RULE MAKER PORTFOLIO

What Happened to Nokia?

Nokia's Q2 earnings were fantastic, but the stock got slaughtered based on a lackluster outlook for the quarter ahead. Such a haircut is not unexpected for a highly valued stock like Nokia. At the same time, Nokia is still the dominant leader among its wireless counterparts. As long as Nokia keeps up its long-term growth in sales and free cash flow, along with a tidy balance sheet, then the company will still do quite well for long-term investors.

By Matt Richey (TMF Verve)
July 31, 2000

Last Monday, I wrote a glowing analysis of Nokia's second-quarter earnings prospects. On Thursday, Nokia's numbers came out, and the stock was immediately crushed for a 25% loss -- more than $70 billion of wealth obliterated. That's a lot of frowny faces inside My Fool Portfolios. So, what happened?

The problem certainly was not the quality of the second-quarter financial results. They glowed just as brightly as I ever could've expected. As Bill and I explained in a Fool News story on Thursday, Nokia's Q2 numbers were superb across the board:

• Revenue grew 55% to just shy of $7 billion.
  
  
• Gross margin increased to 39.8%, matching the company's best showing on that metric in more than two years.
  
  
• Net margin of 13.6% represented a 0.7 percentage point increase in profitability compared to the year-ago quarter.
  
  
• Nokia's cash reserves of $3.6 billion weigh in 3.34 times more heavily than the sum of all interest-bearing debt. Nokia announced Friday that it intends to put some of this cash to use for a stock buyback of up to 36 million shares, or 0.75% of the total diluted sharecount. Smart move.
  
  
• Nokia demonstrated solid working capital management with a Foolish Flow Ratio of 1.16, a slight improvement over the 1.21 showing a year ago.
  
  
• Free cash flow generation came in at 7.7 cents per dollar of sales -- a 7.7% Cash King Margin for you well-versed Rule Makin' Fools. That number isn't up to our 10% minimum standard, but it's on the high-end of Nokia's recent history.

Here's the competitive analysis for the Q2 results of Motorola (NYSE: MOT), Ericsson (Nasdaq: ERICY), and Nokia that I recommended you complete in last Monday's report:

Q2 2000           Motorola   Ericsson     Nokia
Total Revenue      $9,255M    $7,229M   $6,980M
Revenue Growth       15.3%      28.0%     55.4%
Gross Margin         40.5%      39.6%     39.8%
Net Margin            2.2%      15.6%     13.6%
Cash-to-Debt          0.46       0.66      3.34
Flow Ratio            1.64       1.52      1.16
Cash King Margin       N/A      -3.7%      7.7%

Peruse those numbers once again, Fools. I maintain that Nokia is winning the wireless war. Such a scorecard should put a smile on any Fool's face. Nokia meets four of our six Rule Maker Criteria, and the two on which it falls short -- gross margin and Cash King Margin -- are items that are known areas for improvement. In other words, Nokia's Q2 results brought no surprises.

No, it was management's tempered outlook for the next quarter that sent Wall Street packing. This begs the question, has Nokia's business changed so dramatically that its value should be reduced by 25%? Pshaw, certainly not.

Still, this occasion serves as a good reminder that highly valued Rule Makers are very much prone to near-term market slaughter. This is why we preach (and preach, and preach...) the merits of investing for the long term. Consider that, even after last week's haircut, Nokia is priced at some 133x trailing free cash flow. At that price, Nokia is priced for serious growth -- at least 30% annually for a number of years. We realized this full-well when we purchased Nokia back in February. We knew we were buying a dearly valued, much-loved stock that was priced for consistently excellent results. We believed then and we continue to believe that Nokia -- along with our other "overvalued" Rule Makers -- will overcome any valuation risk through excellent operational results in the years ahead.

Remember, we consider ourselves part-owners of Nokia, not traders of slips of paper with "NOK" stamped on them. From this long-term perspective, I don't really care if Nokia misses earnings for a single quarter based on non-linearity between product cycles. This is really no big deal at all. What matters to me is that Nokia continues growing sales and free cash flow by at least 30% over the next several years, all while keeping a tidy balance sheet.

If anything, it's these times when Wall Street panics that present the best opportunity for long-term investors to scoop up shares. You never know when these occasions will pop up, but when greed turns to fear, the Foolish investor can take advantage. That's one of the reasons we in the Rule Maker Portfolio like to add $500 to our account each month. It's not uncommon that we get the opportunity to add to our favorite holdings while they're "on sale."

Speaking of which... next week, the Rule Maker Port will allocate fresh savings to the market. But, in case you're wondering, Nokia won't be on our buy list this time. Not because we don't think it's worthy of consideration. Rather, as you may know, we've been saving our $500 allotments for the past few months for one $2,000 lump-sum purchase of whichever company our Rule Maker Seminar attendees agree to buy. (We announced this intention last month, in case you missed it.) Right now, the seminar participants are weighing the merits of Yahoo! (Nasdaq: YHOO), Cisco Systems (Nasdaq: CSCO), and Oracle (Nasdaq: ORCL). Next Monday, we'll announce the results of their decision.

Related Links:

Nokia Q2 00 Earnings Release

The Case for Quality: Performance Risk Versus Valuation Risk

--Matt Richey, TMFVerve on the Discussion Boards