The Fall and Rise of Nokia

Although my first love in investing styles is Rule Breakers, it's only because I place the majority of my portfolio in stocks that "can fall asleep" -- that is, stocks that give me the luxury of indulging in the much wilder rides that Rule Breakers bring. Stocks such as Nokia (NYSE: NOK  ) , which I hold in my portfolio.

It is these types of companies that Philip Durell looks to find for his Motley FoolInside Value newsletter subscribers: companies that have been undervalued by the market company and are (temporarily) being overlooked by the wise of Wall Street.

The term "inside" is a lovely sobriquet denoting warmth and comfort. When inside your home, you are protected from what is outside and alien. When you are inside your family, a wall of love and security protects you. In the Inside Value newsletter, Philip and his team are dedicated to finding companies that can similarly protect your portfolio. His value strategy is to always buy with a margin of safety, intend to hold for the long term, and wait for the market to recognize the firm's fair value.

Fall from grace
Over the past few years, Nokia fits that bill. No company in its history can execute perfectly all of the time, and since it reached its pinnacle in the mid-'90s, Nokia has certainly faltered a bit in its execution.

This was no more true than in late 2003 and into 2004. At the end of the first quarter of '04, Nokia announced an earnings downgrade and loss of market share. Market share was the noose that the company's CEO, Jorma Olilla, had made for himself ever since he announced the company's goal of taking a 40% worldwide market share some years before. As Jorma learned, if you live by the sword, you also die by it.

At the end of that quarter, Nokia was not even maintaining a market share above 30%, having bled four points in a very short space of time.

Not surprisingly, the market slashed Nokia's valuation from $22 to $17 and, after closer inspection, viewed the problems as terminal. Over the next few months, the market slashed Nokia all the way down to $10. By August 2004, the market determined that Nokia was worth 52% less than what it was six months before.

Long-term investors were forced to find the value inside the company.

Even fans of Nokia's phones conceded that its model lineup at that time was "dated" and, crucially, did not have any compelling "clamshell" phones in range. Nokia had always depended upon the soap-bar block design, and it was taken by surprise when the European market once again embraced the sexier folding phones. The Asian market had always preferred the folding phones, and Samsung out of Korea made great strides in design and functionality, which challenged Nokia at the high end of the market. Motorola (NYSE: MOT  ) had a renewed focus on design, and together with LG Electronics, Motorola ate into Nokia's market share. Even Sony Ericsson (Nasdaq: ERICY  ) -- two companies whose futures in the mobile phone market were assured only by their partnering in the handset division, such was Nokia's previous dominance -- came back to bite at Nokia's heels with some exciting designs.

Nokia was guilty of taking its eye off the ball. This period coincided with a major restructuring of its divisions, which aimed at restoring the right focus to attack the new mobile phone vistas of the future. They looked toward phones with far more video and media content, where software within the phone would become as important as the technology to make telephone calls. So while the company looked into the future, it forgot about the present.

Market overreaction?
The design of a product is a fickle and temporary attribute -- one that consumers respond to. What is not fickle and temporary is a company's ability to make the product and garner profit from it, and ultimately to turn those earnings into free cash flow. And this was one of the three pillars of value inside Nokia. Even while it was losing market share, it was still generating more cash than competitors from its mobile phone division because of its unrivalled economies of scale. The second pillar of value was Nokia's manufacturing strategy, which allows for the luxury of correcting errors in strategy or design and of being able to bounce back. All of Nokia's production units can retool within days, commence production of new models, and have them produced in enough volume to quickly get them to the market. All of which would not matter much if Nokia did not have the third pillar of value: management that could boast of unrivaled success in its industry.

Ultimately, it was this third pillar that convinced me (a shareholder) that the drop in value was temporary. Good managers do not turn into bad managers overnight. At the time of its 52% valuation drop, Nokia had $15 billion in net cash. You do not accumulate a cash hoard of that size simply by being lucky. Although some of its competitors showed renewed focus and success in mobile phones after years of poor performance and bad strategic decisions, Nokia's management still stands out as the long-term gorillas in this industry.

And the company has come back strong. It has finally started to attack the American commercial business market with new offerings to operators Verizon (NYSE: VZ  ) and Qwest (NYSE: Q  ) .

It was no surprise, therefore, to see the market reassess its judgment on Nokia -- and it wasn't a surprise to see the company climb back up to the $16 mark by the end of 2004.

Here was a telecom company sporting a $71 billion market cap that had seen its share price climb nearly 50% in six months. Even today it has a price-to-earnings ratio (P/E) of 18 -- and is still at a discount to the S&P 500 average P/E.

It is situations like these that Philip Durell looks for in his trawl of temporarily undervalued companies. The fall and rise of Nokia is one of hindsight. If you are interested in trying to find companies that might take a similar journey, join Philip for a free 30-day trial to Inside Value.

Rule Breakers nanotechnology analyst Carl Wherrett owns shares in Nokia, owns several Nokia phones, and does his best to enhance his shareholder value by regularly buying Nokia phones for his friends and family. The Motley Fool has a disclosure policy.


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