Nokia Earnings Preview: Networks Margins May Be Under Pressure

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Nokia (NYSE:NOK) is scheduled to release its Q3 2015 results on October 29th.  The results will largely depend on the performance of its Networks segment, which accounts for about 60% of the company’s value, as per our estimates. While we expect the segment to sustain its sturdy topline growth momentum, its bottomline can be under pressure. Even though Nokia was able to improve its Networks EBITDA margins substantially in Q2 following a lackluster Q1, it may not have repeated that stellar performance this time around.

For the third quarter, the company expected a slowdown in software sales, which played a crucial role in 50 basis points year over year improvement in its Networks’ EBITDA margins in Q2. Also, it mentioned that low-margin strategic deals in China would make bottomline expansion difficult. However, even after reporting EBITDA margins at 3.2% in Q1 and 11.5% in Q2, Nokia still believes that it can meet its annual target of 8%-11%. To achieve this, the company would have to report Networks EBITDA margins in excess of 10% for Q3 and Q4, which appears a little challenging. Hence, it will be interesting to see how Networks’ bottomline turned out in the third quarter.

On the topline front, a strong order pipeline is likely to have kept Nokia Networks’ revenues running, which increased 6% in Q2 and 15% in Q1 2015. However, a tough comparable period, when Networks’ sales increased 15%, can be detrimental to the segment’s revenue growth figure.

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Our $7.90 price estimate for Nokia is around 15% higher than the current market price.

See our complete analysis for Nokia stock here

Pressure On Networks’ EBITDA Margins

Nokia Networks’ margins in Q1 (3.2%) declined 610 basis points year over year, due to weak software sales, strategic entry deals (mainly in China), challenging conditions in the market, a rise in operating expenses and a shift in mix in global services. In the second quarter, the company was able to address a few of these issues, which helped get its profitability back on track. A significant increase in software sales and an easing in the impact of low-margin China deals helped Nokia improve its margins sequentially and annually. However, the China deals’ impact is unlikely to have subsided further and growth of software sales was expected to slow down in the seasonally weak Q3. In addition, market conditions were challenging and the shift in mix of global services likely remained a drag. Hence, it is unlikely that the company managed to keep its EBITDA margins in the 10%-11% range.

While pressure on Networks’ EBITDA margins was high, Nokia’s ongoing eight cost-cutting initiatives may have helped it dilute the impact to an extent. The company is looking to optimize its R&D structure in order to improve productivity, efficiency and cost intensity. There were some improvements on this front in 2014, which Nokia believes would continue throughout 2015. Also, the company is striving hard to provide the most efficient delivery model across various business lines in global services, which can help it generate better margins for the division. Other initiatives related to site strategy, consolidation, supply chain transformation, head count control and IT modernization should also help the company manage its expenses better. Although these efforts are pushing Nokia in the right direction, they are more significant from a long term perspective. Hence, we believe that their impact on Networks’ Q3 EBITDA margins would have been minimal.

Strong Order Pipeline Should Help Networks’ Sales

Nokia’s Networks’ revenues witnessed a turnaround in growth in 2014, following the big restructuring program that enhanced the segment’s focus on mobile broadband. Driven by higher LTE spending across geographies and exit from unprofitable service contracts in EMEA and Latin America, Networks’ revenues increased 15% and 8%, respectively, in the last two quarters of 2014. Nokia was able to sustain this momentum in 2015, with 15% and 6% growth in the segment’s sales during the first two quarters. And looking at its strong order pipeline, we expect Nokia to have done well in the third quarter as well.

The company has won several LTE contracts with China Mobile and China Telecom, emerging as one of the leading foreign players in the Chinese LTE development. While European sales have been slow, the deal pipeline remains strong. Also, Nokia’s contracts with T-Mobile and Sprint are supporting its growth in North America. India is also a very important market for Nokia, where it inked 34 deals last year and several others during the first three quarters of 2015. In fact, the company reportedly led the Indian market in terms of contract wins last year, which clearly reflects its strong position in the country. And with so many deals in the pipeline, including the modernization of 2G and 3G networks, 4G deployment, WiFi solutions, security solutions and device management, Nokia appears well equipped to grow its revenues in India.

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