Nokia's Edge

Is Nokia (NYSE: NOK) a dominant technology player that will grow, reinvent itself, and increase profitability year after year? Or, is it merely an above-average company that's executed very well in a fast-growing market as competitors stumbled?

What I'm wondering about here is competitive advantage. Is there something Nokia does better than anyone else, a barrier companies like Motorola (NYSE: MOT) and Ericsson (Nasdaq: ERICY) won't be able to scale?

I think so. From my research, I'd say Nokia has at least two enduring strengths that will be very hard to copy: 1) Its design and branding capabilities, which come from an understanding of the global markets it serves, and 2) sleek manufacturing efficiencies. That's my boiled-down take on why its return on capital soared to 55.7% in 1999 from 29% in 1995, and its earnings multiple expanded by more than a factor of six over the same period.

These strengths helped boost sales at a 27% compound annual growth rate over the last five years, overtaking Motorola as the world's largest producer of mobile phones, and garnering roughly 30% worldwide market share. Some analysts think it could grab nearly 40% market share over the long term.

Former Fidelity fund manager Peter Lynch said investors who couldn't quickly explain why they had their money invested in a specific company were probably going to lose their shirts. That's what I tried to do in the above paragraph. Can you do this with your investments?

For example, Dell Computer (Nasdaq: DELL) and Berkshire Hathaway's (NYSE: BRK.A) GEICO insurance unit have the lowest cost models in the business. This is a competitive advantage that's extremely difficult to copy -- just ask Compaq (NYSE: CPQ). Microsoft (NYSE: MSFT) and Cisco Systems (Nasdaq: CSCO) built products that became technological standards, then expanded product offerings to take advantage of these mighty platforms.

I see Nokia as kind of a combination of Apple Computer (Nasdaq: AAPL) and Dell, with Apple's marketing and design sense, and at least some of Dell's building efficiency.

Let's start with its design edge. Nokia's trademark curved shape, and other features such as removable covers, designer models (think of a credit card with your favorite football team's logo on it), and personalized tones came from its early recognition that mobile phones weren't just a niche product, but a mass-market phenomenon.

As such, it developed a segmentation strategy, targeting different products to different customers depending on how they used their phones. Business customers, for example, favored feature-rich, dual-mode phones, while consumers wanted voice services with easy-to-use handsets.

This strategy led Nokia to introduce 31 phone models in 1997, 17 in 1998, and 18 last year. The move paid off. It drove production volume up 92% to 40.8 million units in 1998 -- the year it took the market-share lead from Motorola, which failed to manufacture digital phones quickly.

As part of its segmentation strategy, Nokia started building its brand years ago, becoming the industry's most aggressive marketer in 1996. Consider that Nokia now has the fifth most valuable brand in the world, according to market research firm Interbrand's July 2000 study. Nokia's brand grew 86% in value to $38.5 billion over the last year -- by far the biggest move among the top 10 companies. Rival Ericsson's brand fell to 32 from 17, and Motorola fell to 49 from 39.

Of course, a segmentation strategy isn't much use if the company can't support differentiation and short product cycles with manufacturing efficiency. From 1996 to 1999, Nokia improved its operating profit margins from 10.8% to an industry-leading 19.8%. That's very respectable for a company with gross margins of just 38.6%. How did it do this?

One of the biggest growth drivers has been its cross-platform manufacturing facilities. Nokia's plants can be reconfigured to manufacture any phone in just eight days, regardless of where the plant is or what it's currently producing. This provides a lot of flexibility to support product launches and manufacturing schedules.

Consider that, in some markets such as Japan, the lifespan of certain models is only one year. This has forced Nokia to keep close tabs on its customers and its own ability to execute quickly on the manufacturing side.

By focusing on telecommunications products, producing phones based on all four dominant technological standards, recognizing how important it is to personalize products, spending heavily to promote its brand, and tying R&D closely to marketing and production, Nokia finds itself on top of the mobile phone mountain, and at the junction of the convergence between wireless phones and the Internet.

That doesn't mean there isn't downside and risk. Motorola isn't as tightly focused as Nokia, but it's a manufacturing wizard. Look for Motorola's margins to improve. Also, what happens to Nokia when mobile phone growth slows? It's still not clear whether Nokia is far enough upstream to avoid becoming just another hardware company as the market matures.

Your Turn:
Am I way off here? Maybe Nokia's real edge is its R&D department. What do you think gives Nokia a lasting competitive advantage, or does it have one? Post your thoughts on the Rule Maker Strategy discussion board.

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