By Ari Bensinger Nokia (NOK
; ranked 5 STARS, or buy; $17.10) shocked the market on Apr. 6 by warning that in the first quarter unit volumes for its handsets grew only 19%, underperforming the overall market. In an uncharacteristic misstep, Nokia experienced certain gaps in its product portfolio, mainly in the mid-level price range (see BW Online, 04/07/04, "Looking Beyond Nokia's Bad News").
For the market as a whole, Nokia estimated that first-quarter mobile-phone volume increased more than 25% year-to-year, well above the 10% growth posted in the prior year's first quarter. Indeed, this is a clear improvement over typical first-quarter results, which historically see handsets sales decline anywhere from 15% to 20%. First-quarter mobile-phone-market stats do not typically fuel investor interest in handset stocks, nor do they normally have much impact on analysts' full-year handset forecasts.
FASHION STATEMENT. This year, something smells different to us. In early February, there were rumblings that the strong handset demand felt during the fourth quarter of 2003 was refusing to let up, with no sign of an inventory build. Korean handset maker LG Electronics posted robust January handset-unit numbers, while rivals Samsung and Siemens (SI
; $75.76) issued guidance for better-than-normal first-quarter handset sales.
With the industry embarking on a new handset product cycle of color screens and improved multimedia capabilities, we think higher first-quarter demand made sense. In case you haven't heard, color handsets are "in" this year. As phones are increasingly perceived more as a fashion statement than merely a communication tool, one would not want to be seen with a cell phone that has -- gasp -- a black and white screen.
Although color-screen phones don't represent a genuine killer application for wireless, the fact that they're more aesthetically pleasing should help to fuel the market. Why settle for seeing caller-ID names appear in boring black when they can be viewed in sea green or midnight blue? One can't underestimate the market demand for color-camera-enabled phones that allow people to send all manner of pictures, even if lots of them are goofy and low-quality.
BREAKOUT YEAR? While various emerging markets shore up the numbers of new wireless subscribers, the replacement market is the key driver of growth. This category accounted for more than 50% of total units sold in 2003 and is growing fast. So, the ability to catch the buyer's eye and to get them to upgrade existing phone models is extremely important. Consumers are currently scrambling to replace their out-of-date phones with the latest color-screen model.
Additionally, we may be seeing the lagging impact of the local-number portability (LNP) regulation that took effect in November. LNP enables consumers to retain a phone number when they switch wireless carriers, or switch from wireline to wireless, within the same general metropolitan area. The mandate will likely increase industry churn and handset sales, since consumers will no longer face losing their phone number when switching carriers.
We estimate the global wireless handset market will grow 12% in 2004, to 530 million units, up from 471 million units in 2003. However, the better than normal first-quarter sales could pave the way for a breakout growth year for the handset market, especially considering that most of the newer, more advanced camera phones are slated to be introduced in the second half of the year. In addition, the average selling prices of handsets are set to rise, thanks to the expansion of the high end of the market.
TUNES AND GAMES. The introduction of next-generation Internet-based handsets with higher data-speed rates should create a tremendous opportunity for handset makers. The success of camera phones at the expense of the digital-camera market suggests that further handset-share penetration into the large consumer-electronics market is likely. Likewise, the potential widespread adoption of wireless handset music and gaming applications could steal customers who might otherwise purchase an MP3 player or Gameboy electronic device.
Moreover, we think the large and untapped enterprise market presents very strong potential. Notwithstanding the recent popularity of its wireless business e-mail service, leading enterprise wireless device maker Research in Motion (RIMM
; 3 STARS, or hold; $105.49) shipped only about 1 million BlackBerry units, vs. roughly 471 million phone handsets shipped in 2003. We believe as the handset industry offers secure wireless networking services, the enterprise customer base should ramp up quickly.
We think the lack of product development and execution for leading handset maker Nokia was partly caused by the implementation of a new organizational structure. Overall, we estimate that it lost roughly two percentage points of its 38% handset market share in the latest quarter. However, over the long term, we believe that the new structure, which segments the important target markets of multimedia and enterprise, will make the company more efficient.
STRONG BRAND. While we're disappointed with Nokia's weak first-quarter handset performance, we expect the company to enhance its mid-level products by introducing new clamshell models and bigger and sharper color screens during the second half of 2004. In the interim, we believe that near-term margins could be hurt by an aggressive price-cut offensive aimed at helping Nokia maintain market share.
Over the long term, we remain confident that Nokia's powerful brand will allow it to increase sales faster than the overall wireless-handset market, as this is a market in which brand loyalty is especially important. In a 2003 ranking, branding consultant Interbrand placed Nokia at No. 7 among world brands. We think that this high rating stems from its strong research and development spending, to the tune of more than $4 billion per year. Nokia has assembled a diverse research team to segment the market and target specific demographics.
The company still maintains a dominant market share that exceeds that of its three closest competitors combined. It has handset operating margins of 25%, roughly five times those of its nearest competitor. And it has compelling valuation metrics compares to its peers, in our opinion. Despite its recent hiccup, we view Nokia, with more than 80% of its sales directly related to handsets, as a core holding for investors who want exposure to the improving wireless handset market. We continue to give the stock our highest investment recommendation: 5 STARS.
Given the recent steep drop in Nokia's stock price, we believe it has favorable risk-to-reward characteristics. We have a 12-month target price of $23, which is based on a blend of our discounted cash-flow analysis -- using a weighted average cost of capital of 12% and a terminal growth in cash-flow generation of 3% -- and the group average price-earning to growth ratio of 2 times based on Nokia's long-term earnings growth of 12%.
Note: Ari Bensinger has no stock ownership or financial interest in any of the companies in his coverage area. He's a registered representative of Standard & Poor's Securities, Inc. Other S&P affiliates may provide services to the companies under discussion. Analyst Bensinger follows communications equipment stocks for Standard & Poor's Equity Research Services