Wednesday, May 03, 2006

Nokia gets a BUY on strong growth and good dividend

It's Finland calling!

As promised, it’s time to analyze Nokia [NOK]. Before starting I will disclose that I already own some Nokia stock. I bought it at $16.88 some time ago at the same time I bought some Motorola [MOT]. Motorola was by far the sexier stock (what with the success of the RAZR and the rumors about the ROCKR phone) but I liked the fundamentals on Nokia. I rode Motorola up a bit and sold at more than the current price, leaving me with only Nokia as exposure to the cell phone market. I generally like the solid long term performance of Nokia (up 35% since I bought it) but as with any stock I will sell it instantly if I come to the conclusion I wouldn’t buy it again today.

Nokia reported first quarter earnings April 20th but the usual databases don’t seem to have the data, presumably because NOK shares in the US are ADRs (American Depositary Receipts) of the Finnish company. Fortunately we live in the age of the internet and the company itself provides the information we need on their website. I calculate a free cash flow from the last 4 quarters (including Q1 of 2006) as $5.46 Billion, which puts the price to free cash flow (at the current market cap of $93.3 Billion) at 17, which is uncomfortably expensive for a large company. This high ratio demands that we take a solid look at the business and see if there is enough growth available to justify it.

Coming up with an implied discount rate (the target price calculation) is a bit more complicated in this case. I generally like to see an implied discount of at least 15%, but in this case NOK seems to be valued just a little bit higher than that so we need to dig into the details and split some hairs. At its current price ($22.82) the growth needed to justify a 15% discount rate is about 12.5% annually for 10 years. The analyst’s current 5 year earnings estimate (there is no consensus 10 year number) is 11.81%. Most of those estimate numbers, however, are older than the last quarter, which saw a three percent market share increase to 35% and a 21% increase in Q1 net profit (although it was a weaker profit than Q4, cell phones being highly seasonal).

We need to take a reality check here and ask ourselves what 12.5% annual growth for 10 years would really mean and if it is reasonable. 12.5% annual growth in shipping volume, compounded for ten years, is a 3.25x increase in unit sales if we heap all the growth onto the current profit model. With an estimated total cell phone market of 850 million unites this year, of which Nokia should sell about 297million units, the total cell phones shipped by Nokia would have to be 855million in ten years. A staggering number to be sure. The global cell phone market itself grew (in units sold) 14 percent in 2005, exceeding estimates. The current estimate is for unit growth overall of 5 percent in 2005. If we split the difference we get a growth rate of 9%, which is almost enough to give Nokia the growth it needs without market share or margin improvement. These numbers are from iSuppli forecasting, Nokia has gone on record expecting 15% growth in industry sales growth for 2006 – which would be even better and makes our current estimates conservative.

How is Nokia likely to do in market share? Well, Motorola has had more headlines for the past few years (at least in the US where it holds a market lead) but Nokia has two things going for it that I think are very important. The first is a solid presence as the low cost phone in developing markets like China and India. By net sales China was actually Nokia’s biggest selling region last year and India comes in fourth behind the US and UK and ahead of Europe. The second advantage is that Nokia is the lead cell phone maker in Europe where the standard is GSM (like China and India) and where cell phone features are typically several years ahead of the US. This combination of solid market presence and clear upgrade path makes the developing nations Nokia’s race to lose. If they don’t mess things up too badly I think Nokia will probably capture more market share in these countries in the future.

Does the business scale that far? Nokia employed 58,874 people at the end of 2005, almost the size of Microsoft, three times that is about 174,000 people – or half the size of Ford or General Electric. A huge company, to be sure, and one which would have a market cap of $300 Billion or so. These numbers sound scary thanks to the wonders of compound growth, but they are still within the realm of reason. When you do market cap and employee count projections the trick is to look out for companies that would need to hire the entire US population or be worth the whole stock market in order to fulfill projections. The Nokia numbers are actually pretty reasonable.

So far we have made moderate assumptions and the story looks reasonable to attractive. The company additionally has improving margins and a new CEO from inside the company who will be eager to prove himself, both good things in this case. Credit scoring looks good so the company is stable, and the dividend yield (3.9%) is fantastic. If you are in a high US tax bracket and take advantage of the lower tax rate on dividends Nokia stock pays almost as well as 30 year bonds even if the stock doesn't increase at all.

This stock gets a solid BUY from me, so I will be maintaining a position. If I reverse the math and apply an 11% discount rate the target price is $28.95, a 27% increase from now, so this isn’t a raging growth stock but you get paid almost as much as a bond to sit and hold it and we should expect good long term performance. I like this stock but I would probably sell if it goes to $29.

What would I like to see done better? Well, I would like to see more traction in the US. Last year Nokia did see a 95% increase in its US market share but it was from such a low base that it wasn’t all that impressive. I have seen Nokia design showcases popping up in American malls where I always embarrass my wife by going in and browsing. Unfortunately the booths don’t have any way to sell you a phone and the attendants seem listless and uninterested, possibly because they aren’t actually selling anything. Most of the demo models weren’t working in the four sites I visited and overall it gave a very poor impression. I would really like to see them add some features to convert interest to sales (even if it means passing people off to cellular providers somehow) and put up a better showing of the phones themselves. Most people who wander through the showcases have no idea what features they missed. For now I guess us American stock holders will continue to be embarrassed to say good things about Nokia; but that’s okay, just count the money they make for you and smile inside.
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Blogger Texrat said...

Very reasonable take on Nokia's potential. Glad to see someone Get It!

12:27 PM  

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