Looks Like Nokia's Margins are Getting Squeezed

Includes: ERIC, NOK
by: Paul DeMartino

When Elcoteq, a Finnish manufacturing services company, warned on earnings in its third and fourth quarters last week, markets took notice because it's a Nokia (NYSE:NOK) supplier. How much of the earnings shortfall relates to demand for Nokia cell phones? Analysts are wondering whether the European cell phone market is squeezing Nokia's mid-range models on price. Investors are right to be concerned with this profit margin-related issue.

Elcoteq blamed "weaker than expected development of manufacturing volumes in Europe and unsatisfactory profit growth in the Americas." In an earlier release, Elcoteq also revealed that 69 percent of its top line was derived from either Nokia or Ericsson (ERICY) business in the first half of 2006, not including Sony Ericsson. That number has trended downward for a few years from 92 percent in 2000.

Analyst Michael Schroeder, in a Sept. 15 report on Elcoteq for Nordic bank Kaupthing, mused, "there could be overall weakness in Nokia's European handset volumes, Elcoteq might still be losing market share to other EMS [electronic manufacturing services companies] or Nokia's capacity hikes in Asia could be carving off some of the business directed to EMS companies." While two of these hypotheses involve Nokia, one is positive for the cell phone giant, at least in the long-term and one is negative.

Right now, our analysis indicates that a new investment in Nokia shares today would require an annualized earnings growth rate of 8.5 percent over the next five years in order to break even. The consensus long-term growth rate of the 16 analysts who provide projections is 12.8 percent, and no one adjusted their growth targets in response to Elcoteq's news, though one bank, Danske Equities, reiterated its growth rate, the highest at 20 percent. The bear of the group projects 7 percent growth.

One could assume that as 8.5 is less than 12.8, the shares are undervalued. We're not so sure about that. In this case, uncertainty has been tossed into Nokia's outlook. Rather than sitting on their estimates, the analysts are probably scouring the globe for more information.

Also, the standard deviation of the growth rates is 3.84. That's so high relative to the projections that neither the 20 percent nor the 7 percent growth rate can be tossed as outliers at a certainty threshold of 95 percent. For the non-statistically inclined, that means that your guess is probably as good as anyone's on how Nokia is going to do for the rest of 2006.

It's quite possible to look at these numbers and the growth in Nokia's Asian production capacity and project that this could be a good entry point to a strong company. We can't quibble with that interpretation. Our gut instinct, though, is to take the most bearish projection as our baseline and check for value. In this light, 7 percent is less than 8.5 percent.

At the time of publication, Paul DeMartino did not directly own puts or calls or shares of any company mentioned in this article. He may be an owner, albeit indirectly, as an investor in a mutual fund or an Exchange Traded Fund.

Note: This is independent investment and analysis from the Reuters.com investment channel, and is not connected with Reuters News. The opinions and views expressed herein are those of the author and are not endorsed by Reuters.com.

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