NSN offers needed reassurance
While Nokia (NYSE:NOK) had hinted at a challenging H1 a few months ago, Q2 was finally a good surprise, with EPS exceeding expectations (EUR0.06/$0.08 vs. EUR0.04/$0.05). NSN was the major contributor to the beat (EUR281m/$378m operating income vs. consensus at EUR194m/$261m), confirming our view that concerns following the Q1 release were overdone.
NSN's Q2 operating margin reached 11%, well above consensus expectations of 8%, leading Nokia to raise its FY outlook for NSN margins to be "at or slightly above" (vs. "towards") the higher end of the 5%-10% range. Interestingly, the 11% margin was only slightly down year-on-year (-80bps), despite declining revenues (-8%), showing an increasing financial discipline. While cost-cutting efforts are paying off, it's also quite obvious that NSN has become picky when it comes to signing new contracts, with a clear focus on profitable deals. We believe that increased financial discipline is now a major trend among western equipment vendors, such as Alcatel (ALU), enabling the industry to weather poor business conditions… and to gun for a strong operating leverage when the top line momentum improves.
Advanced Tech. remains the key valuation driver: 6% to 60% upside
While NSN was the star performer in this release, Advanced Technologies (patent licensing business) also delivered, with a step-up in revenues to EUR147m from EUR131m in Q1 (Microsoft contribution) and with operating income up 7% year-on-year.
We believe that Advanced Technologies, which accounts for 30% of Nokia's Enterprise Value (see our previous article "Nokia: Finding $0.40-3.70 Upside In The Black Box), will be a key catalyst going forward, as Nokia has a great IP monetization opportunity. 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.
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 around 9x EV/EBIT. This is significantly below IP licensing peers such as Qualcomm (NASDAQ:QCOM) and pure IP player ARM Holdings (NASDAQ:ARMH), which are trading at 34x and 11.6x 2014 operating income respectively.
As Advanced Tech. delivers and becomes less opaque for investors, it's likely to rerate towards Qualcomm's and ARM's valuation levels, hinting at a 6% to 60% upside for Nokia.
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