RealMoney Silver - Nokia Delivers a Margin Miracle

Nokia Delivers a Margin Miracle
By Tero Kuittinen
RealMoney.com Contributor
8/2/2007 1:23 PM EDT

Nokia's (NOK) second-quarter numbers are in, and earnings from the Finnish wireless company beat analysts' expectations on soaring gross and operating margins at all three phone units.

Its earnings per share came in 3 euro cents higher than the 29-euro-cents consensus, all the more remarkable because it also had a revenue miss of about 300 million euros.

Despite its margin triumph, Nokia confirmed that concerns about growth in the mobile network market and global phone volumes are real. This particular quarterly report will take some time for investors to process.

Nokia's phone unit volume of 100.8 million wasn't remarkable. After a weak first quarter, sequential volume growth in the handset industry was just 3%. Nokia's sequential unit growth was 9 million -- good, but not great considering Motorola's (MOT) collapse.

Rising Across the Board

The remarkable thing about Nokia's sudden margin spike is its uniformity. Operating margins at the mobile phones unit, which has a massive low-end business, jumped from 16.7% to 21.1%. At the multimedia unit, which has fancy, high-end consumer smart phones, operating margins rose from 16.1% to 20.9%. Operating margins at the enterprise unit, which focuses on business-oriented email phones, vaulted from -22.3% to +18.0%.

These three device businesses have very different model portfolios, at various stages of new product rollouts. It's astonishing that all three are showing similar, sharp margin improvement during the same quarter. Of particular note is the way the low-end margins are now vaulting to levels not seen in years, while the enterprise unit (which has always had negative margins) suddenly became almost as profitable as its bigger sibling divisions.

This is happening with the blended average selling price ticking up one euro sequentially to 90 euros. That's good, albeit not particularly surprising, yet the margin improvement is phenomenal.

To be frank, I don't understand this, and given the margin projections of leading telecom analysts, neither does anyone else. Nokia has shown sudden margin moves at certain points in the past: Drops have freaked investors out, while jumps have caused jubilation. But the company has previously declined to give truly detailed explanations for it and often doesn't guide for these moves.

In its second-quarter midquarter update, Nokia discussed improving market share, but didn't say a word about the quarter's biggest news item: the margin jump. This was clearly a setup to deliver the operating-margin shocker with maximum impact.

My theory is that Nokia wants to signal to analysts that they don't really understand the company and shouldn't dare to presume they do. It's a fair point, but it makes modeling margins going forward a really scary experience. Nokia analysts are being flatfooted with something that resembles relish.

In this morning's conference call, Nokia's CEO referred teasingly to "margin volatility" in the second half of 2007. Implicit is the message: "Figure it out, brainiacs -- I'm not telling." Such commentary could be a warning about margins coming back down from the stellar second-quarter levels -- or it could be another coy sandbag. This company isn't getting any less intriguing.

The Bad News

The phone margin surprise effectively buried the bad news in Nokia's report: The mobile network market is morphing into a bit of a disaster zone. Nokia Siemens' operating margin tanked to -10%, and that's without the substantial charges. Taken together with Nortel's (NT) scary report , the message is clear: Ericsson (ERIC) is trying to crush its smaller rivals Nokia Siemens, Nortel and Alcatel-Lucent (ALU) like a trio of June bugs. This might put pressure on Ericsson's margins next winter while pushing rivals deeper into losses than has been expected.

The global phone volume growth in the fourth quarter of 2006 was around 21%. It dropped to 14% in the first quarter of 2007, and it now seems to have remained at 13% to 14% in the second quarter.

Strategy Analytics actually just pegged first-quarter volume growth at just 11%. There are different methods of counting global sales volumes, but a growth slowdown seems to be continuing. That's happening just as mobile network market growth is flirting with hitting zero.

We are now getting the new wave of major product launches from Motorola, Sony Ericsson and Samsung, as global volume growth drops from the 20% to 30% track of 2003-06. It looks like a very tricky time for phone component vendors.

I'm reading Nokia's report and guidance as a negative for Nortel, Alcatel-Lucent, Ericsson and Texas Instruments (TXN) . Obviously, the global mobile network market is close to becoming a price war battleground, but the outlook for phone component vendors is dicey as well.

Nokia now enjoys negotiating power that probably tops the peak level of 2003; its volumes are bigger than those of the next three vendors combined. At the same time, Nokia has clearly decided to diversify the sourcing of both low-end single-chip solutions and high-end W-CDMA chips. I believe Nokia plans to extract some very tough terms from Texas Instruments: cut prices steeply or more business will be switched to Infineon (IFX) and Freescale.

Nokia's CEO made a blunt comment today about starting shipments of low-end phones using Infineon chips in the first half of 2008. This Infineon relationship is not news, but it does seem that the Nokia-Texas Instruments relationship may not be as cozy as it used to be.

The combination of Nokia's new negotiating power and slowing industry growth is a tough challenge for component vendors.