Nokia: Valuation Appears Tempting but Concerns Remain

Jun.15.10 | About: Nokia Corporation (NOK)

Since mid-April, shares of Nokia (NYSE:NOK) have been under pressure, falling 38% compared to 11% for the S&P 500, and we would not be surprised if investors with a longer-term horizon are eyeing the current valuation of 11x CY10 Street calendar consensus earnings of $0.87 per share.

When we initiated coverage on NOK shares last July, we were concerned about the company’s weak position in the smartphone market, lack of a mid-tier device portfolio and competitive pressure in low-end devices from players like MediaTek (TPE: 2454) and others. In short, those concerns proved to be valid as Nokia’s market share, device ASPs and margins have all come under pressure.

As a result, Nokia’s shares have underperformed the S&P 500 by nearly 60% over the last 11 months. Near term, we see continued risk that may result in the shares being not as cheap as current valuation metrics would imply and in our view catalysts to the upside are at least a few months away.

To be fair to Nokia, it has been in a period of rebuilding its portfolio while battling new device entrants, but the question remains as to whether Symbian 3 slated for September and its MeeGo efforts with Intel (NASDAQ:INTC) and others will jumpstart Nokia’s device portfolio or if Nokia will continue to fall behind Apple (NASDAQ:AAPL) and its iPhone as well as Google’s (NASDAQ:GOOG) Android efforts with Motorola (MOT), HTC and others. As background, MeeGo is a Linux-based software platform designed to work across a range of hardware architectures and devices including mobile computers, netbooks, tablets, mediaphones, connected TVs and in-vehicle infotainment systems.

In our view, it's another multi-platform OS to compete with Apple and Google’s Android as the smartphone battle morphs into the connected device battle. Nokia targets announcing its initial MeeGo products near the end of 2010. Given its Ovi suite of services, we are curious to see how Nokia will combine its device and services offering. As we see it, that integrated offering is one of the reasons along with user interface, ease of content purchasing and others that have made the iPhone such a success.

A lingering question will be how Nokia lures developers to the platform, after all there are several existing platforms and apps stores to choose from; despite efforts from others, including Research in Motion, Palm, and Samsung as well as some carrier efforts, Apple remains the industry leader with Android a distant second when it comes to apps.

While these are medium and longer-term strategic concerns, (raising ASPs, re-building a mid-tier device portfolio and once again offering iconic product) which may be addressed by the combination of Symbian 3 and MeeGo depending on consumer acceptance, near term concerns remain. More specifically, current Street expectations for the current quarter call for Nokia to generate earnings per share of $0.18, down from $0.21 in the year ago quarter and $0.19 this past March quarter.

In terms of revenue expectations for the current quarter, the Street consensus is $12.9 billion, essentially flat on a sequential basis and down from $13.5 billion in the year ago quarter. Inherent in these expectations are modest margin and ASP erosion.

My concern is the consensus expectation could prove to be more optimistic than should be expected given trends in the current quarter. In particular, geographic markets that were good for Nokia last quarter, such as China and India, are facing increasingly tough competition, as Nokia’s product portfolio has grown stale. On the bright side, Nokia recently released the C3, its most affordable QWERTY messaging device with an initial launch price of EUR90. While initial volumes appear favorable, the C3 is but one of 10 QWERTY devices offered from Nokia’s overall portfolio of 55 devices, the vast majority of which is weighted toward the low-tier.

That mix could pressure overall in the current quarter, which has seen increased competition in the low end. As a reminder, Nokia’s mobile device ASPs in the March quarter were EUR 62, which was down from EUR 64 in 4Q09 and flat with 2Q09. Volumes associated with upper end devices, such as the N series and the N97 in particular, are likely to be weaker in 2Q10 than 1Q10 given pull-forward in demand associated with the free turn-by-turn navigation for Nokia smartphones offered early in 1Q10.

Perhaps one of the greater risks would be if Nokia were to aggressively maintain its market position in the short term at the expense of operating margins; after all Nokia guided its 2Q10 Device & Service operating margin between 9%-12% vs. 12.1% in the March quarter and 15.4% in 4Q09.

Another concern will be currency in the quarter. Currently, EUR 1 equals 1.2714 US Dollar compared to the exchange rate of 1EUR = 1.351 US Dollar that Nokia averaged in 1Q10. Given its sourcing and manufacturing, Nokia has several natural currency hedges in place, however, the company does utilize different pricing strategies in different countries and as such there could be some pressure relative to Street expectations.

Already, several other companies have warned of the impact of the falling euro in the current quarter including Blue Coat Systems (NASDAQ:BCSI), McDonald’s (NYSE:MCD), Burger King (BKC), 3M (NYSE:MMM), and Suntech Power (NYSE:STP). We would remind investors that Europe accounted for 34% of Nokia’s overall revenues last quarter; translation aside, recent concerns for economic growth in Europe could also weigh in on the current quarter.

While the U.S. market has been a very small contributor to Nokia, recent data from comScore (NASDAQ:SCOR) shows Nokia’s share of mobile subscribers in that market continued to erode, falling to 8.1% in April from 9.1% in January. With a modest domestic carrier presence and a lackluster portfolio in this market vs. its competition, we do not see the U.S. aiding Nokia near term.

Disclosure: No positions