Nokia Faces Near-Term Margin Concerns But LTE Buildouts Promise Better Future

+15.43%
Upside
3.48
Market
4.02
Trefis
NOK: Nokia logo
NOK
Nokia

Nokia (NYSE:NOK) announced a weak set of Q4 2013 results on January 23rd, as revenues from continuing operations fell 21% amid reduced demand for legacy wireless infrastructure among carriers worldwide. The company’s networks division, NSN, will account for almost 90% of its total revenues after the sale of the devices business to Microsoft (NASDAQ:MSFT), which is expected to go through by the end of the first quarter. The 22% y-o-y decline in NSN’s top-line follows the 26% drop in Q3 and heightens concerns about the company’s ability to offset the impact of the declining legacy spend with share gains in 4G LTE. However, part of the reason for the sustained revenue decline is the fact that NSN has become increasingly focused on mobile broadband and profitability over the past year, divesting non-core operations and exiting service contracts and countries that are inconsistent with its strategic focus. Excluding these factors, NSN’s sales dropped 15%.

What was probably more worrisome was the 320 basis point year-over-year decline in NSN’s operating margins, largely due to the higher costs associated with the initial stages of TD-LTE network deployment in China and declining mix of higher-margin sales in developed markets such as the U.S. and Japan. Nokia expects the pressure on both the top-line and bottom-line to continue in the near term, as contract exits and divestments make for tough year-on-year comparisons while costs increase during the initial network layouts. However, we expect the profitability trend to improve as these projects enter the capacity phase and NSN leverages its recent contract wins at Sprint, China Mobile and China Telecom to bolster revenues towards the back half of the year.

In addition, Nokia expects its annual licensing revenue run-rate to increase by about 20% after the Microsoft deal passes regulatory muster. However, licensing EBITDA margins, which the company announced for the first time, turned out to be much lower than we expected, in the mid-60s. We have slightly revised our price estimate for Nokia to $7.50, taking the near-term NSN margin concerns and the lower licensing margins into account.

Relevant Articles
  1. Is Nokia Stock A Buy At $4?
  2. Nokia Stock Looks Undervalued At $4
  3. Nokia Stock Poised For Recovery After Dismal Week?
  4. Nokia Stock Looks Set For Rally After Rough Month
  5. Can Nokia Stock Continue Weathering The Storm In The Broader Markets?
  6. Can Nokia Stock Continue Its Post-Earnings Outperformance?

See our complete analysis for Nokia stock here

NSN’s Strong LTE Focus

Over the past year, Nokia Siemens Networks had 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 more contracts in 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 with T-Mobile and US Cellular, and is now 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. Long-time NSN customer Softbank’s recent acquisition of a 78% stake in Sprint helped NSN displace Ericsson in a recently signed LTE deployment contract with the carrier. Sprint is building out a faster 4G TD-LTE network covering around 100 million PoPs by the end of this year in a bid to catch up with rivals Verizon and AT&T. The Sprint win will help NSN offset some of the revenue hit it would have otherwise incurred due to the tapering down of T-Mobile’s LTE roll-out in the coming quarters.

However, NSN’s top-line growth may be a concern for a couple more quarters, with some of the divestments and managed service exits likely to impact revenues until the second quarter of this year. However, we expect the LTE transition to pick up in pace in the coming months as carriers in China and Europe start upgrading their networks. NSN has done well to bag LTE contracts with China Mobile and China Telecom, and is on track to becoming the leading foreign player in the Chinese LTE buildout. These deals, together with the Euro 1.5 billion in cost savings that NSN has achieved through restructuring, should help it hold on to much of the impressive margin gains it has made in the past few years, despite the near-term softness.

IP Licensing Potential

Nokia has an immense upside potential to tap in its IP licensing business – the only remnant of the now-discontinued mobile device operation. Currently, Nokia generates about Euro 530 million in annual revenues from patent royalties. However, pursuant to the closing of the Microsoft transaction, the company expects its licensing revenue run-rate to increase to about Euro 600 million as Microsoft becomes a more significant IP licensee.

Going forward, we assume that the company will only slightly improve its royalty run rate in the coming years given the uncertainties associated with the timing and royalty rates of future licensing agreements. However, there could be a significant upside to our price estimate if Nokia manages to monetize a greater proportion of its patent portfolio and is able to renegotiate existing contracts at higher rates when they come up for renewal in the coming years. It recently extended its patent licensing contract with Samsung, which would have otherwise expired by the end of 2013, by another five years. The companies haven’t agreed on the royalty rate and other contractual terms yet, but expect to settle through arbitration in 2015. Patent deals with Samsung and HTC, with which Nokia has multiple IP lawsuits pending in many countries, could set the ball rolling for more such deals, especially with a number of Asian handset manufacturers that are gaining share in emerging markets.

Considering that Nokia now has no phones to sell and therefore faces less danger of being countersued, it should now have greater bargaining power in setting patent licensing terms going forward. Currently, Nokia generates all of 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. This could bring further upside to our IP valuation, limited to an extent by any regulatory issues it might have to face while enforcing its IP strength (see Nokia Could Have An Additional $4.5 Billion Opportunity In Patent Licensing).

Understand How a Company’s Products Impact its Stock Price at Trefis