It's a good quarter for Rule Makers to learn a lesson regarding numbers and how they must be put into context with a company's business strategy.
Look at a handful of Nokia's numbers compared with results a year ago.
Q3 2000 Q3 1999 Sales growth 50.4% 49.2% Gross margins 35.1% 37.2% Op. margins 11.9% 13.1% Net margins 11.8% 12.1% Receivables growth 60.1% 49.5% Free cash flow growth 0% (1.2%)What's to like, right? Other than sales, which grew slightly faster than last year, Nokia's performance is worse in most categories.
But, it would be a mistake -- this quarter and always -- to look at the numbers without putting them in context with the company's business strategy. At the end of Q2, Nokia guided investors to expect lower Q3 margins as the company dropped prices and rolled out lower-margin products (it also missed a few timely rollouts) to capture additional market share. The strategy is paying off.
On the conference call, Nokia CEO Jorma Ollila said the company gained several points of market share, putting its share in the 32% to 33% range, compared to rival Motorola (NYSE: MOT), which has lost significant market share over the last year, and Ericsson (Nasdaq: ERICY), which is on the verge of pulling out of the mobile phone business if it can't find profitability.
In other words, Nokia's industry-leading margins and production efficiency, which give it the ability to roll out new models for hungry consumers, gives it the flexibility to attack competitors and gain market share. The company is clearly the lead steer in the handset business. Ollila expects margins to return to more normal levels in Q4.
On the receivables front, which directly affects the kind of cash flow Nokia generates, Ollila argued that booming sales in the second half of September related to the rollout of the 6210 and 3310 series led to higher receivables. He stressed that it doesn't indicate any changes in the way Nokia runs its business or manages working capital. It's worth watching, but quarterly fluctuations in a fast-growing industry don't usually worry me unless it becomes a trend the company can't explain away.
That doesn't mean there aren't changes worth watching. Nokia's operating profits jumped 39% year-over-year, to $1.13 billion from $810 million, which is very nice growth. At the same time, average total assets (minus cash and investments) jumped 56%.
In other words, profits are growing at a slower rate than the assets needed to produce them. I wouldn't expect these figures to move in lockstep every quarter, but on the whole we want to invest in companies that grow profits at a slightly faster rate than assets.
While this observation needs to be put in perspective, given Nokia's strategy in the second half of 2000, it's worth keeping an eye on how expensive it is for Nokia to continue its worldwide romp. Operating profits now represent 10.7% of total assets (minus cash) this quarter, down from 12% a year ago.
It's probably worth mentioning something else for posterity. With trailing 12-month sales of $23.4 billion, Nokia's growth rate will inevitably slow at some point, probably sooner rather than later. Ollila expects growth rates in the 25% to 35% range next year.
All the focus from investors at this point is on growth rates and Nokia's ability to execute product rollouts. When the growth rate slips, the shares will tumble regardless of how well it's executing. Some of this will be quite justified. After all, Nokia currently trades at about 116x future cash flow, a very rich valuation.
But, investors should consider their timeline, given how focused the market is on the short term. We're willing to sit back and watch patiently for five, eight, or 10 years, as Nokia gains market share, providing phones for consumers worldwide. We'll monitor the company's ups and downs and hopefully continue holding for a decade or more. Investors playing the momentum gain with this company are treading on very thin ice.
By the way, our recent purchase of 34 shares of Nokia at $31.31 per share lowered our cost basis more than 11%, to an average of $42.10 per share. We think it makes sense to be opportunistic when it comes to buying shares of existing Rule Makers, and you can expect to see more of the same behavior. When the market gives us an opportunity to buy shares at a better value, we'll take advantage using our $500 monthly investments -- provided the company's outlook and performance is strong.
Have a great day.
