A Safer Way To Play Nokia

| About: Nokia Corporation (NOK)

Where does Nokia come from?

Nokia (NYSE:NOK) has had a rough ride: once the undisputed leader of mobile telephony, the Finnish tech company today is only a shadow of its former self. In its glory days, the Finns dominated the mobile phone industry. According to Gartner, Nokia's market share in 2007 was nearly 50 per cent. Research conducted by Timo Tyrväinen, the head economist at Aktia Bank, cited in the Helsingin Sanomat, concludes that the role of Nokia and its domestic suppliers was crucial for growth between 1995 and ­2000. According to Tyrväinen's analysis, what he calls the "Nokia sector" accounted for additional growth of 5­6 per cent in Finnish GDP. At the same time, the author notes that the proportion of exports to GDP rose from 20 per cent in 1990 to nearly 50 per cent in 2000. Back then, Nokia was able to leave behind the likes of Motorola and Ericsson.

The glory days are long gone. Nokia has suffered a classic boom bust cycle. It has lost sight in which direction the market was headed and has completely misjudged major trends in its industry.

The decline started with a small mistake, underestimating the importance of having a so called "clamshell" phone instead of the "candy­bar", Nokia's preferred product design. That should have been the first warning signal to investors. Nokia had become too complacent in its role and, maybe too arrogant, convinced that it could impose trends on consumers, rather than listening to their needs. Very few companies are an Apple (NASDAQ:AAPL), inventing needs people didn't even realize they had.

The next misstep turned out to be even more critical: one might think Nokia just bet on the wrong operating system (Symbian). The truth goes beyond that. As Tim Ocock puts in his guest post for TechCrunch dated November 8, 2010: "When Apple launches a new product, it might look like something you've seen before. But they define totally new categories, it just takes a while for everyone else to realize." In the case of Nokia, Tim Ocock argues, it failed to understand a new category was emerging. Nokia had underestimated the velocity of technological innovation and the need for a powerful operating system, a new platform like iOS or Android. Without that, Nokia wasn't able to keep up with its peers in the fight for the most juicy part of the market, the smartphone segment.

Is there an investment case for Nokia?

However, since Nokia teamed up with Microsoft, it seems the Finnish tech giant has recovered its poise. There is a valid case for cheap smartphones for emerging economies that still don't need ultra-chic iPhones. It's a volume business with low and decreasing margins, but that's something tech companies are used to.

In fact, analysts have become curious again. Before reporting Q1 numbers, the majority of the sell side analysts rated it "buy". More than 90 per cent were bullish and only 10 per cent were bearish on the stock. Looking at the performance of the stock, investors proved to be more cautious. The 6 ­month return is 38 per cent, the 1 year return ­17 per cent.

Investors were right to be cautious. The market had anticipated a weak Q1. Quarterly sales fell by 20 per cent to € 5.85 billion ($7.6 billion), missing analysts' estimates by more than 10 per cent. Profit margins were negative. Nokia sold 61.9 million phones, less than the 73 million units analysts had predicted.

To compensate for a declining revenue base, Nokia has already cut its work force by more than 20,000 and closed some plants as well as parts of its R&D centers.

In terms of top line strategy, Nokia has announced that it plans more competitive pricing through affordable smartphones like the Asha 310, as well as an ultra low price point phone, the 105. According to Nokia's CEO, that should help get volumes under control.

What does this all mean for an investor?

Is the worst over? Is it a buy for the long run or is it just worth a trade? Are there alternative ways to play it?

Let's stick to what we know:

Nokia is still in good shape. It remains the dominant mobile phone manufacturer in the world, with a decent market share of roughly 10% in the developed world and some 15% in emerging markets. However, competition is fierce out there. The before mentioned numbers show a marked slowdown from the 22 per cent market share in 2011. Furthermore, there's huge margin pressure. Operating margins have dropped from above 20 per cent in 2007 to negative. The top­ line evolution in the future is hard to predict. Nokia is aware of this and has started to act, introducing restructuring measures intended to compensate for lower sales and weaker margins.

On the other hand, Nokia's balance sheet is rock solid. Nokia's net cash increased to € 4.5 billion from € 4.4 billion at the end of last year after having scrapped the annual dividend. Furthermore, Nokia has demonstrated its ability to generate positive cash flows over the cycle. That means the cash pile will grow further.

So, going back to the question if Nokia is worth investing in, there is undoubtedly value in the company. But is this enough for the buy case on the stock? Few equity investors are willing to pay for negative growth and margin pressure, even if the balance sheet is rock solid.

However, an alternative for broader based investors exists. The capital structure shows that Nokia has some interesting bonds outstanding. One is denominated in US$ trading around 99 cents on the dollar yielding a decent 6 per cent till maturity (2019). Compared to a Finnish government bond yielding less than 1.5 per cent, this is very respectable, especially since Nokia still constitutes a big chunk of Finnish GDP.

So, investors have a riskier choice of timing a bet on Nokia's turnaround for the stock, or a safer 6 per cent yielding bond (maturing in 2019) using the $4.5 billion cash pile. If you chose the latter, the ISIN is US654902AB18.

Disclosure: I am long the Nokia corporate bond (ISIN: US654902AB18). Otherwise, I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.