Rule Maker Portfolio Nokia's Ring Isn't Fading
A continuation of the Rule Maker review

As our Rule Maker review continues, Todd Lebor bids farewell to the Rule Maker gang with a checkup of Nokia. Nokia's balance sheet and operating margins remain the envy of the telecom industry and not much has changed since our first investment in early 2000. Not much except Nokia's proven execution in good times and bad, plus a few market share points. We're not complaining.

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By Todd N. Lebor (TMF TeeTime)
July 25, 2001

Our housekeeping continues this week with a look at Nokia (NYSE: NOK), the maker of all things wireless. Seriously folks, it's time we stopped thinking of Nokia as just the world's largest handset maker. Nokia is determined to become the planet's #1 wireless infrastructure maker as well and from the looks of it, it's off to a pretty good start. Its Nordic neighbor and infrastructure nemesis Ericsson (Nasdaq: ERICY) currently holds the title of world's largest wireless infrastructure company, but depending on what day of the week it is, Nokia and Ericsson are both claiming to be ahead in the hotly contested race to provide new third-generation (3G) equipment.

This is where the future is for Nokia. The handset market is becoming saturated and although replacement handset sales, new functionality, and necessary upgrading should provide respectable growth for years to come, wireless infrastructure is where Nokia's biggest expanding possibilities are. Like Johnson & Johnson (NYSE: JNJ) with its consumer goods, Nokia can send in the handset troops to warm up the markets to its technology and then turn that technology comfort into infrastructure contracts.

The key to Nokia's success with infrastructure is similar to its success with handsets: operating efficiencies. The eighth wonder of the world seems to be how to make handsets profitably and Nokia is the only company that knows the location. Ericsson has been turning a decent profit in the wireless network arena for years, but Nokia's operating margins are even better than Ericsson's.

             OPERATING MARGINS
          Q201  Q101  6 mos  Last Yr
Nokia     16%    18%    17%    18%
Ericsson   1%     4%     3%    14%

Enough relativity. Clearly, Nokia is a superior operator to its major competitors, but it also stands tall in a room all by itself:

                    Last Qtr  Last 12 Mos
Sales Growth           5.2%     29.2%
Gross Margins         37.0%     36.3% 
Net Margins            8.0%     11.4%
Cash-to-Debt Ratio     3.1       3.2
Flow Ratio             1.25      1.17
Cash King Margin       6.4%      9.2%

When we first bought Nokia in February 2000, we were fully aware that it would never achieve gross margins in the 50% range. Few manufacturing companies can consistently deliver gross margins in that range -- because few products are that valuable -- and we were glad to compromise on the gross margins for that gorgeous balance sheet and expanding possibilities. Bill Mann put it best when he wrote, "Pardon me whilst I drool."

Little has changed since those days, except the price of Nokia's shares. Since our first investment at $34.41 in May 2000, Nokia is down 40%, yet it has significantly added to its market share, proven its ability to remain solidly profitable in even the toughest markets, and held on to its cash. Nokia still sits on a cash pile of $3.6 billion with less than $1.2 billion in debt.

The Cash King Margin (CKM) has taken a hit lately, as revenues and operating cash flow have slowed, but capital expenditures have stayed within a regimented range for the past few years and, most importantly, Nokia is weathering the storm with positive free cash flow. Considering the telecom environment, this is an accomplishment worthy of more than a light-hearted golf clap. Jorma Olilla, Nokia's CEO, has stated numerous times that Nokia plans to remain cash flow positive, no matter what.

As evidence of this, Olilla is refusing to participate in the price war started by rival phone maker Motorola (NYSE: MOT). According to the Gartner Group, Motorola finally increased its global handset market share in the first quarter and is expected to gain more in Q2. The situation is a little scary because Motorola is liable to act like a cornered pit bull for the next few quarters. It has nothing to lose; management is under intense pressure from its board and shareholders to return it to the communications powerhouse it once was and it's hit rock bottom.

But taking market share from Nokia over the next few quarters via a price war will only weaken its paltry handset margins and I suspect the plan will be abandoned without significant damage to Nokia. Until Motorola solves its manufacturing problems, it will never challenge Nokia in the handset market. Period.

Inventories and accounts receivable are tracking revenue (that's a good thing) and although Nokia has been more aggressive on the vendor-financing front than we'd like, it has not suffered any severe losses from this strategy. Perhaps its "conservative financing policy" is just that and Nokia deserves a gold star for picking its partners, or maybe it's just been lucky so far. Either way, vendor-financing has been around for a while, it's here to stay, and if we are to remain Nokia investors, we have to accept it and trust management's decisions. So far, those decisions have not disappointed.

Over the last 12 months, Nokia generated $2.6 billion in free cash flow. The Finnish giant currently has a market capitalization of $93 billion. In order for a double in five years, we need to justify a $185 billion market cap. Assuming a price-to-free cash flow of 25x -- the S&P 500 P/FCF is currently 23x -- in five years, Nokia needs to grow its free cash flow 24% annually. This is a tall order, but as we stated in our Rule Maker Top 25 report, company guidance forecasts revenue growth of 25% to 35%. Considering that over the last 12 quarters Nokia has grown free cash flow sequentially an average of 31.1% on sequential revenue growth of 8.3%, I expect a 24% free cash flow growth rate is achievable.

A company with Nokia's mind share, brand power, balance sheet, and competitively superior operating efficiencies deserves a premium to the S&P 500. As the crash-and-burn flames are extinguished throughout the telecom industry, we expect Nokia to show some first-degree burns that will heal quickly. That's nothing compared to the third-degree burns covering its competitors that are much harder to recover from.

(Note: Thanks to our devoted readers, I revised my cash conversion cycle analysis of Intel from July 10. The trends are not as favorable as I originally calculated.)

This is Todd Lebor's final Rule Maker column as a Fool employee but not his last day as a Fool. That, he'll always be. At the time of publication, he owned shares of Nokia. Todd's other holdings can be found online, along with the Fool's complete disclosure policy.


 

Rule Maker Portfolio


7/25/01 as of ~8:30:00 PM EDT

Ticker Company Price
Change
Daily Price
% Change
Price
AXPAMER EXPRESS0.260.69%38.06
CSCOCISCO SYSTEMS0.321.74%18.70
INTCINTEL CORP0.541.87%29.42
JNJJOHNSON & JOHNSON(0.01)(0.02%)52.70
KOCOCA-COLA CO0.781.76%44.98
MSFTMICROSOFT CORP1.161.75%67.48
NOKNOKIA CORP ADS0.412.14%19.61
PFEPFIZER, INC0.240.60%40.10
SGPSCHERING-PLOUGH(0.75)(1.98%)37.20
TROWT.ROWE PRICE GRP INC0.230.63%36.84
YHOOYAHOO INC(0.10)(0.59%)16.87

Overall Return -- total % Gained (Lost)
  Day Week Month Year
To Date
Since
Inception
(1/6/1998)
Rule Maker1.03%(0.84%)(3.10%)(26.03%)(22.70%)
Comparable S&P 500n/an/an/an/a7.49%
S&P 5001.61%(1.68%)(2.77%)(9.83%)21.84%
S&P 500 (DA)1.58%(1.66%)(2.73%)(9.70%)23.62%
NASDAQ1.28%(2.22%)(8.16%)(19.68%)24.48%

Internal Rate of Return -- Annualized Rate of % Gained (Lost)
  Since Inception (1/6/1998)
Rule Maker(9.70%)
vs. S&P 5003.13%

Trade Date # Shares Ticker Cost/Share Price Total % Ret
2/3/9866PFE27.4340.1046.17%
2/3/9859MSFT49.3567.4836.73%
4/3/0110JNJ43.6552.7020.73%
2/3/9875TROW34.1236.847.97%
2/13/98147INTC27.4429.427.23%
5/26/9879AXP36.4738.064.37%
8/21/9844SGP47.9937.20(22.49%)
6/23/98182CSCO24.7218.70(24.13%)
2/27/9827KO69.1144.98(34.91%)
2/15/00132NOK40.2119.61(51.23%)
2/17/99106YHOO57.6016.87(70.71%)

Trade Date # Shares Ticker Total Cost Current Value Total Gain
2/3/9859MSFT$2,911.79$3,981.32$1,069.53
2/3/9866PFE$1,810.57$2,646.60$836.03
2/13/98147INTC$4,033.23$4,324.74$291.51
2/3/9875TROW$2,559.06$2,763.00$203.94
5/26/9879AXP$2,880.87$3,006.74$125.87
4/3/0110JNJ$436.50$527.00$90.50
8/21/9844SGP$2,111.70$1,636.80($474.90)
2/27/9827KO$1,865.89$1,214.46($651.43)
6/23/98182CSCO$4,498.75$3,403.40($1,092.32)
2/15/00132NOK$5,307.79$2,588.52($2,719.27)
2/17/99106YHOO$6,105.72$1,788.22($4,317.50)
 
Cash: 
Total: 
$548.21
$28,429.01
 


Notes
The Rule Maker Portfolio began with $20,000 on February 2, 1998, and it added $2,000 in August 1998 and February 1999. Beginning in July 1999, $500 in cash (which is soon invested in stocks) is added every month.