Nokia: Refocused And Resurgent

Sep. 3.13 | About: Nokia Corporation (NOK)

Nokia (NYSE:NOK) is a once great company that hopes to recapture at least some of its former glory. Nokia's global smartphone market share has fallen from more than 50% in 2007 to less than 5% in 2013 (Chart 1) and its more general mobile device market share has fallen from nearly 40% in 2008 to less than 15% in 2013 (Chart 2). Nokia's rapid hemorrhaging of market share in the mobile phone business has driven down revenue and profits and has forced the company to shed 40,000 employees since Stephen Elop became CEO in May, 2010. Though this restructuring plan has not helped the company increase its revenues - net sales have decreased 24% in the past year - it has helped it decrease its operating loss by more than 75% this year. As Nokia has successfully stemmed its negative momentum and restructured its operations to accommodate a smaller, leaner company, it has demonstrated that it is both a resilient and innovative company. Microsoft, which has had a long and promising relationship with Nokia, appreciated Nokia's commitments and sacrifices and has agreed to buy Nokia's mobile device business for a premium as well as license its mapping and other services. Nokia had proven that it deserves this high valuation by demonstrating that it was not desperate for Microsoft (NASDAQ:MSFT) aid. Its experience in the telecommunications industry, strong management, and newly acquired stake in Nokia Siemens Networks, will help Nokia successfully transition itself into a telecommunications equipment manufacturer and create a new future for itself.

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Ways to Evaluate Nokia's Growth Potential

When people evaluate the future of Nokia, they emphasize either its deep partnership with Microsoft or its telecommunication equipment subsidiary, Nokia Solutions and Networks (NSN).

Nokia's Relationship with Microsoft

In 2011, Nokia not only agreed to use Windows as its principal smartphone operating system, but it also entered a partnership to "form a broad strategic partnership that would use their complementary strengths and expertise to create a new global mobile ecosystem." Nokia has helped Windows Phone grow 77% over the past year and has led it to become the fastest growing and third largest operating system. It now controls 3.7% of the global market share and its market share in France and England is about 9%. Nokia accounts for 86.9% of all Windows Phone sales (Chart 3) and it has increased its sales of its Windows-operated Lumia phone series by more than 32% in the past year. Nokia has also made strides in partnering with American wireless providers, something it hadn't done during its heyday, and which had largely accounted for its failure to make better inroads in North America. Now it has some exclusive partnerships with AT&T (NYSE:T).

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Nokia's Lumia-series phones have gotten generally favorable reviews. Nokia has succeeded in releasing both strong, relatively inexpensive smartphones such as the Lumia 920, 925, and 928 and premium smartphones such as the Lumia 1020, which caters to avid photographers. These phones rate highly among both major tech reviewers and customers. Nokia is also planning to expand into the tablet market; it will release its Lumia 1520 phablet and a larger 10.1-inch tablet in September.

Though many people believe Nokia's partnership with Microsoft may be what it needs to rebrand itself, there are still some who believe the relationship is limiting Nokia's options and driving it further toward collapse. The Economist posited in 2011 that abandoning its own Symbian operating system would decrease Nokia's profits per phone, but it acceded that Nokia had needed to improve its software to remain competitive. Nokia's strengths lie in its manufacturing and logistics and Microsoft's software expertise and large research budget make it a valuable partner.

Many people are concerned that Nokia is too reliant on Microsoft's operating system because they fear that if people lose interest in Windows Phone then the company will be left with no backup plan. Perhaps, though, if Google (NASDAQ:GOOG) makes an unpopular move to profit from Android's vast market share, other phone manufacturers will require an alternative operating system; as Windows Phone is the only real alternative, Nokia will have a head start. Regardless of whether the Nokia-Microsoft partnership is beneficial, Nokia is still hemorrhaging money and market share (Chart 4). A recent report by Pierre Ferragu of Sanford Bernstein projected that Nokia's stock will fall 50% mainly because of the relative insignificance of its phone manufacturing business - Nokia now earns just a third of what it used to earn per phone, according to the Marginal ASP metric. Therefore, even if Nokia's new plan to boost smartphone sales succeeds, it may not be enough to return to profitability.

The Microsoft Acquisition

The fact that Microsoft just announced that it will buy Nokia's smartphone and mobile handset business for $7.2 billion, means that Nokia had been cultivating a relationship of trust and that its great strides in reclaiming market share in the smartphone market had been appreciated. Though it may seem now that Nokia's "main" business has been acquired and there is no reason to hang on to Nokia's stock, it is not the case. Over the past few years, Nokia has been reducing its reliance on mobile devices and has been transitioning itself to become a telecommunications equipment manufacturing company. Its experience in the mobile device industry and its relationship with the American software giant, Microsoft, will help it succeed in its new core business of developing wireless networks.

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Nokia Solutions and Networks Role in Nokia's Future

Though Nokia is known as a mobile phone manufacturer, Devices & Services accounted for only 51% of its net sales in 2012. Its 50% stake in Nokia Siemens Networks (NSN), its telecommunications equipment manufacturing (TEM) business, accounted for 45% of its net sales (Chart 5). NSN has struggled to remain competitive ever since its 2007 creation, when Nokia and Siemens (SI) merged their TEM businesses, because of the industry's strong competition and the company's high operating costs. However, once NSN adopted a massive restructuring plan, cutting staff by nearly 20%, it reached profitability despite a sales drop of nearly 5%.

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In July, Nokia announced that it would take complete control over this joint venture by buying out Siemens's stake; it later renamed it Nokia Solutions and Networks. Nokia hopes to use NSN's strong financial situation as a counterweight to its more volatile mobile phone business as well as NSN's patents as a stable revenue source. Pierre Ferragu, the same analyst who's betting against Nokia said, "With this transaction, Nokia buys itself a future, whatever happens in smartphones and feature phones." He also opined that Nokia had made a good deal by paying half the estimated fair value of Siemen's stake. Trefis, a stock analytics company, believes that NSN will be the driving force behind Nokia's growth especially as NSN continues to increase profits by selling off non-core assets and focusing on its wireless infrastructure business. It has increased its market share in 4G LTE manufacturing from 13% in Q3 2011 to 22% in Q3 2012 and has significant room to grow in the United States where it already has a strong foothold and not much competition.

Not everyone is optimistic about Nokia's acquisition of Siemens's stake in NSN. S&P downgraded Nokia's credit rating days after the acquisition was announced because of fears that Nokia's diminished cash reserves will make it more vulnerable. George Kesarios of Seeking Alpha echoes these concerns. He suggested that Nokia should sell its stake in NSN to increase its cash flow and focus on its core businesses instead. Deutsche Bank maintained their "sell" rating on Nokia because of Nokia's dire financial situation and because it holds that Nokia has few avenues for growth and a high likelihood that its feature phone business will continue to suffer tremendously.

Whether or not the NSN acquisition was beneficial for Nokia, Chart 5 implies that a doubling of NSN's 2012 sales (as it now owns double the equity) would cause NSN to comprise more than 62% of Nokia's future net sales. Though Nokia's CEO, Stephen Elop, has said that he will keep NSN as a separate entity, analyst Chris Nicoll suggests that the strong relationship will allow Nokia to become more like Samsung and Huawei, which control both their mobile device and telecommunications equipment manufacturing. Additionally, NSN can help Nokia develop better relationships with American telecom providers who rely on NSN for their networking equipment.

Some Bright Spots in Nokia's Dire Financial Situation

Though Nokia's financial situation is no longer relevant as it is now flush with cash from the recent Microsoft acquisition, its ability to stem the tide of its financial decline shows the perseverance and competence in the company. It is clear that Nokia had been in a tough financial situation: it has been bleeding money since 2011, its market share is decreasing, and it has a "junk" credit rating. However, its recent restructuring has helped it slash costs and its acquisition of the remaining stake in NSN has given it a larger source of relatively stable revenue. Nokia has recently been able to decrease the rate at which its net sales have been decreasing so that it fell only 3% in the last quarter. It has also managed to increase sales in North and Latin America over the past quarter, two regions it has long struggled to penetrate. As Nokia is already moderately popular in Europe, perhaps a resurgent European economy can also help it boost sales.

Nokia Group has "achieved underlying operating profitability for the fourth consecutive quarter" and boasts "a strong balance sheet and solid cash position, with gross cash of EUR 9.5 billion and net cash of EUR 4.1 billion." Nokia has been able to improve its operating profit in both its Devices & Services business and NSN in the past year and has announced that it will continue to trim down expenses (Chart 6). Just as NSN was able to achieve profitability by shedding non-essential personnel and divisions while still experiencing declining sales, it appears Nokia Group is on its way to do the same.

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I Know First's Nokia Prediction

I Know First is a financial startup company that uses its unique algorithm to quantitatively predict the stock market. The stock forecast algorithm constantly updates itself as it processes new information and averages many independent models to output a continuous stream of signals that project the magnitude that each particular stock will move. (To learn more about the algorithm, see my article on Citigroup). The relatively high signals of Nokia indicate that the algorithm predicts that the stock will increase in the three-month time horizon (see Chart 7).

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Comparison of Nokia to Alcatel-Lucent

I Know First correctly forecasted Alcatel-Lucent's (ALU) meteoric rise, a company that shares many similarities with Nokia. Both companies are now shades of their former glory, part of the super-competitive telecommunications industry, and have struggled to remain profitable while enduring many consecutive quarters with negative profits. Just as Alcatel-Lucent carved out a niche for itself in specific telecom equipment manufacturing sectors, Nokia has seized a dominant role in releasing hardware that support Windows operating systems and NSN has been expanding its market share in the wireless infrastructure business.

Microsoft Buyout

Before today's announcement, most people thought that a Microsoft buyout of Nokia was slim; in fact Microsoft had been in "advanced talks" to acquire Nokia, but negotiations fell through in June because Nokia felt it deserved a higher valuation. Though Nokia knew it could benefit greatly from Microsoft's $66 billion in cash reserves, Nokia decided to continue its struggle to return to profitability through its own means. Nokia's confidence in itself indicated to investors that it believed it could overcome its present challenges. Despite the fact that there was no acquisition, the Microsoft-Nokia relationship remained strong and now that longtime Microsoft CEO, Steve Ballmer, has announced that he'll soon step down, many people have speculated that current Nokia CEO and ex-Microsoft executive, Stephen Elop, will take his place. Nokia proved to Microsoft that it deserved the higher valuation because it showed them that it was no longer desperate and it had a promising future with or without Microsoft.

Conclusion

Though Nokia is clearly in a much better position today than yesterday, it still has a long road ahead of it. Nokia still has a large stake in the success of Microsoft's new mobile phone business, as it earns money from licensing its mapping and other miscellaneous software. Now that its finances are in order and that it is no longer burdened by its cumbersome mobile devices business, Nokia has the potential to successfully transition itself into a major player in the TEM industry. It has the focus, experience, infrastructure, and relationships it needs to prosper in this new field.

Nokia's management has proven that it is highly capable by successfully increasing its operating income by cutting unnecessary spending and refocusing its product lines by adopting Windows as its primary mobile operating system. Nokia has shown its willingness to transition away from its mobile device business by acquiring the remaining stake in NSN. I believe that even though today's Nokia will be far different from yesterday's, Nokia shows great promise to become a major player in the telecommunications equipment industry.

Business relationship disclosure: I Know First Research is the analytic branch of I Know First, a financial startup company that specializes in quantitatively predicting the stock market. This article was written by Ethan Fried (Harvard College '16) one of our analysts. We did not receive compensation for this article (other than from Seeking Alpha), and we have no business relationship with any company whose stock is mentioned in this article.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.