Nokia's (NYSE:NOK) stock has almost doubled in value since it announced its decision to sell its loss-making handset business to Microsoft (NASDAQ:MSFT) about three months back. From less than $4 at the time the deal was announced, Nokia's shares shot up to nearly $8 as investors recognized the value that the deal had helped unlock. The sale not only helped Nokia offload a risky asset that was being negatively valued by investors, but also bolstered its cash position by over $7.2 billion. More importantly, the deal let Nokia keep its patents which, freed from being used only to defend its handset business, could prove even more valuable as an income-generating asset going forward.
The stock is trading close to our $7.75 price estimate for Nokia, which we believe is fair value given its current royalty run rate of Euro 500 million and the uncertainties associated with the timing and royalty rates of future licensing agreements. However, there could be a significant upside to our price estimate if Nokia manages to monetize a greater proportion of its patent portfolio and is able to renegotiate existing contracts at higher rates when they come up for renewal in the coming years.
Nokia's IP Clout
As a result of the high R&D spend incurred over the past decade, Nokia has built a very strong patent portfolio, comprising close to 16,000 issued patents and 4,500 pending patent applications in the U.S. Outside the U.S., the company has over 20,000 patents (both issued and pending) with a majority of them in Europe.  Nokia's patents stand out not just in their sheer numbers but also quality. In a 2011 review of the 3,000-plus patents considered essential to 4G LTE technology, Thomson Reuters and Article-One found that Nokia held close to 19% of the standard essential LTE patents and was the LTE leader by a big margin.  Qualcomm, the dominant mobile chipset manufacturer, trailed Nokia with a share of about 12.5% of the LTE patents deemed the most essential.
Nokia's LTE patents are likely to become even more valuable with time as carriers around the world transition to the wireless standard and a greater number of handsets support 4G. Additionally, it should be noted that Nokia's patents are not just limited to LTE but also include Wi-Fi and older 2G/3G technologies such as GSM, GPRS, EDGE and W-CDMA. In fact, Nokia likely has a greater grip on these patents considering the much bigger role it had played in the development of the older mobile technologies in the 1990s than the more recent LTE standard. Although LTE holds much promise for the future, we expect handsets to remain compatible with many of these older technologies well into the future. This should give Nokia an opportunity to grow its licensing revenues going forward.
Upside Potential For Licensing Arm
However, despite possessing a strong portfolio, Nokia has not been able to monetize its patents as well as Qualcomm has in the past. At the current revenue run rate, Nokia's IP licensing arm will generate about 500 million Euros ($685 million) in royalty income this year. We estimate that about 1.8 billion mobile phones will have been shipped globally in 2013, which at an estimated average selling price of about Euro 100 ($135) would account for about 1.8 billion Euros ($240 billion) in revenues this year. This brings Nokia's royalty rate to about 0.25% for every handset that is sold globally. In comparison, Qualcomm collects a licensing fee of about 3.2% on the ASP of each device containing its technology.
The reason why Nokia's royalty rate is so low is that it has historically never used its patents to generate revenues, unlike Qualcomm. When Nokia had its handset business, it was more concerned about protecting its IP for use in its devices as well as cross-licensing them so as to reduce its costs of licensing rivals' patents. As a result, Nokia has only licensed out about 10% of its patent portfolio, which are standard-essential and are required to be licensed to others at fair and reasonable rates. On the other hand, Qualcomm doesn't sell mobile phones and is therefore able to license out the breadth of its patent portfolio to handset manufacturers. As a result, while Qualcomm has over 250 patent licensees paying it recurring annual royalties currently, Nokia has only about 40. 
With the sale of its mobile device business though, Nokia is free to license the rest of its patents as well as bring more of its erstwhile handset rivals under the fold of its essential patents. It also faces less danger of being countersued, and should therefore have greater bargaining power in setting patent licensing terms going forward. If the overall handset market grows to about $300 billion in the long-term (25% ahead of our 2013 estimate) and Nokia is able to reach a royalty rate of 1% as it aggressively pursues patent licensing deals, it could be generating about $3 billion in royalty revenues alone going forward. Assuming an EBITDA margin of 85% (as related costs would be very low) and a tax rate of 20% (Finland's corporate tax rate from 2014), Nokia could be adding another $1.2 billion to its cash flows from patent licensing deals going forward. By our estimates, such a scenario could add another $4.5 billion to Nokia's valuation, or about $1.20 per share. This implies a 15% upside to our price estimate.
Opportunities and Risks
There could be an even bigger upside to our estimates if Nokia is able to negotiate better licensing deals and add more patent licensees in the coming years. It recently extended its patent licensing contract with Samsung (OTC:SSNLF), which would have otherwise expired by the end of 2013, by another five years. The companies haven't agreed on the royalty rate and other contractual terms yet, but expect to settle through arbitration in 2015. Patent deals with Samsung and HTC, with which Nokia has multiple IP lawsuits pending in many countries, could set the ball rolling for more such deals, especially with a number of Asian handset manufacturers that are gaining share in emerging markets.
However, the timing of such deals is uncertain considering how long patent lawsuits can take to settle. It is also tough to ascertain the royalty terms of such deals that are usually shrouded in secrecy. Also, Nokia could face regulatory issues while negotiating licensing terms. The European Union has appeared concerned about Nokia misusing its patent strength to charge high royalty rates for licensing out its portfolio. While speaking at a conference earlier this month, European Competition Commissioner Joaquin Almunia said that he would have no qualms launching an antitrust case against Nokia should the company act as a patent troll in enforcing its IP.  This could potentially limit the royalty rates that Nokia can charge for its patents going forward.
Disclosure: No positions.