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Nokia (NYSE:NOK) announced a mixed set of Q1 2014 results on April 29th, as sustained top-line weakness in its networks business caused revenues to decline by 15% year-over-year, but margins improved on a higher mix of software sales and strong cost controls. The company continued to see its networking services revenues shrink on the back of divestitures and contract exits in unprofitable regions. This impact was somewhat offset by healthy demand for mobile broadband infrastructure among carriers, especially in regions such as China and Western Europe where the transition to 4G LTE is beginning in earnest. Although Europe remained challenging during a seasonally weak first quarter, the company has built a strong pipeline of orders on a number of recent contract wins that should bolster sales towards the latter half of the year. A second-half revenue boost is expected in the U.S and China as well, with carriers such as Sprint (NYSE:S), China Mobile (NYSE:CHL) and China Telecom (NYSE:CHA) expected to substantially increase their network spending.

The company also appointed Rajeev Suri, the erstwhile CEO of Nokia’s networks division (NSN), as its new CEO, and outlined a strategy to return excess cash to shareholders, following the close of the sale of its handset business to Microsoft (NASDAQ:MSFT) last week. The deal is expected to net Nokia about Euro 5 billion in cash after taxes and other considerations – lower than our previous expectation of euro 5.44 billion. The company plans to return around 60% of this amount to shareholders through dividends and share repurchases planned over two years, and use the rest to decrease its debt load, optimize its capital structure and improve its debt rating. This should leave the company with upwards of euro 5 billion in cash in a year’s time which, together with a strong credit rating, will provide it with enough ammunition to consider acquisitions for bolstering its networks and HERE maps businesses. Our $7.30 price estimate for Nokia is about in line with the current market price.

NSN Banks On LTE Transition

The sale of the handset business has made NSN the biggest contributor to Nokia’s value, accounting for almost half of its total value by our estimates. It is therefore not surprising that NSN’s CEO, Rajeev Suri, was promoted to CEO of the whole company. At the helm of NSN, Suri is credited with turning the division around to sustained profitability on the back of a big restructuring program that cut its operating expenses by Euro 1.35 billion and increased its focus on mobile broadband. However, the transition has taken a toll on NSN’s top line, which declined last quarter by 17% year-over-year as the company exited unprofitable service contracts, primarily in EMEA and Latin America. Excluding the impact of divestitures, contract exits and currency fluctuations, Nokia’s Q1 networks revenues declined by just 6% over the same period last year – an improvement from the year-over-year decline of 12% in the previous quarter.

Going forward, rising 4G LTE deployment activity, especially in regions such as China and Western Europe, should help offset some of the service declines. NSN has done well in winning LTE contracts with China Mobile and China Telecom, and is on track to become the leading foreign player in the Chinese LTE buildout. These deals have started bringing in revenues, with China being the only region worldwide in which NSN saw yearly growth in revenues last quarter. Although European sales have been slow to recover, the deal pipeline looks strong as carrier spending returns amid receding macroeconomic uncertainty. In Europe, NSN has won two large LTE contracts with Everything Everywhere and Vodafone, which should help stabilize revenues in the second half of the year. NSN’s contract win at Sprint is also unlikely to prop revenues until the second half, with the carrier unlikely to splurge on its Spark program before the completion of its initial LTE layout by mid-2014.

NSN’s operating margins in Q1 were boosted by a higher-than-expected gain in software sales in Japan, growing by 230 basis points over the same period last year. This offset the impact of some low-margin deals that the company took in strategically important countries such as China to bolster its LTE standing. With software sales unlikely to contribute as much to margin growth going forward, NSN could face near-term margin pressure. However, NSN expects a strong recovery later in the year to more than offset the dilutive impact of such deals to post margins towards the high-end of its long-term guidance of 5-10%.

Licensing Opportunity Increases After Microsoft Deal

Nokia’s licensing business, which is the only remnant of the erstwhile Devices and Services unit, accounts for almost 15% of its overall value by our estimates, and is its second most important division after networks. Our price estimate accounts for only a modest increase in royalty revenues going forward, since there is a lot of uncertainty regarding the timing and contractual terms of such deals. However, there could be a significant upside to our estimated value if Nokia manages to better monetize its huge patent portfolio. That Nokia no longer has a handset business to defend through cross-licensing deals should allow it to renegotiate its existing royalty rates when the agreements come up for renewal in the coming years. Also, Nokia expects its annual licensing revenue run-rate to increase by 20% this year to Euro 600 million now that Microsoft has bought its handset business and has become a more significant IP licensee.

The company recently extended its patent licensing contract with Samsung, 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. Nokia scored another big patent win last quarter, signing a licensing agreement with HTC (OTC:HTCCY) in exchange for dropping litigation in many countries. Such patent deals could get the ball rolling for more such agreements, especially with a number of Asian handset manufacturers that are gaining share in emerging markets. Nokia clarified during the earnings call that it has made no concessions to regulatory bodies during the review of its Microsoft deal that might limit its licensing opportunity in the coming years.

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