19 April 2007

NOK: Financial Analysis through March 2007

Nokia (NOK), headquartered in Espoo, Finland, is a global seller of cellular phones and the equipment for mobile phone networks.

Nokia once held a commanding, and quite rewarding, position in the mobile phone market. However, the marketplace changed, and the popularity of different cell phone designs began to move up and down like hemlines. Nokia's products fell out of favor, compared to the Razr-powered Motorola, and its profits fell commensurately. Now, there is some evidence that the fortunes of these competitors has reversed again. Challenges remain, however, including an increasingly intense battle with Qualcomm over patents.

Readers should be aware of some facts about Nokia's financial reporting that distinguish it from companies based in the U.S. First, the 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 easily apply our analytical methodology. Second, the Euro is the currency used in Nokia's financial statements. Third, Nokia isn't required to file 10-Q reports with the SEC. Instead, they issue detailed press releases, each of which gets submitted to the SEC under a Form 6-K (Current Report of Foreign Issuer) cover letter.

When we last analyzed Nokia, after the results from December 2006 became available, the Overall score was a solid (and improving) 45 points. Of the four individual gauges that fed into this composite result, Growth was the strongest at 20 points. Value was weakest at 7 points.

We have updated the analysis to address Nokia's financial results for the first quarter of 2007. Some key ratios are listed below. Except for the first item, the cost and revenue figures are trailing-four-quarters values.

  • Revenue growth qtr to yr earlier qtr
  • Revenue growth year on year
  • Gross margin/Revenue
  • Operating expenses/Revenue
  • R&D/Revenue
  • Sales,G&A/Revenue
  • Operating profit growth year on year
  • Net income growth year on year
  • Revenue/Total assets
  • Return on Invested Capital (trailing yr)
  • Inventory/Cost of revenue (days)
  • Long-term debt/Stockholders' equity
  • CFO growth year on year
  • FCF/Equity

After processing these and quite a few other data points and ratios, our gauges now display the following scores:

Cash Management. This gauge dropped 2 points from 16 to 14. The Current Ratio is now 1.86. It has been inching up, ever so slowly, and we would be happy to see this continue. Long-Term Debt/Equity is an inconsequential 1 percent. The debt ratio has been between 0 and 2 percent since September 2000. Inventory/Cost of Goods Sold is unchanged from December at 20.5 days, and the inventory level is now significantly leaner than last year's 27 days. Unfortunately, Nokia does not identify the proportion of inventory made up of Finished Goods; the missing information would give us more insight. Accounts Receivable/Revenues is now 51 days, which is at the lower end of its normal range. In other words, the company is not finding it more difficult to get paid by its customers.

Growth. This gauge maintained the excellent 20 point score achieved in December. Revenue growth, however, slipped to 14 percent year over year from 19 percent a year ago. Net Income growth similarly slowed to a modest 11 percent from last year's 14 percent. It should be noted that Net Income in the current period benefited from a 2 change in the income tax rate from 26 to 24 percent. A powerful 37 percent CFO increase could be viewed as outweighing the slower growth in Revenue and Net Income; to be sure, last year's weak CFO made the comparison easier. Revenue/Assets is 182 percent; this ratio jumped up into the 180's last June. The company evidently took some action (asset-reducing stock buyback?) to become more efficient at generating sales.

Profitability. This gauge increased 3 points from the prior quarter. One might have thought that the previous year's 40 percent ROIC couldn't be topped. However, ROIC grew to an even more impressive 44 percent. Similarly, FCF/Equity jumped to 37 percent from 30 percent. Operating Expenses/Revenue were kept under control, increasing only from 86 percent to 87 percent. A 2 percent decrease in Gross Margin (34 to 32 percent) was essentially balanced by an equivalent reduction in R&D/Revenue (11 to 9 percent). The Accrual Ratio, which is ideally both negative and declining, moved in the right direction from +3 percent to -1 percent. The 4 percent delta is very good, and it tells us that more of the company's Net Income is due to cash flow (rather than non-operational balance sheet accruals).

Value. Over the course of the quarter, Nokia's stock price increased from $20.32 to $22.92. The Value gauge, based on the latter price, is on life support at 1 point. Is the solid operational performance described above already reflected, and then some, in the stock price? The trailing P/E at the end of the quarter was 21.5, which is pretty much its long-term median value. (With our value mindset, points are given only when the share price has become less expensive). We should note that the average P/E for the Communications Equipment industry is a more expensive 25. To remove the effect of overall market changes on the P/E, we found that the company's current P/E is at a 33 premium to the average P/E, using core operating earnings, for stocks in the S&P 500. Historically, the premium has been closer to 25 percent. Do prospects for earnings growth faster than the average company justify the expanding premium? The PEG ratio of 1.88 isn't signaling a bargain. The Price/Revenue ratio, now at 2.2, has been stable at around that level. The average Price/Sales for the industry is 5.35.

Now at a so-so 35 out of 100 possible points, the Overall gauge has been weak since 2003. If we didn't overweight Value relative to the other gauges, the score would have been much, much better. Maybe this is why the stock market greeted the latest earnings report so favorably, or maybe it was the optimistic view of the future. We would be tempted to put Nokia aside for a while, but reconsider it the next time a market drop pushes down valuations.

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