For the past year now I have been monitoring the situation with Nokia (NOK) as a potential turnaround company. The debate on the prospects of this company has been fierce, with articles pouring out of SA and other financial media outlets presenting both the bull and bear cases.
In my investing philosophy, I like to follow the advice of value investing guru Benjamin Graham in his book the Intelligent Investor, where he explained that anyone putting money into the stock market has to distinguish their activity between "investing" and "speculating." Speculation can be a lot of fun, but there are significantly more risks involved and very few people have been consistently good at it over the long term.
Although I very much like the Nokia Lumia product line, and I think it provides a great smartphone for the money, in my opinion there is just too much uncertainty at this point as to whether Nokia can really turn the corner and gain enough smartphone market share to be profitable long term. At this stage, the stock is still a speculative play and not an investment.
Nokia's Business Prospects
Despite notable troubles, Nokia is still the world's second largest mobile phone maker. Most of this market share has come from its long standing dominance in the cheaper feature phone category. However as the company continues to restructure and transition itself to try and take more of the smartphone market, the overall market share has been dropping.
Between 2010 and 2011 the company's market share dropped more than 22%:
The company has continued to lose ground to Samsung (GM:SSNLF) and Apple (AAPL). Despite the company's partnership with Microsoft (MSFT) since 2011 to focus exclusively on Windows Phones in its smartphone lineup, overall market share has continued to decrease. With the exponential rate of smartphone adoption, Nokia continues to fall farther behind the competition as it struggles to gain any market share with its Windows based smartphones. As you can see in the table below, Nokia is not even in the top 5 smartphone vendors, which puts it with a market share below 4%.
Indeed all this means that Nokia still has a long way to go before it has any chance to gain significant market share and develop any meaningful competitive moat in the smartphone market. Making this difficult will be the sheer size and competitive moat that Google's (GOOG) Android OS now enjoys (75% market share). Combined with the strength of Apple's iOS, there is not much room in the market for other major players.
I have personally seen and used the Lumia phones and I think they are great products selling at very attractive prices. Despite this, it is clear that Nokia has an uphill battle in front of it and it is anyone's guess as to whether they can be a meaningful player in the market in the coming few years.
Nokia's Balance Sheet
Through all of the turmoil that Nokia has seen, the company still retains an attractive balance sheet. Looking at some of these financials, the company definitely has some value characteristics:
- Cash is nearly $12B
- Total Debt $6.75B
- Debt/Equity is 0.56
- Book Value/Share is 2.74
- Total Cash per Share is 3.23
What immediately jumps out here for me is that with a current share price of $2.65, the company is trading below book value and below current cash levels. It should be noted though however that tangible book value is only about $0.74/share and the company is still carrying goodwill in excess of $6B on the balance sheet. So any further deterioration in the business could bring impairment charges.
Value Investors Should Focus on Good Businesses, Not Bad Ones
Nokia does have plans in place to improve the business. Almost all businesses that go on hard times come up with elaborate restructuring plans and strategies to sell off assets, focus on new markets, etc.
But here's the thing - currently the company is not a good business. Nokia is losing money. Earnings in the trailing 12 months were -$911m. Operating cash flow was -$366m. The core business has deteriorated rapidly the past few years.
Many people think that value investing is about finding bad out of favor businesses which have a chance at turning around. In my opinion, that is not value investing, it is speculating. The most successful value investors focus on good businesses which for one reason or another are out of favor in the market and are undervalued. This is one reason why I like methodologies such as the Magic formula screens developed by Joel Greenblatt. In that methodology you find good businesses which have exhibited high returns on capital in the previous year. You combine this by also looking at the earnings yield of the business, using the EBIT/EV ratio. So in other words, seeing what is the cash on cash yield you can expect to earn as a part owner of the business. This is completely logical, because the focus is on good businesses with high earnings yields. A company that has negative earnings really cannot be considered a "good" business, unless it can be shown that this is really an anomaly due to unusual circumstances. Clearly Nokia's earnings deterioration has been due to competition and the company's inability to adapt to the rapidly changing mobile phone market.
Therefore in closing I would say that Nokia very well might turn the corner and start gaining market share. If they can do this and return to profitability its quite possible that shareholders could see sizeable returns. But as long as the company has poor earnings this potential outcome is too risky for my taste and is speculative. My advice would be to watch the company closely, and upon any sizable improvements in earnings then you can consider to buy. Although you might miss the initial bounce, there would still be upside potential and it would provide a better risk/reward ratio.
Speculation is fun when you are ahead of the game, but always remember that very few do well at it in the long run, so my advice would be to think carefully with purchasing companies like Nokia.