20 January 2007

NOK: Analysis through Sept 2006

Mobile phone giant Nokia will report 4th quarter and annual results for 2006 on 25 January. We are preparing for that event by reviewing the analysis we performed last October after Nokia issued their data for the 3rd quarter of 2006. We will also identify data in the 4th quarter results that would provide an initial indication into the strength or weakness of Nokia's performance.

First of all, readers should be aware that Nokia's financial statements are prepared in accordance with International Accounting Standards (IAS), rather than U.S. Generally Accepted Accounting Principles (GAAP). Fortunately, IAS and GAAP are similar enough that we can apply our analytical methodology without difficulty. [Alas, this is not the case with UK accounting standards.] Secondly, Nokia's financial statements use Euros as their currency; not that it matters, but when we first analyzed Nokia we had to make conversions from the now retired Finnish Markka.

After the third quarter, our Cash Management gauge for Nokia displayed 7 out of 25 total points. The Current Ratio was 1.79; it had been over 2.0 almost every quarter between December 2002 and December 2005, but below 2.0 in the first three quarters of 2006. Long-Term Debt to Equity was an inconsequential 1 percent, probably a remnant of the late 1990s when money came in so fast the company was able to pay off the debt it had accumulated during its startup phase. Inventory had backed up to 31 days (measured by Cost of Goods Sold). Inventory levels have been trending higher -- they were in the 25-27 day range for a long time. We fear that the increased inventory is an indication of less demand for the company's products due to increased competition. It might also be that the company intentionally built up inventory in anticipation of strong holiday sales. Unfortunately, the company does not identify the proportion of inventory made up of Finished Goods. (Perhaps this is one difference between IAS and US GAAP.) Accounts Receivable were 51 days of Revenue; because this parameter has been relatively stable, there's no indication that the company is having any problems get paid.

The Growth gauge showed a healthy 16 points. Revenue growth was 19 percent year over year. Revenues had stagnated or slumped in 2002-2004 after the go-go 1990s, but they have been growing at double-digits rates for the last year and a half. The same pattern can be seen with Net Income growth, which was 13 percent after the 3rd quarter 2006. Cash Flow from Operations (CFO) took a deeper dive in this decade; we can take faint comfort that CFO stopped dropping. Nevertheless, we are concerned that CFO in the four quarters ending September 2006 was essentially identical to the CFO in the four previous quarters. Revenue/Assets was the good news story indicating improved efficiency; now at 1.85, it was much higher during the last two quarters than any prior periods. This appears to be the result of the company drawing down its cash levels to buy shares of its common stock.

Profitability scored 11 of 25 points. The Return on Invested Capital (ROIC) jumped up to an impressive 44 percent; this is also partly explained by reduction in stockholders equity after share repurchases. Free Cash Flow (FCF) to Equity, at 29 percent, has been stable. Since CFO, as mentioned in the previous paragraph, hasn't been growing, the FCF/Equity performance must be attributed to scaled back capital spending and the number of shares outstanding. With increased competition, Gross Margin has been trending down from percent values in the upper 30's to the lower 30's. The company has, by and large, compensated for this by cutting R&D expenditures. Therefore, Operating Expenses as a proportion of Revenue, recently 86 percent, have been relatively stable. But, one can see that this value has edged up a couple of points over the last few years. The failure to increase CFO means that a growing proportion of Net Income has been due to non-operating factors (i.e., changes in accruals). This is seen in the Accrual Ratio hitting +4 percent. Some would say that is an indication of lower-quality earnings.

The Value gauge read a weak 5 points. The Price/Earnings ratio at the end of September was 19. This is a little lower than it had been, but not enough to get more than a point in our scoring system. The P/E ratio was about a 25 percent premium to the market as represented by the S&P 500. Since the premium has not come down, it doesn't get value points. We note a small drop in the PEG ratio, caused by the 13 percent earnings growth, to 1.47. The story is basically the same for the Price/Revenues ratio, stable at 2.0 -- not a drop that would make us think the stock is undervalued.

Rolling up all of the above, the Overall gauge came in with a score of 33 out of 100 points. The value is low enough to worry us, and we're not seeing any increases to make us think the company is on the upswing.

Things to look for in the 4th quarter:

Revenue: Did holiday sales cause a noticeable bounce in sales? Nokia's robust sales in the 4th quarter of 2005 set a high threshold for the company to meet in 2006. The Wall Street estimate is 11.2 billion Euro for the quarter. Our model predicts a more modest 10.6 billion Euro. A value lower than this latter value would signify trouble.

Gross Margin: 35+ percent would signify that company is regaining pricing power.

Net Income: The market estimate is 0.26 Euro per share for the quarter. Our estimate is 0.25 Euro.

Inventory: We'd like to see Inventory/CGS drop to 27 or so days. More than 30 days would be problematic.

CFO: Positive CFO growth is a must, and will, hopefully be on par with Net Income.

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