Recently there has been a tonne of confusion regarding Bernstein's research note on why Nokia's (NOK) cash position may be a little on the tender side. An interesting article painted the conclusion that the analyst in question misled the market by ignoring the cash contribution from NSN but I believe this not to be the case.
Before continuing with my argument I would like to clarify that I am a Nokia bull, as detailed by my articles, here, here and here, with a price target of EUR3.90. Let me also add that I have advised buying protective puts until the iPhone 5C (AAPL) is released which will benefit both from an increase in volatility (which will increase the premium and therefore the selling price of these puts) as well as cushioning any adverse impacts as the market digests the potential of Apple's foray into the wider smart phone market.
The Balance Sheet
I would like to break the balance down argument down into two sections. Firstly, a cold hard CURRENT look at the status quo of Nokia INCLUDING NSN's assets. This means that part one will not look at the benefits of positive cash flow from NSN and any other business segment.
Secondly I will add in NSN's cash contribution and show that the balance sheet depends upon the devices segment breaking even in the next few quarters.
Also bear in mind that the NSN acquisition was completed for EUR1.7bn where 500m will be financed through a specific loan while cash will be used for the EUR1.2bn although the firm has secured credit facilities (i.e. an extended overdraft) against this transaction. Also remember that despite the deal being announced two months ago, the deal had not closed by Q2 meaning that the most recent accounts DO NOT include any cash outflows from the acquisitions
|Current Portion of long term loans receivable||47.0|
Of Nokia's current assets, the major forms of liquid cash are of course cash, the cash equivalents (bonds, stocks etc) and other liquid assets. It is these three assets that make up the cash pile of gross cash. As of the second quarter, these amounted to EUR 9.5bn
In order to come to the company's estimation of net cash, we have to deduct their total debt pile of EUR5.2bn as well as currently utilized over drafts of c EUR 170m which leaves us with net cash of roughly EUR4bn and bang in the middle of the company's estimates upon acquisition of NSN. Next we deduct the cash portion of the NS acquisition (EUR1.2bn) which leaves us with net cash post deal of EUR2.8bn leading us to the next question....is this cash enough for a loss making company to become profitable without needing to come to market for additional capital?
The next point of consideration is provisions relating to losses from restructuring, warranties, lawsuits etc, etc that have been charged to the income statement but have so far been non-cash expenses. For the fully year 2012, Nokia saw a cash outflow of the entire 2bn+ of provisions and therefore it is reasonable to assume that we may seem additional expensed non operational provisions flow out of Nokia's bank account.
Using Nokia's full year report you can see that of the EUR2.6bn of provisions, the largest amount (700m) came from warranties (the cash incurred to replace devices and pay for repairs etc etc) but this is arguably a working capital expense and therefore not strictly a pure cash outflow. The rest came from restructuring (450) patent infringements (400) and other things such as project losses, taxes etc.
As of the second quarter, provisions amounted to EUR 2.4bn and the report lets us know that the company expects EUR850m of restructuring outflows although the timing may be spread over more than a year. For an estimation I will assume the percentages remain constant and as such the 700m of warranties will be counted as working capital as opposed to non operational cash outflow. THis means that an additional EUR1.7bn must be deducted from net cash, leaving us with EUR1.1bn of net cash left.
From here on in, we have to look at working capital how this number moves over time. For those less versed in accounting principles, working capital is simply the short term assets that the company REQUIRES in order to operate. As a completely rough guide, Working capital equals current assets minus current liabilities, but you should also subtract cash (only a small amount of cash is required to keep a company solvent) and add back short term debt. Furthermore, you should ignore items such as restructuring provisions as these are not operating expenses.
If we exclude provisions and subtract only the warranty related 700m, Working Capital stands at -EUR1.5bn. This means that during normal business operations, the company actually holds additional money over a short period of time. It also means that if the company were to wind down operations then once working capital had been wound down, the firm would face an additional cash outflow of 1.5bn to reach 0 working capital. Subtracting this working capital yields -EUR400m in cash, AKA a liquidity shortage which means that for a company with a near-junk debt rating, the only solution is a capital increase or rights issue.
The thing about working capital is what will happen over time. Is it an unusual situation for a company such as Nokia to be in?
Firstly, take a look at Apple, its working capital as a percent of revenue is -6% meaning it also has negative working capital. This is because they sell direct to consumers which pay up front, while payments to suppliers can be spread over time. In fact, for consumer companies, the majority will have negative working capital simply because they do not offer any kind of payment terms to customers.
On the flip side, remember that Nokia is mainly NSN and it may be better to compare the working capital requirement to companies such as Ericsson who have a net working capital (at full year end) of 32,338SEK or +14% of annual revenue.
If we assume these working capital requirements for each business segment, we come to a Nokia requirement of +EUR831m meaning that Nokia may need an additional EUR2.3bn cash outflow to achieve the industry standard working capital with 1.1bn (net cash) - 2.3bn meaning a negative cash balance of EUR1.2bn!!!
This is how Bernstein and other bears have done their calculations and they are correct in the assumptions to this point. So how can I remain bullish on Nokia out of all of these things and furthermore, how can Bernstein remain bearish even with NSN (which is also a fair assumption).
Firstly, when we are working through cash, we must remember that debt is not due for repayment this year. Therefore despite net cash being lowered by the amount of debt, this cash will not flow out of the company until the debt is due for repayment and even then, the company will likely refinance (albeit at a higher rate). The next significant repayment is due in February 2014. This debt amounts to EUR1.75bn with interest of 5.5%. As it stands, the company will be able to refinance this debt but at a significantly higher rate due to the firms current debt status.
Regardless, the following maturity isn't until 2017 so if we look at ACTUAL cash including the disaster working capital scenario above, we have -EUR1.2bn - 1.75bn (for the maturing debt that won't be rolled over) + EUR4.3bn (debt we subtracted from gross cash) leaving us with a +EUR1.35bn net ACTUAL cash position by the end of the year.
Let me add to the positive side that working capital does not have to be optimized in one year and the company may take two or three years to become comparable to market, depending on the flexibility of their creditors.
Hopefully the above has explained how the balance sheet is a little on the fragile side, but how will the future operations from Devices and NSN impact our balance sheet going forward.
Unfortunately I haven't got enough time to add this portion and I think you have enough on your plate to give me a few days to write up part two, but let me just elaborate the bear argument in bullet points.
1. NSN will not generate cash every quarter. The company operate in a business where the firm must offer base stations at a loss in order to secure lucrative upgrades in the future.
2. Customers have the power of credit and the product is capital intensive meaning the company has to invest working capital in the near term to derive returns in the future.
3. Ericsson's operating cash flow (page 4) is not always positive. 1Q13 showed an outflow of 3BN SEK and 2Q12 showed an outflow of 1.4BN SEK
4. NSN's most recent plan to expand restructuring means a crimp on cash flow for the next few quarters.
In my next article I will try and explain how the cash flow in the future will impact the balance sheet and how the development of the Devices business holds the key to solving the cash cliff that Nokia faces.
Additional disclosure: I have bought protective front month puts ahead of the iPhone 5C launch