Nokia: Just The Beginning Of The Synergy Story

| About: Nokia Corporation (NOK)

Summary

Both Nokia and Alcatel-Lucent are in strong shape just ahead of their full combination.

The uninspiring 2016 revenue outlook should not overshadow that Nokia is a compelling synergies/margin story heading into the first year of the merger.

In our view, the synergy upside is significant and is far from being reflected in the current stock valuation (12.4x/10.2x 2017/18 P/E).

Following the disappointing Samsung arbitration outcome and reduced revenue expectations for its Technologies unit, Nokia (NYSE:NOK) had to reassure about the strength of its core Networks business. In our view, Nokia and Alcatel-Lucent's (ALU) Q4 earnings reports did the job last week.

While Nokia Networks' top line was soft (-12% at constant FX) due to continued weakness in the telecom infrastructure market, this was offset by a stronger-than-expected 14.6% margin, well ahead of expectations thanks to a better mix (more software) and continued cost control. Over the full year, Networks delivered a 10.9% margin, at the high-end of the long-term 8-11% target.

Alcatel-Lucent (now owned at 91% by Nokia) managed to beat on revenue despite adverse market conditions thanks to a solid performance in optical and US wireless and to exceed its Shift Plan targets (EUR1.03bn/$1.14bn cumulative fixed cost savings vs. EUR950m/$1,055m expected), leading to significant margin and cash flow upside (EUR1.0bn/$1.11bn vs. a consensus of EUR400m/$444m).

In all, the combined Networks businesses delivered an EBIT of EUR972m/$1,079m in Q4, 9% above consensus, suggesting that neither Nokia nor Alcatel have suffered any business disruption in relation with their announced merger and that both companies are in strong shape just ahead of their full combination.

That said, Nokia refrained from providing a 2016 guidance and simply stated that Q1 would be particularly challenging (worse than normal seasonality) and that the wireless infrastructure market should decline in 2016. In light of rising macro concerns, Nokia's conservative stance should not come as a major surprise. In addition, this uninspiring revenue outlook should not overshadow that Nokia is a compelling synergies/margin story heading into the first year of the merger with Alcatel-Lucent, as illustrated by the company's second positive synergy update in a row.

While Nokia had announced at the time of Q3 that its EUR900m/$1,000m merger synergy target would be reached one year earlier than expected (2018 vs. 2019), last week it brought forward by a year (2016) its yearly EUR200/$222m interest expense savings target.

This confirms our view that Nokia's opex savings target is conservative and leaves scope for major upside. Wireless alone could provide EUR500m/$555m synergies assuming Alcatel's Wireless unit (revenue slightly below EUR5bn/$5.5bn, low operating margin) performs in-line with Nokia's own Wireless business (double digit margin). In this case, Nokia would have to cut Alcatel's costs by only EUR400m$444m, or 1.6% of the combined entity's revenue, to reach its EUR900m/$1,000m savings target. This appears easily achievable in light of past sector transactions.

And importantly, Nokia's expected synergies do not include Alcatel-Lucent's huge tax loss carryforwards (EUR13bn/$14.4bn) that could give a massive boost to its earnings should the Finnish company get the opportunity to use them.

In our view, this upside is far from being reflected in the current stock valuation. On consensus estimates, Nokia would generate an operating margin in a 12-13% range and an EPS around EUR0.45/$0.50 in 2017 and a 13-14% margin and EUR0.55/$0.61 EPS in 2018. That would put the stock on a 12.4x/10.2x 2017/18 P/E, a level we view as too low in the tech sector for an above-average earnings growth outlook, significant earnings upside (thanks to the above-mentioned synergies) and expected shareholder returns.

Disclosure: I am/we are long NOK.

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.