Nokia Ready To Soar On Lumia 900 Success

| About: Nokia Corporation (NOK)

By Matthew Smith

At the end of March, Nokia (NYSE:NOK) was trading around $5.50 per share. By the middle of April, its shares dipped under $4 as the company reduced its profit margin in the Device and Services segment for the first quarter of 2012 to a negative 3%. Following this announcement, a few days later, Moody's reduced Nokia's rating to Baa3 (still investment grade) with a negative outlook.

Many investors commented that this was the final straw for the company and the stock price nosedived. I believe this is a temporary situation and a knee jerk reaction by Wall Street due to Nokia's threat to Apple's (NASDAQ:AAPL) virtual monopoly. At this point, only a few weeks after its launch, it is too early to estimate the success of the Windows phone although the early signs point to good acceptance. Also, Nokia is cash flow positive, has nearly $15 billion in cash, and the downgrade in its stock, while a negative, is something that should not affect the shares to the extent that it did. If I could respond with one word to the recent negative news and drop in Nokia's share price, it would be "buy."

When Nokia reduced its quarterly result in the beginning of April, I think investors did not notice a few positive comments such as a decrease in inventory and the sale of over 2 million Lumia phones through AT&T (T). Lumia phones started selling late in the first quarter of 2012 and the two million sales number is pretty impressive for about one month of sales. How many Android or even iPhones were sold in the first few weeks? In my opinion, the new Nokia Lumia will not be the next Zune (Microsoft's (NASDAQ:MSFT) failed MP3 player), as Microsoft is providing the software, and Nokia providing the hardware, with the integration done by both. It makes sense to have a partnership, as both companies excel in different areas.

Looking closer at Motorola Mobility Holding's (MMI) income statement, the company had sales of $13 billion in 2011 and gross profit of $3 billion. For comparison, Nokia had revenue of $50 billion and gross income of $14 billion. Nokia's income and gross profit is over four times that of Motorola Mobility, yet Nokia's valuation is less than two times that of Motorola Mobility. I wonder if this means Motorola Mobility is overvalued or if Nokia is undervalued. Or maybe both?

I think that a Nokia Windows phone can be successful in developed countries as well as developing countries. On one hand, Nokia does not necessarily need to sell a sub $200 phone in developing countries to be successful. All it needs to do is offer good quality, a decent camera, Wi-Fi, FM radio, hardware compatibility, and software (such as Microsoft's Skype) which I think Nokia and the Lumia in particular does. On the other hand, it would be much easier for users in emerging markets to integrate their Windows phones with Windows computers.

According to several sources, Nokia will launch a Windows 8 tablet by the end of this year. Research In Motion (RIMM) as well as Hewlett-Packard (NYSE:HPQ) tried to launch a tablet unsuccessfully based on their own operating systems. Nokia is focused on communications and is a leader in near field communications. I would not be surprised if we see in the next one to two years a Nokia Windows 8 tablet paired with a small Nokia phone that "talks" through the tablet.

It is difficult to see where the Microsoft and Nokia partnership will go. I think there are three possible paths. First, the partnership does not start well, Nokia continues to linger between a profitable and not-profitable company for a few years. By the end of 2017, Nokia will declare bankruptcy and will have to sell its assets at a fire sale. The company's book value is $2 per share currently and assuming book value does not change and it sells its asset at a 25% discount at the end of 2017, shareholders will receive $1.50 per share. I give this scenario a probability of 20%.

My second scenario is that the partnership starts well, Nokia returns to solid profitability of about 5% but its sales stay stagnant and eventually other hardware makers become more successful. Under this scenario, I see the shares staying at $4 until the end of 2017 when another company buys Nokia at a 40% premium or $5.20 a share. I think the probability of this happening is about 30%.

Finally, under the best scenario, I see Nokia growing sales by 5% a year and reaching a net profit margin of 8%, which is about the average net profit margin of the S&P 500. Under this scenario, Nokia would have $70 billion of revenue in 2017 and $5.6 billion in profits. Its share count would also grow about 5% per year and by the end of 2017 it would have 4.9 billion shares outstanding. This gives 2017 earnings per share of $1.14. Assuming a price to earnings ratio of 15, the shares would trade at $17.15 at the end of 2017. The probability of this scenario is the remaining 50%.

After calculating the share price times the probability and summing it ($1.50*0.20 + 5.20*0.30 + 17.15*0.50), I arrive to a price per share $10.44 at the end of 2017. This is a 150% rise from current levels. I am not discounting for the time value of money as this role is taken by Nokia's dividend which has an annualized yield of 4.6% - a generous yield, given the zero interest rate policy of our central bank.

To end this analysis, I think it is too early to judge Nokia's success in developed and emerging markets following its Microsoft partnership. It is difficult to predict what makes for a successful partnership. Think of Microsoft and Yahoo, Sony and Ericsson, Dolce and Gabana, Ben and Jerry, and Romeo and Juliet (just kidding about the last one). Time will show, but I think Nokia, with its Lumia Windows based phone, is off to a good start.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.