Nokia (NOK) jumped 4% in heavy volume after-hours trading on Wednesday night (6/19/13) after the Wall Street Journal reported that Microsoft (MSFT) had been in talks to acquire Nokia's phone business as recently as this month. Coming the day after Huawei's reported interest in Nokia (later half-heartedly retracted), I believe this represents fantastic news for Nokia shareholders and here's why. Just by these reports circulating, the market will start waking up to the true underlying value of Nokia's assets and start to re-adjust its valuation upwards accordingly. In this article, I give a review of Nokia's assets and just what may have happened between Nokia, Microsoft and Huawei in the past month.
Nokia Is Undervalued
Most Seeking Alpha readers I believe recognize that Nokia is significantly undervalued with strong potential for upside. It is this which attracted me and I believe many others to Nokia over the last year. However with EPS hovering a few cents either side of zero for the last two quarters, it is difficult to come up with a standard P/E ratio estimate for Nokia. Instead of that, I have done a sum-of-parts valuation for the company starting with NSN.
Nokia-Siemens Network (NSN)
NSN is a joint venture with Siemens (SI) in the field of telecoms infrastructure. Its chief competitors are the likes of Alcatel-Lucent (ALU), Ericsson (ERIC) and yes, Huawei. As the latter is a rather opaquely-owned Chinese company, we cannot use it to help create a valuation for NSN. However, I believe using the first two companies mentioned is sufficient to give us a decent indication of NSN's true value.
I've compared the three companies' metrics below.
All of these figures have been taken from their last 4 quarterly earnings reports (April 2012-March 2013) and converted to USD where necessary.
Looking at the table, if we go by Alcatel-Lucent's Price-to-Sales ratio, we obtain a NSN market capitalization of $4.16 billion. However, NSN is a lot more similar to Ericsson with a currently identical operating margin of 1.5%. Therefore, using the same Price-to-Sales ratio as Ericsson, we obtain a market value for NSN of $20.08 billion. I think this is a fair reflection of NSN's true value as it is now firmly in profit. However, it is worth bearing in mind that Canaccord Genuity and Morgan Stanley prefer to accord NSN a value of 0.4-0.6 of its Price-to-Sales ratio. Let's therefore give a 25% discount on this estimate giving NSN a value of $15 billion. With Nokia owning half of this enterprise, this gives Nokia $7.5 billion.
The HERE mapping division, formerly known as Navteq, is a difficult one to estimate the market value for. Over the last 4 quarters it has generated $1.38 billion in sales but managed to lose $304 million with operating margins in the last quarter (Q1'2013) of -44.9%. It is quite difficult to give this division any value at present. However, with its widespread acceptance in the automobile industry and other intangible benefits accruing to Nokia (such as being a central component of the WP8 experience); it is fair to assign this division a value of $1 billion.
Device & Services
Whether to purchase BlackBerry or Nokia shares is often a discussion that crops up on Seeking Alpha. This is due to both companies having similar backgrounds, both being previously high-flying phone manufacturers which have had share price collapses over the last few years. With the two companies attempting to recover, they also make useful comparators for one another.
It is worth bearing in mind that BlackBerry's Price-to-Sales ratio includes its assets such as patents and cash while Nokia's comparison does not. Therefore, despite Nokia's D&S having a better operating margin in the last 12 months compared to BlackBerry, let us apply a generous 50% discount to the division's value. With a Price to Sales ratio of 0.33, Nokia's D&S division yields a value of $6.3 billion.
Nokia holds approximately 19% of all standard essential LTE patents. These are some of the patents driving the future innovation in this industry through better connectivity standards. There have been two excellent Seeking Alpha articles estimating the true value of the company's patents here and here. The latter article estimates Nokia could generate up to $5 billion per annum in patent royalties if it monetizes them to its utmost potential. The former article estimates that in the last year, Nokia generated $1.28 billion.
If we assume that it is too optimistic that Nokia will generate $5 billion in revenues in the future through patents alone and use the $1.28 billion figure only with a P/E ratio of 10. We derive a value of $12.8 billion, similar to Nokia's current market capitalization.
On March 31st, 2013, Nokia had $11.52 billion in cash. Minus its short- and long-term debt liabilities, this comes to $5.95 billion.
NSN - $7.5 billion
HERE - $1 billion
Patents - $12.8 billion
D&S - $6.3 billion
Net Cash - $5.95 billion
Nokia Value - $33.55 billion
This represents 132% upside over its valuation of $14.42 billion on 06/19/2013.
How Microsoft and Huawei help
This significant variance of 132% has perpetuated over the last year I believe for a couple of reasons. Firstly, it becomes difficult to value a company making losses. Valuing a company on P/E ratios is a lot simpler than picking it apart and finding value in individual divisions as I did in this article. Once Nokia starts registering positive EPS quarter on quarter, this imbalance will take care of itself. The other reason is simply that I believe the market thought Nokia was going to go bankrupt. With D&S operating margins increasingly edging into positive territory again, I believe Nokia's true valuation will start to shine through. The interest shown by Huawei and Microsoft in this regard really help. By becoming a potential take-over target, analyst spotlights will begin to shine deeper into Nokia and start delivering considerably more refined insights. It also means that Nokia's next earnings report due 18th July will be watched with even keener interest than usual. Therefore, while I was already expecting a positive market reaction to these results, with an increased focus on them, I think the upside could be even more pronounced than before.
What really happened between Nokia, Microsoft and Huawei?
Let's give a brief recap and my take on it. On Tuesday (6/18/13), it was reported in the FT that Huawei was open to buying Nokia. However it described the WP8 platform as "weak" and hampered by having license fees as opposed to Android which is technically free. That's actually a slightly disingenuous statement as while Huawei is one of the few Android manufacturers which do not pay Microsoft patent royalty fees, that is not guaranteed to continue. Nokia on the other hand, does pay license fees to Microsoft, but is indemnified from WP8 related lawsuits and receives platform support payments of $250 million per quarter. Huawei retracted this statement indicating an interest in the company by saying it had "no plans to acquire Nokia".
The following day, on Wednesday (6/19/13), it was reported that Microsoft had had detailed discussions with Nokia in regard to purchasing its phone segment. These had almost reached oral agreement stage but were then cancelled. This final meeting happened as recently as this month.
My take is pure speculation, but it is quite possible that with Siemens looking to divest itself of NSN, larger companies have been taking a look at Nokia as a whole. If NSN was to be spun-off from Nokia, it would make it an attractive target to Microsoft and may have been a reason for Microsoft and Nokia to engage in preliminary discussions. With Huawei having a strong telecommunication infrastructure arm, it would be well aware of the NSN situation and again would have been possibly considering taking over Nokia as a whole to give it a stronger presence globally.
I think it was quite interesting that Huawei criticized WP8. Personally, if I was negotiating with someone, I too would look to critique the items under negotiation to receive a more favourable price. That is how I interpret Huawei's statement. With Microsoft also being put off by the supposed high price of Nokia's phones segment, it shows a vote of confidence by Nokia's management into the company's true value. Nokia's CEO Elop has been unfairly criticized as a mole put in place to sell Nokia cheaply to Microsoft. If that were so, he would have recommended whatever offer Microsoft put on the table this month. He didn't and that can only be a good thing.
There probably won't be a bidding war over Nokia, naturally if there is, shareholders will benefit. I think in the longer term however, the organic growth Nokia can achieve is far greater than any offer outside interests can put on the table as of now.
With Nokia's Q1'2013 results out soon, I believe the company will show another robust increase in Lumia sales. This will quite possibly lead to a fundamental re-appraisal of Nokia's value and move it to a permanently higher plane and probably make it too expensive for the likes of Microsoft and Huawei. In retrospect, the two companies may come to regret their parsimonious attitude towards Nokia.