Since the day Nokia (NOK), and Microsoft (MSFT) signed the partnership agreement in 2011, there has been speculation that Microsoft will buy Nokia's handset business. These speculations finally came true this month, when Microsoft announced the acquisition. What becomes of Nokia after selling off its devices and services business? It's surprising to find that, a company which was known as a leader in handsets, derives around 46% of its revenue from wireless infrastructure. Nokia is now in a better position to focus on its other promising segment, Nokia Solutions and Networks, or NSN. Let's discuss how Nokia can take advantage of this opportunity.
What's the fuss all about
On Sep 3, 2013, Nokia agreed to sell its devices and services business and patent licenses to Microsoft in a deal worth $7.2 billion. The deal is expected to close in the first quarter of 2014. This deal is Microsoft's move to jump start its presence in smartphones. It has failed to make any substantial gains with Windows phone in its partnership with Nokia, due to duopoly of Google's (GOOG) Android, and Apple's (AAPL) iOS. Microsoft has a limited presence in hardware business, apart from its Xbox gaming consoles. By acquiring Nokia's phone business, Microsoft is increasing its hardware exposure. With the acquisition of Nokia's phone business, Microsoft hopes to achieve 15% share of smartphone shipments and reach 1.7 billion units by 2018.
We believe Microsoft can accelerate the growth trajectory of Windows smart-phones by taking control of product development and marketing its Windows phone. Due to the growing popularity of cellphone internet usage, Microsoft could grab a golden opportunity by marketing its Windows phone. Nokia has the second largest mobile phone sales globally with a share of 14% in second quarter of 2013. Microsoft could leverage Nokia's large user base and upgrade these users to the Lumia series. The biggest hurdle lies with the Microsoft app store; it has only 160,000 apps and games in comparison to Google's 700,000 and Apple's 850,000. In our view, Nokia's windows phones are not likely to benefit from Microsoft's ownership, unless Microsoft accelerates the Windows app marketplace to compete against Google's free android platform, and Apple's iOS.
Oppenheimer has estimated that Nokia's net cash position after the deal would be $9.47 billion. It's likely that Nokia will use the cash to pre-pay its existing debt and distribute cash to the shareholders. Devices and services contributed roughly 50% of Nokia's revenue in 2012, with NSN representing 90% of the other half. The NSN segment is a specialist in telecommunication and networking equipment, especially 4G LTE. Its operating margin of 11.8% is the highest among its segments. Devices had a negative operating margin of 1.2%, and "HERE", mapping and location services, had a positive margin of 3.4% in the second quarter of 2013. For a long time Nokia used its cash from NSN to keep its devices business running, but after the sell-off, we believe that Nokia will be able to focus on its profitable NSN segment.
What's next for Nokia?
After the acquisition, Nokia will have three business segments: NSN, HERE, and Advanced Technologies, responsible for technology development and licensing. With NSN contributing a meaningful part of Nokia's revenue, the spotlight shifts to this segment. It also assumed full control of its Nokia Siemens Networks, now known as Nokia Solutions and Networks, or NSN, after buying 50% of its stake from Siemens in July 2013.
Under this segment, it recently obtained orders from leading telecom providers to upgrade their network. NSN will implement the LTE network for Tele2 Netherlands and supply network related infrastructure to enable 4G services. Similarly, NSN also struck a $200 million deal with Mobile Telesystems (MBT), a leading telecom operator in Russia, to supply 4G-LTE related instruments in Central Russia and Moscow. Moving forward, we expect more investment in 4G LTE networking, and NSN will be the direct beneficiary for the same.
With the help of NSN, Nokia has been showing some strength after struggling for the past few years. NSN is building a strong position in networking, and it could contribute to the company's turnaround. Thus, with the help of new orders, NSN's revenue could show some growth after declining in past two quarters. The device and services segment will no longer drain the profitability of the NSN segment. NSN will benefit from the growing demand for 4G service, and the future of this segment looks bright with the need for worldwide upgrades of broadband services.
Heated competition in 4G-LTE
The global demand for LTE is rising and so is the investment in LTE infrastructure. According to Informa Telecoms & Media, Huawei, and Ericsson (ERIC) accounted for 40% and 34% of the global LTE contracts respectively, while NSN received 17% of the contracts.
In the buildup towards 4G auctions in China, telecom providers have increased their infrastructure to capitalize on this 4G revolution. China Mobile (CHL), the largest mobile company in terms of subscriber base of 740 million, leads the race to grab this market. In its initial spectrum auction in August 2013, which was worth $3.2 billion, China Mobile awarded Huawei and ZTE (OTCPK:ZTCOF) (OTCPK:ZTCOY) 50% of the contract, and it awarded the rest to various European manufacturers. NSN received 10% of the contract.
We think that 4G-LTE will continue to ramp up at a rapid pace worldwide and will be the driving force for these equipment manufacturers. These companies have the technological expertise and infrastructure; therefore, each will continue to attract new contracts in the coming years.
Since the start of 2008, Nokia's stock price has been declining, and it has lost around 67% of its value. The Microsoft deal has helped Nokia to regain some of its value, but looking at future growth in its NSN segment, we believe there's more potential for Nokia.
NOK data by YCharts
From the valuation point of view, Nokia is trading at a cheap valuation with an EV/EBITDA of 5.96 times in comparison to Ericsson's 9.49 times and Alcatel's (ALU) 7.85 times for the trailing twelve months. Although both Nokia and Alcatel showed losses in the past two quarters, Nokia hopes to turn the table and show positive earnings with the sale of its unprofitable devices and services segment and new contracts in its NSN segment.
Nokia has radically transformed its investment case in 2013, buying its 50% stake in NSN the segment and selling its devices business. We believe Nokia is an attractive investment option.