Nokia: Finding $0.40-3.70 Upside In The Black Box

| About: Nokia Corporation (NOK)


With the Microsoft deal now closing, investors will have the opportunity to focus on what really matters: cash returns and the group's new strategy.

We do not see real synergies between NSN, Advanced Technologies and HERE, and believe that NSN could be next on the disposal list.

We are confident in M&A-driven upside at NSN, but believe that most of the valuation upside lies within Advanced Tech., also called the "black box".

The business is undervalued, but could trade in line with either Qualcomm or ARM if Nokia makes a disclosure effort: we see a 5%+ to 50%+ rerating potential for Nokia.

The Nokia (NYSE:NOK)-Microsoft (NASDAQ:MSFT) deal will finally close on Friday, April 25, as China approved the transaction and as minor adjustments have been made. Note that the Chennai plant's future remains uncertain and that this could lead to a temporary contract manufacturing deal between the two companies.

The closing should mark the beginning of the new Nokia and spark a rich newsflow, starting with Q1 earnings on April 29, probably followed by the appointment of a new CEO, the widely-expected announcement about shareholder returns and the presentation of the group's new strategy.

As for Q1 earnings, we would not expect a strong reaction on the stock market, either positive or negative, as Q1 and Q2 are traditionally weak quarters for most telecom equipment players and as Nokia hinted at a challenging H1. Nokia's NSN is currently engaged in some major network rollout projects that, in the early stages, involve the supply of lower-margin equipment, while higher-margin capacity upgrades come later in the contract cycle.

In all, we believe that the Q1 release will be overshadowed by the expected announcements about the special dividend/share buybacks (Nokia is expected to have $11bn in net cash by the end of the year) and about the group's new strategic plan.

NSN could be the next major disposal

Obviously, NSN (telecom equipment) and Advanced Technologies (patent licensing) will be in the spotlight, as they will account respectively for 65% and 30% of Nokia's Enterprise Value, according to consensus figures (EV will be equal to the equity valuation once the $11bn net cash position is returned to shareholders).

Source: AtonRâ, based on consensus figures

But in our view, the combination of NSN, Advanced Tech. and HERE (maps) offers very little synergies, and thus makes little sense. We have long been saying that NSN could merge with Alcatel-Lucent (ALU) or another peer in order to extract cost synergies, to gain increased exposure to the U.S. market and to better deal with the rising bargaining power of telecoms operators, which are consolidating at a fast pace in Europe. The closing of the Microsoft deal could now be the opportunity for Nokia to focus on the disposal of this asset at attractive conditions (most telecom equipment stocks are trading at multi-year highs).

We are therefore confident in M&A-driven upside at NSN. But we believe that most of the valuation upside lies within Advanced Tech.

Advanced Tech. is a no-brainer

Even if the 2014 guidance failed to impress ($828m revenues vs. consensus of $856m), we are convinced that Nokia has a great IP monetization opportunity ahead. First, Nokia is just starting to renegotiate some patent licensing deals as, until now, management was focused on the completion of the Microsoft deal. A greater management focus on this core division should pay off in coming quarters with growing royalties.

Second, Nokia will have the opportunity to gain new customers that could not work with the company previously due to its presence in the device business.

But more importantly, we believe that the patent business is significantly undervalued, something understandable in light of Nokia's lack of disclosure on this division. Analysts have indeed been complaining about this for a while, with several of them calling Advanced Tech. a "black box". Unsurprisingly, they apply a large discount when valuing the business.

Assuming $828m revenues and $580m EBIT (70% margin) for Advanced Tech. in 2014, the business is valued at 8.8x EV/EBIT. This is significantly below IP licensing peers, such as Qualcomm (NASDAQ:QCOM) and pure IP player ARM Holdings (NASDAQ:ARMH).

Source: AtonRâ, based on consensus figures

As we said above, we believe that the valuation discount is due to Nokia's secretive attitude regarding Advanced Tech. But as Advanced Tech. becomes core, Nokia will probably make a disclosure effort soon, likely to spark a rerating:

  • In a conservative scenario (Advanced Tech. trades in line with Qualcomm), the impact on Nokia's valuation would be $0.40/share (5%+).
  • In a best-case scenario (Advanced Tech. trades in line with ARM), the impact on Nokia's valuation would be $3.70/share (50%+).

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.