When a company finds itself in trouble and markets start questioning its viability, the best clues for future prospects often lie in the company's bonds. The reason for this is that bondholders are the top of the food chain (or second if there is large bank exposure) and when bond prices swoon, it often means bondholders are expecting the worst and could possibly be impaired.
Nokia's (NOK) current situation is one where bonds can tip investors to the creditor's view of the company's viability.
Nokia has two outstanding bonds which can be used as a window into the creditors' minds:
|Yield to Mat||9.312%||8.83%|
Let's take a look at both bonds price movements (Source: SIMFA/FINRA):
As the chart above shows, the seven year (2019) bonds are approximately 22 points below their March high with price at volume weighted at $85.
The 27 year bond is off over 30 points from its March high, with price at volume weighted towards $80.
Bonds have been falling similar to equities as investors' pessimism regarding the company's prospects increases.
A look at the equity to show the similar trend:
Nokia's equity confirms the slide in bond prices and the concern surrounding the company. Note that the bond slide was a preview to the equity sell-off, if an investor is considering buying the equity, waiting for the bonds to settle in or turn upward might be prudent. Better to leave a few nickels on the table than lose a couple dimes.
Why are investors so concerned about Nokia? In a nutshell, Nokia has been a day late and a smartphone short. Smartphones are vital as handset growth is premised on them. According to Forward Concepts:
Sales of smartphones continued to drive mobile device market growth, reaching 139 million units in the first quarter of 2012, up 44.4 % year-over-year. This quarter also saw the top two smartphone vendors, Apple and Samsung, raising their combined share to 45.7%, up from 30% in the first quarter of 2011.
Among the top 10 cellphone vendors, Nokia, Samsung and Apple topped 2011 unit shipments while Chinese suppliers Huawei, ZTE and TCL also moved into the top ten. In revenue. Apple led over Samsung and Nokia in smartphones. Samsung passed Nokia in overall cellphone unit shipments in Q1/2012, with Apple taking the 3rd unit position.
Nokia has been late to the party with a viable competitor to Apple's (AAPL) iPhone and Samsung's (SSNLF.PK) Galaxy line. Nokia has recently released its eagerly awaited (mostly by investors) Lumina line, which operates on a Windows 7.5 (Mango - not really sure why smartphone OS' are named after foods) platform that is geared toward seamless integration with MS Outlook and, of course "social".
What is the cost of delay? Cash burn. As reported by Reuters:
REUTERS: Over the past five quarters, the onetime darling of mobile telecoms has eroded its cash pile by 2.1 billion euros ($2.7 billion) - a rate that would wipe out its entire 4.9 billion euros reserves in a couple years.
Analysts on average expect the company will burn through almost 2 billion euros more in just three quarters, while the most bearish see the company wiping out its 4.9 billion euros net cash buffer completely next year, a Reuters poll of 30 banks and brokerages showed on Friday.
The company, which had more than 10 billion euros in cash on hand in 2007, has two bond issues outstanding, 1.25 billion euros of 5.5 percent bonds maturing in 2014 and 500 million of 6.75 percent notes due in 2019.
Five-year credit default swaps (CDS) were at 749 bp on Friday - an all-time high, according to Markit. Since its year-low of 309 in late January, it has therefore increased some 142 percent. According to according to Gavan Nolan, director of credit research at Markit, this implies a default probability of 49 percent over the next five years.
Some information from Q1 2012 earnings give rise to the concerns
Devices and Services:
- Net sales were 4.2 billion Euro, down 29 percent sequentially and down 40 percent year over year
- Non-IFRS gross margin in Q1 was 24.4 percent, down 140 basis points sequentially primarily driven by a lower gross margin both in Smart Devices and Mobile Phones, partially offset by an increase in Devices & Services Other gross profit
Location and Commerce:
- Net sales were 277 million Euro, down 9 percent sequentially and up 19 percent year over year.
- Non-IFRS gross margin in Q1 was 77.7 percent, down 10 basis points sequentially.
- Non-IFRS operating margin was 12.9 percent in Q1, up 340 basis points sequentially driven by lower OPEX
- Net sales were 2.9 billion Euro, down 23 percent sequentially and 7 percent year over year.
- Non-IFRS gross margin was 26.6 percent, down 260 basis points sequentially
It's a trifecta of weakness - all three business lines.
In response to the earnings, on April 27th, S&P cut the company's rating by one notch to BB+ stating:
We have also revised our free operating cash flow (FOCF) expectations to incorporate our weaker margin assumptions; we now expect consolidated FOCF of minus EUR1 billion in 2012. We continue to view Nokia's cash position as a positive factor but now expect net cash to fall much faster than we had previously anticipated to EUR3.5 billion-EUR4.0 billion at Dec. 31, 2012, from EUR4.9 billion at March 31, 2012. This anticipated sharp decline also includes a dividend payment of EUR750 million in the second quarter of 2012.
The negative outlook reflects the possibility of a downgrade in the next 12 months if we see that the non-IFRS operating margin in the Devices and Services division remains at or below break even, or if consolidated FOCF remains negative, as this would further reduce Nokia's net cash position. This could be the case for instance if revenues from Lumia smartphones do not increase significantly toward the end of 2012 as we currently expect, or if margins deteriorate further due to competitive pressure.
We could revise the outlook to stable if revenues in the Devices and Services division stabilize, cash burn declines significantly, and non-IFRS operating margins return to at least mid-single digit percentage levels.
This follows the Fitch Ratings downgrade on April 24th which stated:
The downgrade reflects Fitch's view that the deterioration in the company's core Devices and Services division in Q1, together with the company guidance of -3% non-IFRS operating margins or below for the division for Q2 and the general lack of visibility beyond this point, means Nokia's profile is no longer commensurate with an investment grade rating.
In order to avoid further negative rating action, Nokia needs to demonstrate substantial improvements over Q312, Q412 and 2013. Fitch believes that Nokia needs to stabilise revenues and be capable of generating low-single digit non-IFRS operating profit margins and positive pre-dividend free cash flow, if Fitch is to affirm the rating at the 'BB+' rating level. Given the potential headwinds facing the company, Fitch is currently not convinced that Nokia can attain this over the course of 18 months.
After all this negativity, the only real bright spots are that Microsoft (MSFT) has paid Nokia $1 billion to put Windows on the Lumina and AT&T (T) plans to carry the phone (okay, a massive company supporting them and the second largest wireless carrier carrying the phones certainly isn't insignificant).
Bottom line: Nokia is a turnaround play, pure and simple. This is speculative and some might say to look at Nortel for guidance how it could play out (when I first looked at the company, Nortel popped into my head with the talk of new products and patents - neither of which worked out for them). If an investor wants to take a position in the company, the 2019 debt might be a consideration as there is significant upside to par (20%), the duration is not huge (5.50) so rates won't overly kill you if they rise (not that Nokia is trading off rates anymore) and you are senior in the capital structure. Is the upside as great as the potential upside for the equity? No. Is it safer? It is senior, and in that respect safer. If you really like the company and think everyone has gotten it wrong - buy the bonds and let the coupon pay for longer dated call options, or hedge with bonds and puts.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Additional disclosure: This article is for informational purposes only, it is not a recommendation to buy or sell any security and is strictly the opinion of Rubicon Associates LLC. Every investor is strongly encouraged to do their own research prior to investing.