More than five months ago, I called Nokia (NOK) a "zombie stock" here. Since then, the stock has lost more than a third of its value. The company made a lousy attempt to gain traction through forgettable products, like the Ovi App Store and Symbian OS. The tide looked like it was changing when the company partnered with Microsoft (MSFT) - becoming the leading manufacturer of the software-maker's Windows Mobile product. The company's alert that it was bleeding in its lower-end phone business sent shockwaves across the Street. Analysts subsequently slashed price targets and investment recommendations.
But the reaction may have been overblown. In this article, I will run you through a DCF model on Nokia and then triangulate the result with an exit multiple calculation and a review of the fundamentals compared to Cisco (CSCO) and Alcatel-Lucent (ALU). I find that Nokia is now meaningfully undervalued.
First, let's start with an assumption about the top-line. Nokia finished FY2011 with 38.7B euros, an 8.9% decline from the preceding year. I model growth trending from -7% to 2% over the next half decade or so.
Moving on to the cost-side of the equation, there are several items to consider: operating expenses, capital expenditures, and taxes. I model cost of goods sold as 69% of revenue versus 11% for SG&A, 13.4% for R&D, and 1.5% for capex. These figures are around historical 3-year average levels. I estimate that taxes will be 20% of adjusted EBIT (i.e., excluding non-cash depreciation charges to keep this a pure operating model.)
We then need to subtract out net increases in working capital. I estimate that this figure will be at around 1.7% over the explicitly projected time period.
Taking a perpetual growth rate of 2.5% and discounting backwards by a WACC of 10% yields a fair value figure of 4.94 euros. That is a 60% premium to what the market currently assesses. Now, the market currently is factoring in a WACC of 20%, which is frankly absurd. With the bar set low, investors have a substantial opportunity for high risk-adjusted returns.
All of this falls within the context of the company beginning its "second life", so to speak. As management puts it:
"The fourth quarter of 2011 marked a significant step in Nokia's transformation. As I have shared in my previous remarks, a transaction of the magnitude on which we have embarked is significant.
And while we progressed in the right direction in 2011, we still have a tremendous amount to accomplish in 2012 in order to properly position Nokia for sustainable long-term growth. We are now in the heart of our transaction. Most notably, in Q4 we introduced new mobile phones and smartphones, further evidence of the strategy shift in our Devices & Services business".
According to FINVIZ.com, analysts believe that fair value of the company is at a 40% premium to today's price. While Nokia offers high risk-adjusted returns, I still find that there are other undervalued picks with greater safety. Cisco trades at a respective 15.5x and 10x past and forward earnings. And Alcatel-Lucent trades at just a respective 5.4x and 6x past and forward earnings. Both of these are substantially discounted to Nokia's 16.1x forward multiple.
Consensus estimates for Cisco's EPS forecast that it will grow by 13.6% to $1.84 in 2012, and then by 7.6% and 8.1% in the following two years. Assuming a multiple of 14x and a conservative 2013 EPS of $1.93, the stock would hit $27.02 for 36.1% upside. For a company that is in a much less precarious position than Nokia, Cisco is an investment worth making.
The ride for Alcatel-Lucent is rockier. Consensus estimates for the company's EPS forecast that it will decline by 40.4% to $0.28 in 2012, grow by 17.9% to $0.33 in 2013, and then decline by 51.5% in 2014. The stock is expected to lose business, which may actually make the company a takeover target. If a larger firm believes it can "turn the tide", apply a tourniquet to the losses, and expand products to a wider base, the revenue and cost synergies may very well be substantial. Accordingly, like Nokia, I recommend Alcatel-Lucent only as a speculative investment.