Nokia’s Q3 Results Help Stock Reach True Value, Driven By NSN And Patents

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Nokia (NYSE:NOK) announced a strong set of Q4 results on Tuesday, reporting a surprise operating profit of Euro 118 million on strong Lumia sales and a sustained turnaround in its networks business. The company sold 8.8 million Lumia smartphones during the quarter, about 19% higher than the same period last year, as the North American market saw a sudden rise in demand due to the launch of the 1020 and the 520’s continued strength at the low-end. What likely also contributed to the surprise was spiralling demand for BlackBerry (NASDAQ:BBRY) handsets, which probably caused some wireless carriers to shift their marketing resources to Windows Phone. This helped Nokia’s handset division cut its operating losses to less than Euro 90 million from more than Euro 670 million in the year-ago quarter.

However, what was more important to Nokia’s investors, considering that the handset division will most likely be sold off to Microsoft (NASDAQ:MSFT) soon, was the continued recovery in Nokia Solutions and Networks (NSN), of which the company assumed full control this quarter. With the jettisoning of the devices business, NSN will become all the more central to Nokia’s value. The division has recovered well from years of losses to achieve its sixth straight quarter of underlying profitability, on the back of a restructuring program that has shrunk its top-line but enhanced its focus on margins and cash flows.

Based on the ongoing turnaround in operations, we believe that NSN is worth over Euro 8 billion – a lot more than what it paid for Siemens’ 50% stake last quarter. As a result, we have revised our Nokia price estimate higher by over 20% to $6. This also includes a structural change to the model as we have stripped out royalty fees from the devices segment to form a separate division for licensing. Consequently, the handset ASPs as well as margins have taken a hit in the new model, but that effect is equally offset by the newly formed licensing division’s revenues and margins, thereby hardly impacting our overall valuation for the company. The mobile division (excluding licensing) in the new model is what Nokia plans to sell to Microsoft in the coming months. We haven’t yet accounted for that transaction though, as it is yet to receive shareholder’s approval. If the deal goes through, we expect the post-deal Nokia to be worth about $7.75 per share, in line with the current market price after the 15% jump post-earnings.

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NSN’s strong LTE Focus

Over the past year, Nokia Siemens Networks has increasingly shown signs of turning the corner as a result of an ongoing restructuring that has not only helped improve its operating margins but also restored focus on its wireless business. As a result, NSN has fast emerged as a leader in the ongoing 4G LTE transition around the world, and is taking share away from competitors.

NSN’s LTE focus should help it win contracts in hitherto under-penetrated countries such as the U.S., where Chinese manufacturers such as Huawei and ZTE have been blacklisted amid security concerns. Nokia has done well to secure recent LTE wins at T-Mobile and US Cellular, and will be looking to take advantage of the ongoing consolidation in the U.S. wireless market to improve its position in a region where it has historically been a laggard. NSN has a strong relationship with Softbank in Japan that it could leverage to win more contracts at Sprint, which is now 78% owned by Softbank. Even T-Mobile’s recent merger with MetroPCS is likely to work in NSN’s favor. T-Mobile currently sources its equipment from Ericsson and NSN, while MetroPCS does the same from Ericsson and Samsung. As the carriers look to consolidate suppliers, NSN has an opportunity to displace Samsung owing to its relationship with the bigger T-Mobile.

At the same time, NSN is divesting some of its non-core operations and exiting certain contracts and countries that it believes have little strategic importance in the longer term. This is in keeping with NSN’s strategic focus on mobile broadband and profitability. However, this caused its revenues to decline almost 26% over the same period last year and margins to take a small hit due to lower operating leverage. The top-line growth may be a concern for a few more quarters, with some of the managed service exits likely to impact revenues next year as well. However, we expect the LTE transition to pick up in pace in the coming years as carriers in China and Europe start upgrading their networks. NSN has done well to bag the highest revenue share (>11%) of China Mobile’s initial LTE buildout among the foreign bidders, which is likely to become accretive to the bottom-line next year. This, and the ongoing restructuring which is expected to be completed by the end of the year, should help NSN hold on to the impressive margin gains it has made in the past few years.

IP Licensing

As a result of the high R&D spend incurred over the past decade, Nokia has a very strong patent portfolio, comprising close to 16,000 issued patents and 4,500 pending patent applications in the U.S. Outside the U.S., the company has over 20,000 patents (both issued and pending) with a majority of them in Europe. [1] Even in terms of quality, Nokia’s patents stand out. In a 2011 review of the 3000+ patents considered essential to 4G LTE technology, Thomson Reuters and Article-one found that Nokia held close to 19% of the standard essential LTE patents and was the LTE leader by a big margin. [2] Qualcomm, the dominant mobile chipset manufacturer, trailed Nokia with a share of about 12.5% of the LTE patents deemed the most essential.

At the current run rate, Nokia’s IP licensing arm generates about 500 million Euros in steady royalty income every year. If we assume this to hold over the average remaining term of its U.S. patents, which is 13.8 years, discounted cash flows (12% discount rate) show that the patents would be worth at least $4 billion in value, or $1 per share. We estimate that this is a floor on the value that Nokia’s shareholders should be attaching to its patent portfolio. Considering that Nokia will now have no phones to sell and therefore faces less danger of being countersued, it would have greater bargaining power in setting patent licensing terms going forward. Currently, Nokia generates all its licensing revenues from about 10% of its patent portfolio, which are standard-essential and are required to be licensed to others at fair and reasonable rates. Without the handset division though, Nokia will be free to monetize the rest of its patents, which had been exclusive to its handsets until now. Additionally, its 4G LTE patents are likely to become even more valuable with time as carriers around the world transition to the new wireless standard and a greater number of handsets support 4G. This could bring further upside to our IP valuation.

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Notes:
  1. Nokia Has a Valuable and Relatively Young US Patent Portfolio, EnvisionIP, July 19th, 2012 []
  2. LTE Standard Essential Patents Now and in the Future []