In the recent weeks, a lot of investors are cheering the "new Nokia" (NOK), which is expected to be far more profitable than the "old Nokia" because it kept the most profitable parts such as the networking infrastructure business while getting rid of its money-losing handheld devices business. While things surely look nicer for the company as we move ahead, I would also be cautious about painting a rosy picture.
Last quarter, Nokia's Solutions and Networks (back then known as Nokia Siemens Networks) posted impressive results. The business unit's operating margin was 11.8%, which is much higher than competition such as Ericsson (NASDAQ:ERIC) or the Chinese companies (like Huawei and ZTE). NSN's strong margins were highly surprising, because telecommunication networking companies tend to have single-digit operating margins. For example, Ericsson's 2012 operating margin was 4.59% and the company's operating margin for 2011 was around 8.10%. The Chinese companies have even lower margins.
Since Nokia's networking business achieved unusually strong margins, this led analysts to ask some questions in Nokia's latest earnings call. More specifically, Andrew Gardiner from Barclays asked: "I was just wondering if you could shed a little further light on the need for additional restructuring there, particularly given that NSN has been solidly reporting very nice gross margins, high-single digit, low-double digit margins, better than peers who are significantly larger than you. Are you planning on making cuts here ahead of a potential for decreased revenue opportunity in future periods? Just any additional color would be helpful."
To this question, Stephen Elop's response was: "Yes, let me take that. I think the way to think about this is, this is something we all see and learn as we go through restructuring cycles. That is, you tend to take the big first steps to really restructure the company, get it focused on its core business, make the structural changes organizationally, to the sales organization, what have you. And as you get through that, what you begin to see are new opportunities for fine tuning, for tightening things down in certain areas. So I wouldn't interpret this at all of any forward-looking indicator of what we anticipate. It's more there is an opportunity there to continue to manage the business tightly, make sure we are keeping OpEx at the right levels, while still ensuring, particularly important, that is heavy R&D investments available to us to continue to compete effectively. So I wouldn't interpret anything other than there is opportunity there that gets uncovered as we have gone through the major rounds of restructuring we saw over the last year."
Following this, Gareth Jenkins from UBS asked a more specific question about NSN's margins and Timo Ihamoutila, the CFO of Nokia responded by saying that NSN's long-term operating margin target was somewhere between 5-10% (mid-point falls between 7-8%). In fact, Nokia's guidance for the third quarter included an operating margin of 7.0%, which is more like normal.
Keep in mind that this is still good because NSN was not very profitable for a long time. In 2007, Nokia Siemens Networks was newly founded and it generated $17.41 billion in revenues and $1.7 billion in operating loss. The next year, it generated $19.90 billion in revenues and $430 million in operating loss. In 2009, NSN generated $16.34 billion in revenues and nearly $2 billion in operating loss. As the losses continued, both Nokia and Siemens (SI) had to inject money in the joint venture in order to keep it alive. Thankfully, Nokia's phone business was highly profitable during that time and this didn't create a problem for the company. In 2010, NSN's loss was near $1 billion and 2011's loss was $400 million. Last year was the first time in the history NSN was profitable. In the future the company is likely to stay profitable but there is no guarantee here.
NSN is in an industry that is difficult to predict. The company chases many contract opportunities around the world in order to generate revenues. Sometimes it captures high-margin contracts, sometimes it has to make concessions to grab a contract. A lot of times contracts will not have much of a margin. Some quarters you will get lucky, some quarters you are not so lucky. When analysts are estimating Nokia's future earnings, they make the mistake of assuming 12% operating margins in the future, even though the company sees last quarter's operating margin as a peak.
Nokia's mapping business has also struggled to stay profitable for the last few years but it is still in its infancy and there is still potential for it to grow into something big if it's used right. Having said that, the losses of HERE will most likely more than offset by the profits from Nokia's patent portfolio which has more than 40 licensees around the world.
If NSN generates $18 billion in revenues with 7% operating margin, its operating profit will be $1.26 billion. Just to be conservative, let's say that HERE posts a loss and it gets offset by Nokia's patent business. Considering that Nokia will have a net cash position of $10 billion after the acquisition, and assigning a P/E value of 15, the company's value should be close to $30 billion. Currently Nokia is worth $25 billion, so there is still some upside left. Of course, the company could easily outperform my conservative estimates.
For the time being, I am still out of Nokia and I might wait until next year to initiate another position in the company.