20 0.3%
Shares 4,795 4,738 1.2% 4,843 -1.0%
Segment (EUR M) Q2FY00 Q2FY99 %Chg. Q2FY00E Variance
Network Systems 1,925 1,390 38.5% 1,850 4.1%
Mobile Phones 4,883 2,922 67.1% 5,081 -3.9%
Other Operations 193 203 -4.9% 200 -3.5%
Adjustments (21) (22) -4.5% (30) -30.0%
Margins Q2FY00 Q2FY99 %Chg. Q2FY00E Variance
Gross 39.8% 38.1% 1.7% 38.4% 1.4%
Operating 20.2% 19.6% 0.6% 19.8% 0.4%
Pretax 19.9% 19.2% 0.7% 19.7% 0.2%
Net 13.6% 12.9% 0.7% 13.5% 0.1%
Operating Expenses Q2FY00 Q2FY99 %Chg. Q2FY00E Variance
SG&A 655 434 50.9% 710 -7.8%
R&D 677 395 71.4% 589 14.9%
Source: Chase H&Q Estimates and Company Reports.
Table 2: Balance Sheet Metrics
Balance Sheet (EUR M) Q2FY00 Last Qrt %Chg.
Cash 1,021 884 15.5%
Accounts Receivable 5,604 5,548 1.0%
Inventories 2,418 1,993 21.3%
DSO 72.3 76.4 -5.4%
Inventory Turns 7.0 8.1 -13.7%Source: Company Reports
Consumer Products
Strategic decision to cut prices on the soon-to-be discontinued 6100 series in
order to accelerate market share gains. Management indicated its intention
to trade some of the company''s industry-leading operating margin for rapid
gains in unit share in 3Q. At 25% operating margins, Nokia is vastly more
profitable in phones than either Motorola (4%) or Ericsson (-21%) and can
certainly afford to steal share by slashing prices in our opinion. Moreover,
given competitor weakness and the advent of 2.5G handset in 2001, we believe
the time is right for a ''land grab''. The company has chosen the 6100 as the
best vehicle for this move as this three year-old product will soon be
discontinued and therefore will not be a future drag on profits. Aggressive
price cuts could put the phone into the hands of many first-time, entry-level
subscribers who would likely upgrade to another, more profitable Nokia phone
in 12 - 18 months. Once discontinued in 2H:00, the 6100 series will be
replaced by the 6200 series which will sell in the mid-range at more historic
operating margins (low 20% range).
With Ericsson struggling and Motorola in transition, Nokia is responding
to an opportunity to pick up significant market share, in our opinion. The
company estimates that its market share held steady 2Q:00 at just over 30%,
but targets an increase to 34-36% by year-end. The release of the 6200 was
delayed and we believe the company is entering 3Q with a slightly older
product portfolio, ripe for end-of-life price cuts. Given the severe problems
with production at Ericsson and Motorola''s product transition, we believe
Nokia stands a good chance to gain market share in the entry-level segment.
If successful, the company could exit the year at a 140 million units, which
would be 17% higher than our original estimate of 120 million phones and
substantially greater than Motorola''s 80 - 90 million and Ericsson''s 40 - 50
million.
Expect sequential increase in revenue and market share 3Q:00. Since the
company plans to replace the 6100 series at the end of 3Q with the improved,
higher-margin 6200-series, lower gross margins will last just one quarter
before returning to "normal" levels (low-20% range for Nokia). We believe
price cuts on the soon-to-be replaced 6100 series phones should stimulate a
large enough increase unit shipments to more than offset the effect of lower
ASP on revenue. Nokia is guiding for a sequential decrease in ASP in 3Q to be
followed by an increase in Q4 as the 6200 ramps to volume production.
We do not expect 3Q price cuts on entry-level phones to have a negative
impact on the profitability of new products. Nokia is cutting prices only on
products that it plans to discontinue (the popular 6100 series and the 3310)
by year-end. Products planned for a September release will carry a lower
production cost but should command a premium price given the new feature set
and Nokia's strong brand affiliation.
Inventory increases as the company builds a "war chest" of components in
anticipation of large unit volume increases in 3Q. Like Ericsson, Nokia
reported "tight" supplies of components this quarter but built raw material
inventory in preparation of much greater production in 3Q. We do not believe
component shortages impacted Q2 performance and now believe the company has
sufficient stock to follow through on its plans for higher production.
Network Systems
Stronger-than expected performance and positive outlook in Network Systems.
The company expects operating margins to remain in the 18% range for the
foreseeable future, even as it invests heavily in 3G technology. We believe an
18% margin level is respectable, as it is in-line with Ericsson's (the market
leader). The company seems to be strengthening its position in next generation
networks as it has received several W-CDMA contracts as has delivered GPRS
core network upgrades to over 40 operators.Opinion and Valuation
We believe yesterday's 25% sell-off is an overreaction and presents an
excellent buying opportunity:
*The reduction in margins was a calculated decision by management to gain
market share and should not be interpreted as a lack of control (aka
Ericsson), a slow-down in demand or problems in product transition. In fact
the market recently rewarded Motorola for trading market share for margins
when it discontinued the sale of unprofitable entry-level handsets.
*Nokia's guidance has taken margins from very significantly higher than
average to much higher than average. Even at the 16%, Nokia''s handset
operating margins would still be well above any other OEM in the industry.
*CEO Jorma Olilla's comments on the conference call were somewhat unclear, and
we expect, like us, many were left with questions following the call.
Detailed post-call discussions and verification with other vendors
(competitors and suppliers) were required to fully grasp the strategy behind
the reduction in margins.
*We believe the company stands to gain substantial market share if this
approach is successful while suffering a temporary, controlled profit decline.
A 9% q/q reduction in operating margins on our 3Q:00 Eu 5.4 billion handset
revenue estimate amounts to less than Eu 500 million. Though a large sum, we
believe it is a small price to pay for a potential market share gain of 3-5%.
Moreover, the division will still make a substantial profit in 3Q. By
comparison, Ericsson lost roughly Eu 400 in its handset division last quarter -
- an amount expected to get worse -- and the company trades at a 25% premium
to Nokia on a forward P/E basis.
Nokia is currently trading at a 14% discount to its peers on a forward price-
to-earnings basis. We believe such a discount is unwarranted given Nokia's
increasing dominance in the wireless handset market, its consistent track
record for financial performance, upside potential from 2.5G and 3G
infrastructure contacts, and potential long-term upside from a likely gain in
market share in 2H:00. Adjustin estimates to reflect lower operating margins
in phonse Q3:00. We reiterate our BUY rating and our 12-month price target of
$75.Table 3: Estimate Revisions FY 2000 FY 2001
(EUR) Current Previous Q1 EPS Eu 0.19 A Eu 0.19 A
Q2 EPS 0.20A 0.20A Q3 EPS 0.14 0.20
Q4 EPS 0.21 0.21 FY EPS 0.73 0.79
FY REV (B) 29.33 29.20 Source: Chase H&Q
Table 4: Comparable Companies
Price Mkt. P/E CY01/99 CY01 PE/
Company 7/27/00 Cap. ($M) CY:00 CY:01 EPS CAGR
Ericsson $18.50 $147,871 101.5x 59.2x 36%
Lucent $46.88 $153,188 44.2x 34.0x 20%
Motorola $33.50 $75,365 31.9x 23.4x 51%
Nortel Networks $78.63 $228,720 115.6x 89.3x 33%
Mean 62.4x 51.5x 35%
Nokia $41.00 $196,595 59.0x 44.2x 29%
(Discount) / Premium to Average (5%) (14%) (17%) (7%) |
