Nokia Earnings Preview: Cash Allocation And NSN Margins In Focus

Nokia (NYSE:NOK) is scheduled to release its Q1 2014 results on April 29. This will be its first earnings call without its mobile division, which was sold to Microsoft (NASDAQ:MSFT). In return, Nokia expects to pocket upwards of Euro 5.44 billion in cash, and shareholders will be interested in hearing what management plans to do with the extra cash. While the payout of a one-time special dividend or share repurchases could be in the offing, Nokia might also look to acquire other companies as a means to bolster its remaining businesses and drive long-term shareholder value. The erstwhile handset maker is also likely to announce a new CEO following Stephen Elop’s transfer to Microsoft along with the devices and services business.

With the jettisoning of the handset division, Nokia is left with three primary business segments: Nokia Solutions and Networks (NSN), of which it assumed full control of last year after buying out Siemens’ 50% stake for EUR 1.7 billion; patent licensing, which was earlier reported as part of its devices business and has a current annual revenue run rate of EUR 600 million; and the Navteq mapping unit, which it acquired in 2007. Of the three, NSN is more central to Nokia’s value and the margin trends in this business are key to our $7.50 price estimate for Nokia. Although the company has done well to expand margins on the back of a recently concluded restructuring program, higher costs related to the initial roll-out of LTE in regions such as China could impact NSN’s near-term profitability. We will also be looking for management comments on Nokia’s future patent-monetization strategy, given that the company currently derives all its royalties from only 10% of its patents and therefore has huge upside potential. Our price estimate is almost in line with the current market price.

See our complete analysis for Nokia stock here

NSN Banks On LTE Transition

The sale of the handset business has made NSN the biggest contributor to Nokia’s value, accounting for almost half its total value by our estimates. It is therefore not surprising that NSN’s current CEO, Rajeev Suri, is being touted as the top contender for the post of Nokia’s next CEO. Suri was at the helm when NSN announced a big restructuring program in 2011, to cut operating costs by Euro 1 billion and increase focus on mobile broadband. The company has since sold off non-core units and successfully turned itself around to sustained profitability, generating positive cash flows for over two years now.

However, the transition has taken a toll on NSN’s top line, which declined by 18% last year as the company exited unprofitable contracts and saw reduced demand for legacy wireless infrastructure among carriers worldwide. Going forward, rising 4G LTE deployment activity, especially in regions such as China and Western Europe, should help offset some of the legacy declines. 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. Vodafone, fresh off the sale of its stake in Verizon Wireless, has allocated about Euro 8.5 billion to modernize its network and build out LTE. NSN is one of the two vendors selected to help Vodafone with the network upgrade.

In the U.S., where NSN has had a relatively smaller share of carrier contracts in the past, it has successfully managed to shore up its presence with recent contract wins at T-Mobile and Sprint. In the first nine months last year, the company increased the share of its revenues from North America year-over-year from 7% to 13%, mostly on the back of its T-Mobile win. With T-Mobile’s LTE build-out mostly complete, NSN will bank on Sprint’s Spark program to boost revenues this year. However, any benefit from Spark will likely only accrue towards the back half of the year and have limited impact in the first quarter.

Greater China and Europe, together with the U.S., account for almost half of NSN’s revenues. A good showing in these regions should bolster NSN’s prospects this year. However, higher costs associated with the initial stages of LTE network deployment are likely to pressure margins in the near term. Last quarter, NSN’s operating margins declined by 320 basis points over the year ago quarter. 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. It will be interesting to see if Nokia has been particularly aggressive at bidding for new contracts, which might stem the revenue slide but impact margins going forward.

IP Licensing Potential

Nokia has an immense opportunity to tap in its IP licensing business – the only remnant of the divested mobile device operation. Last year, Nokia generated about Euro 530 million in 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.

The company 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. Nokia scored another big patent win last quarter, signing a licensing agreement with HTC in exchange for dropping litigation in many countries. Such patent deals could get the ball rolling for more of such agreements, 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 is 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).

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