The market was taken by surprise by the Nokia (NOK) Q4 sales update. The company had built quite a reputation of missing estimates and warning down over the last 2 years. In my article from October last year, I predicted a 300% potential, based on the second wave of smartphone adoption. A third of that potential has now been realized. It is tempting to take money off the table after such a fast rush. Although some short-term profit-taking is possible, the long-term potential is still intact. Since the summer, Apple's (AAPL) stock has lost around $100 billion in market cap, while Nokia's has gained only $4 billion. That puts the stock recovery in perspective.
Why the excitement about 4.4 million Lumias
Nokia missed the first inning of the smartphone race completely. The market has counted them out for the smartphone race and the company was priced as it would slowly bleed empty and lose its customers to Apple, Samsung, Research In Motion (RIMM) and maybe even HTC. Apple OS and Android (GOOG) would divide the cake as Nokia was held up in the locker room. Over 2011, the company sold only 1 million Windows 7 phones. This led to significant losses as the operational scale was too low.
The increase to 4.4 million Lumia (Windows) handsets does not only indicate that the company is crawling slowly back in the game. It also means that they have reached a profitable scale again. This is the real reason why analysts will have to upgrade their watered-down expectations. Most analysts have cut their expectations to explain last year's share price fall. Now they will have to inverse these numbers. Unlike Apple, Nokia is by no means an over-owned stock. In fact, it could be exactly as hated as Apple was loved. Any upgrades will not miss their effect on the share price.
One battle is not the war
We are still a long way off from my expectations for 2013 on Windows phones.
I still stick to my sales expectations as Nokia will introduce cheaper Windows 8 models. Nokia has learned that attacking the market with 25 models at the same time doesn't work. In the meantime, the Windows 7 models are discounted deep below $200. The current vast mass of 260 million Nokia Symbian users have not stopped breathing because they had no access to an App store or market. I believe Nokia still stands a chance as these Nokia users upgrade to a smartphone. The even larger pool of "stupid phone" users also have other priorities than the early iPhone adopters. Last quarter, Nokia still had 86 million global handset shipments. That is still a significant market share. The Nokia market share will decline further, but I believe the ASP will increase on product mix effects.
Profits will matter again
Over time, the market value of a stock is related to the expectations of its future profit. For Nokia, the market assumed that the phone business would eat away all the profitability of the other network activities till eternity. Now, with the possibility of the phones turning in a profit, the group profitability will matter again. The valuation technique will shift again from valuing the stock on 0.3x book value to a P/E rating on a normalized profit. This explains the binary nature of the stock. It is either worth 0 or $8. After the recent surge, Nokia is now trading at 10x my 2014 EPS. That is not the bargain basement anymore. I expect the margin to recover further well beyond 2015 as Nokia settles as a number 3 smartphone player behind Apple and Samsung.
Nokia-Siemens is the network equipment JV and has also weighed down margins over the last couple of years. Nokia already reduced FTEs by a third to 80k. The company is still too heavy and will cut another billion euro from its payroll over the next year. As the restructuring costs decrease and the cost savings take effect, SG&A on sales should decrease below 15%.
Conclusion and DCF valuation
Nokia lost more than 90% of its market value over the last 5 years. There is no doubt that Nokia totally missed the app train and inflated its cost base. Nokia sales and profitability will not return anywhere near its previous highs. My DCF shows that with only a marginal improvement in mix and cost base, the share price will triple. However, the next couple of months will be critical. If the windows 8 Lumia products flop for some reason, the bear case takes over. My bear DCF shows that this risk is already priced in. I use a Lumia 710 and love the robust Windows 7.5 OS. It doesn't have the good looks of iOS, but can do everything an iPhone can for a third of the price. I experience better Wi-Fi and mobile connection than my last iPhone 4S. The Nokia newsfeed will be easier to follow now. In the past, Nokia bombarded the market with 35 models at the same time, now the Lumia is the key to share price appreciation. All figures are in euros.
Bear DCF and P&L
Disclosure: I am long NOK.