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Introduction

Last week, Nokia (NOK) climbed to $4 on the news that Microsoft (MSFT) had attempted to purchase Nokia's Smart Device Division. Unfortunately for Microsoft, Nokia demanded too high a price and rejected the bid. However, the question still remains: could Nokia's Smart Device Division be acquired, and if so, at what price?

Today, I will try to answer the latter question through a DCF valuation of the division.

In a DCF analysis, the fair price of the division is determined by estimating the present value of the future free cash flow. To make the forecasting process easier, I will start by estimating revenue, and then look at profitability ratios later on.

How many smartphones will Nokia sell?

In a previous article on Apple, I used forecasts by IDC to estimate the future market size of the smartphone industry. Afterwards, I multiplied the market size with my own market share estimates for Apple's iPhone business. As this is probably the most accurate way of forecasting sales over a longer period, I will use the same approach for Nokia

As can be seen in the below graph, Nokia has gone from being the market leader in the smartphone industry with a 40% market share to just 2.9% in the most recent quarter. The decline is a consequence of the phasing-out of Symbian smartphones, and Windows Phone not being the successful replacement management had hoped for.

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Source: Nokia's earnings reports and IDC.com

The good news for Nokia is that it barely can get any worse. Most market research firms, such as IDC, Gartner and Canalys, actually forecast a significant increase in market share for the Windows Phone operating system. I am, however, a bit more skeptical, and while I acknowledge that the Windows Phones are of pretty high quality compared to their prices, I doubt the operating system will obtain a 12%+ market share in 2017. The problem I see for WP is that it doesn't give users a compelling reason to buy it. Why would a consumer switch from Android or iOS if all WP offers is a different, but not a significantly better experience?

So in my forecast, I use a more conservative approach and assume that the market share of Nokia will increase from 2.9% to roughly 6% in 2017. As shown in the below graph, this actually results in quite a significant increase in sales for Nokia.

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Source: Nokia's earnings reports

Revenue

Besides estimating the future amount of smartphones sold, we also need to determine the average price of the phones (ARPU) to calculate the future revenue.

When Lumia was first introduced, it had a relatively high ARPU of 220 EUR. But over the last year or two, cheaper models have been introduced, which has resulted in lower average selling prices.

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Source: Nokia's earnings reports

The problem with the current level of ARPU is that it is so low that it doesn't cover the costs of the division. While the gross margin was 18% in the most recent quarter, the fixed costs represented 38% of revenue, thus the operating margin was negative for the smart device division.

Therefore, it is a necessity for Nokia to increase its ARPU over the next couple of years. Will sales keep up if prices are increased? I think they will as long as the price increases are gradual.

Concurrently, in the table below, you can see my revenue expectations.

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Earnings

As sales of smartphones declined, margins deteriorated as well, and Nokia hasn't been profitable on an operational basis since Q1 2011. While Nokia is in the process of restructuring its organization, it hasn't scaled down its operations fast enough to fully compensate for the lower sales.

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Source: Nokia's earnings reports

Besides higher operational expenditures, the costs of producing smartphones have also gone up with the switch to Lumia phones (below graph). I do, however, believe that Nokia will benefit from increased scale in the future, both in terms of operational expenditures and costs of goods sold.

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Source: Nokia's earnings reports and my own estimations

So how valuable is the division?

Based on the assumptions presented in this article, we can estimate the value of the division. Obviously, there are some issues with this method as we do not observe the free cash flow for the division. Instead, I assume that operating profit after taxes are roughly equal to the free cash flow of the division. Given these assumptions, the division will barely turn profitable in 2017 with an operating margin of 2%.

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The smart device division is, according to my estimates, worth $0.44 per share ($1.6 billion). My theory is that Microsoft bid roughly that amount, but Nokia rejected it as it believed it could get an even more attractive offer from Microsoft. The logic behind that theory is that the division is worth more to Microsoft than its fundamental value. By acquiring Nokia, Microsoft will have more control over the Windows ecosystem, which will benefit its other business divisions. So acquiring Nokia for a price over the fundamental value could potentially still be a rational acquisition for Microsoft. Therefore, I think it's likely that negotiations will be resumed within a year or two. I estimate that Microsoft will pay roughly $2 billion for the acquisition.

Source: How Much Should Microsoft Pay For Nokia?