Halloween may be over, but the communications industry still has a few zombies at play. Investors have been rushing to the exit for both Research in Motion (RIMM) and Nokia (NOK), yet buyout rumors still remain very much in the air. First came the former's relentlessly descent. Then came the takeover of Motorola Mobility Holdings (MMI) by Google (GOOG), which accelerated market excitement and resulted in talks about "mobile consolidation". During the month period that the buyout was announced, RIM appreciated more than Nokia - a probable, although limited, sign that the market values the Blackberry-maker more as a takeover target. Indeed the RIM's enterprise value now trades at 1.82 EBITDA and still holds arguably considerable value in patents. However, I find that Nokia is more likely to be taken over due to better stability (beta of 1.55 versus 1.86), sustainable cash flow generation, liquidity, and dividend distributions.
Nokia may be trading at a respective 26.9x and 18.7x past and forward earnings, but its dividend yield of 8.5% is staggering and reduces risk substantially. With an interest coverage of 10.4 and a free cash flow payout ratio of 46.6% as of mid-July, I believe that the company is in strong financial position to continue to return this level of cash to shareholders.
In addition, the communications firm has $7.7B worth of net cash, representing about one third of its market value. Comparatively, Research in Motion has less liquidity with just slightly more than a tenth of its market value represented by cash. The talk about Carl Icahn taking a stake in the company has also yet to materialize any proof, while Jaguar likely has too little ownership to produce a successful activist campaign. As I underlined in an earlier article, declining sales at RIM could severely impact liquidity to the extent that an activist campaign would be limited in growing shareholder value. Nokia, on the other hand, remains in an interesting position given its metrics and connections to Microsoft (MSFT).
At the third quarter earnings call, CEO Stephen Elop pitched the company's future as one of "transformation":
"I am encouraged by the progress we made during Q3, while noting that there are still many important steps ahead in our journey of transformation …
In summary, in Q3 we started to see signs of early improvement in many areas, but we must continue to focus on consistent progress so that we can move Nokia through the transformation and deliver superior results to our shareholders."
Could this transformation entail a buyout? I believe so. Microsoft has $42.6B worth of net cash - more than double the enterprise value of Nokia which now trades at below 5x EBITDA. In addition, Microsoft has a strong partnership with Nokia currently and remains vital to the mobile company's success. Management at Nokia is pushing its Windows-based Lumia 800 and Lumia 710 and is undergoing restructuring in R&D. Its manufacturing facilities are being made more efficient, its assets consolidated, and its marketing revamped. At the same time, Microsoft is undergoing its "cloud renaissance" as I detail here.
The two would make a perfect fit by enabling Microsoft to stay alive in the mobile market against Apple's (AAPL) iOS and Google's Android - the latter of which continues to eat away at the competition. Although, Windows is modeled to increase international market smart phone shipments to around 14% in 2013 from 4% in 2010, in terms of market share, it is struggling with growth. Reviews of Mango may be positive, but like Nokia, Microsoft's products have largely lost their "cool" to the always-emotional consumer. Over the last twelve months, Nokia has lost ~2100 basis points of the smart phone market. And Windows HD2 experienced considerable returns after a popular initial launch.
The battle in the smart phone market is, however, far from over for both firms if they team up. A takeover of Nokia could unlock revenue and cost synergies while generating substantial cash for Microsoft that can then be then leveraged to getting its cloud capabilities out into the market. Integration of Office into mobile is one such catalyst that, in my view, can easily win over the emotions of technology consumers. As I explained in "The Future of The Apple, Inc. Craze", here, technology is often nothing more than a craze. Although that may sound sinister, the truth is, trends come and go more in technology than arguably anywhere else. Put differently, "supply creates its own demand".
In terms of sales, investors are expecting sequential growth in devices & services - with 18M dual SIM device shipments experienced in the third quarter. Towards this end, Nokia is launching its first smart phones that run Symbian Belle while improving inventory levels to keep up with demand. The key value driver going forward will be in Asia, as opposed to Europe, where the firm has a major opening to penetrate the market. Should Microsoft acquire Nokia this process would be made only easier.
Consensus estimates for EPS are that it will decline by more than a third to $0.53 by 2013, while gaining in the last year. I model revenue declining by roughly 12.8% from 2011 to 2012. With analysts rating the stock a "hold" and the valuation not exactly cheap, investors may benefit from higher risk-adjusted returns while, ironically, receiving one of the highest dividend yields in the market as a takeover candidate.