Nokia (NYSE:NOK) suffered a setback in its Indian tax case last week, as the Supreme Court rejected its appeal against a lower court order which had directed the company to submit a $570 million guarantee before transferring its local assets to Microsoft (NASDAQ:MSFT.  The handset maker is willing to deposit around $370 million in an escrow account to cover its tax liabilities, but the Indian IT (Income Tax) department believes that the amount isn’t enough to meet its tax claims, which range between $650 million and $3.4 billion. With the Supreme Court upholding the IT department’s demands, Nokia will weigh its options which include either fronting up the extra cash as a guarantee or shutting down its handset manufacturing plant altogether. The Chennai factory is one of Nokia’s largest globally, employing around 8,000 people and constituting about 25 percent of the workforce that will be transferred to Microsoft as part of the handset division sale.
However, the good news for Nokia is that it is not liable for its subsidiary’s (Nokia India Pvt Ltd.) liabilities, with the Supreme court ruling that the IT department can’t force the parent company to submit an assurance. This limits Nokia’s exposure to the extent of the value of its Indian assets, which it claims to be in the range of $440-$500 million and is probably what Microsoft is paying it for the asset as part of the $7.2 billion deal. If the tax dispute isn’t resolved soon or negotiations with local authorities do not bring its tax liabilities down to below $500 million, it might be in Nokia’s best interests to walk out of India without transferring its assets to Microsoft. This will give Nokia less than expected cash from the Microsoft deal, but limit legal distractions while not hitting its overall valuation by much. By our estimates, Nokia’s stock is worth about $28 billion and a $500 million hit due to the Indian tax dispute would cause its valuation to drop by less than 2%. Our $7.50 price estimate for Nokia is about in line with the current market price.
Alternatives to Indian Factory Limit Valuation Impact
This will, of course, depend on Nokia’s discussions with Microsoft and the value that the Windows maker attaches to the Chennai plant. Around 250 million handsets (smartphones and feature phones) are estimated to have been sold in India in 2013, up year-over-year by about 14% according to Gartner. With a market share of about 19%, according to CMR India, Nokia sold about 48 million mobile phones in India last year.  Assuming an average selling price (ASP) of $35, or about Rupees 2100, we can reasonably expect Nokia to have generated revenues of about $1.6-$1.7 billion from Indian handset sales in 2013. This implies an Indian sales mix of about 15% of its total device revenues for the year. Given the high growth of India’s smartphone market and Nokia’s better brand value at the low end, this mix could increase going forward.
India is therefore a strategic market for Microsoft, and not having control over a local manufacturing plant could harm its long-term interests in the country. But if it becomes too expensive to pay the taxes, Microsoft and Nokia could go ahead with the blocked transfer and consider setting up manufacturing plants outside India instead. Given the cheap labor available in other Asian countries such as Thailand, Vietnam and Indonesia, this could be a smart move. With the asset transfer blocked, Nokia would then get back control of its factory, which it could run as a contractor to Microsoft in the near term until the overseas facilities are set up. Following this, Nokia could exit India altogether, with the subsidiary declaring bankruptcy and leaving the factory assets with the IT department as cover for its tax liabilities.
This is why the Supreme Court has also asked Nokia to submit a valuation report of its Indian assets.  The value agreed upon at the end of the negotiation process is unknown, but Nokia has said that the figure falls in the $440-$500 million range. It is also not clear how much Microsoft is paying Nokia for its Chennai plant which, together with the potential losses that it might incur in running the factory on a contractual basis in the near term, could set the upper limit for Nokia’s end of negotiations. But given Nokia’s low initial estimate, we don’t think the final asset value will be of significant concern to Nokia’s shareholders. The underlying assumption here is that the terms of the Nokia-Microsoft deal do not include a substantial break-up fee should Nokia not manage to close the sale of all its handset assets.Notes:
- India court rejects Nokia appeal over asset transfer to Microsoft, Reuters, March 14th, 2014 [↩]
- Samsung smartphone Q4 2013 market share surges to 40.4%, Micromax dips to 15.7%, Telecom Lead, March 3rd, 2014 [↩]
- Supreme Court orders Nokia to submit valuation report of Chennai assets, Firstpost, March 14th, 2014 [↩]