Nokia: Investments In R&D Are Starting To Pay Off

Summary

• Nokia is the only end-to-end 5G provider with a global cover.
• Q1 2019 sales growth accelerated by a stunning +8.3%.
• Nokia dominates 5G in the U.S. and China through major deals with T-Mobile and China Mobile.
• My DDM simulation suggests a Fair Value of $8.70 for Nokia.

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I expect Nokia to cut down on R&D

Nokia's (NYSE:NOK) stock has remained flat for years now as the company failed to report positive earnings, but “the times they are a-changin.”

What’s less known is that R&D expenses surged by 240% in 2016, from $2,309 (€2,080) million in 2015 to $5,547 (€4,997) million in 2016, and has since remained near the peak. But this was fully in line with Nokia's long-term strategic goal of becoming a leader in 5G solutions. Now, the company has a cost savings program in place totaling $784 (€700) million. And with roughly 50% percent of R&D personnel working on 5G technology, a technology which is now moving from development to implementation, it’s natural to cut down on R&D expenses.

As the innovation of 5G has now been made, R&D in 5G technology has now had its breakthrough for Nokia, i.e. 5G solutions from Nokia are currently both tested and market ready. Hence, it’s even likely that a major cut down on 5G related R&D will occur, leveraging its earnings outlook in the near future.

Nokia's R&D Expenses: 2015 to 2018

Source: Nokia Annual Report 2016 & 2018

The huge spike in R&D expenses, seen in 2016, is due to the acquisition of Alcatel-Lucent, but looking at the above chart, we see that R&D expenses have since decreased by 7.5% to $5,452 (€4,620) million in 2018.

Compared to its peer, Ericsson (ERIC), Nokia spent a lot on research. R&D as a share of total revenues was at 21.0% for Nokia while it was 17.8% for Ericsson (FY 2018). Hence, lots of room exists to reduce R&D also when comparing to peers.

What if Nokia cut R&D expenses by 20 percent? For FY2018 that would have transformed into a $1,120 (€924) million cost cut, resulting in pre-tax earnings of $665 (€564) million for Nokia instead of the reported loss at $425 (€360) million.

Major deals in 5G allow Nokia to lead in key regions

Nokia is now the only end-to-end 5G solutions provider with a global cover and has won big deals so far with major CSP clients. In 2018 only, Nokia signed a $3.9 (€3.5) billion deal with T-Mobile (TMUS) for the deployment of their 5G network in the United States. The same year, the company also signed a $2.2 (€2) billion deal with China Mobile (CHL). These deals indicate that Nokia’s end-to-end 5G solution is highly competitive, and the company currently has 100+ corporate customers engaged in the implementation of 5G and 400+ corporate customers within 4G.

Sales are picking up

Nokia's financial results, Q1 2019 compared to Q1 2018

Source: Nokia Q1 2019 Slide Deck

Nokia is incredibly dependent on their Networks division. The segment represents 78% of total revenues as of Q1 2019, with net sales of $4,425 (€3,944) million. On a constant currency basis, YoY growth was flat, but taking into account that Nokia had $224 (€200) million in sales outstanding at the end of the first quarter (expected to be realized before the end of 2019), sales actually grew by an impressive +5.3 percent compared to -3% in Q1 2018. Hence, YoY sales growth within the Networks segment actually accelerated by a stunning +8.3%.

As the only end-to-end 5G solutions provider with a global cover and already a market leader in the United States, China, Japan and South Korea, it’s very unlikely that the revenue of the company will decrease. On the contrary, a steady increase in revenue is logical and it's also what the CEO of Nokia predicts.

As of Q1 2019, 30% of Nokia’s revenues come from Europe and as the region turns to 5G, which is already on the map for most EU member states, Nokia will also have its share of revenue in Europe. The European Commission recently announced a 5G for Europe Action Plan with the purpose to have 5G accessible to all EU by the end of 2020.

Cost efficiency improves

At the same time, Nokia has successfully improved their cost efficiency on a yearly basis. This is apparent when inspecting Nokia’s financial statement. Loss before tax fell from $1,520 (€1,369) million in 2016 to $486 (€360) million in 2018, while at the same time revenues remained roughly the same and my calculations (based on data from Nokia's 2018 annual report) suggest that Nokia’s cost efficiency increased by 3% for the period. This excludes any effect from the latest $784 (€700) million cost savings program, which started in early 2019.

The total effect of (1) improved sales from 5G solutions, (2) increased gross margins, (3) a reduction in R&D expenses and (4) the full implementation of the cost savings program will have a positive impact on company earnings and Nokia will see its stock price spike.

In line with Nokia's own outlook metrics

Nokia's Outlook Metrics, Q1 2019

Source: Nokia Q1 2019 Slide Deck

Nokia’s own outlook is in line with my point of view. They see a sharp increase in revenues together with increased cost efficiency that will boost earnings already by year-end 2019 and even more so by year-end 2020. The company expects earnings per share for 2019 to land within the range of $0.28 to $0.32 (€0.25 to €0.29). First quarter earnings landed at negative $0.022 (€0.02) in earnings per share. But the first quarter tends to be weak for Nokia and the full year earnings forecast still stands. Furthermore, Nokia had $224 (€200) million in outstanding sales from 5G deliveries which they expect to be realized before the end of 2019.

Some fundamental tweaking

Price-to-Earnings insight

The expected P/E ratio of Nokia, using the lower bound (upper bound) of the 2019 earnings outlook, currently lands at 18.36 (15.83). Taking into account a potential cut in R&D expenses of up to 20% lowers the P/E ratio towards 11.

The average P/E ratio for the telecommunication equipment industry is at 19.11. Hence, based on Nokia's own FY2019 earnings forecast, and compared to the industry average, Nokia's stock is undervalued with a potential correction of up to +20.72%. Including a 20% cut in R&D, a correction of +73.73% would be expected.

In the long run, the outlook is even more promising, as confirmed by Nokia, which expects both revenues and earnings to continue to rise in 2020.

Of course, due to Nokia's $784 (€700) million cost savings program, set to finish in 2020, the earnings outlook most likely includes a decrease in R&D. But interestingly enough, we end up at a P/E ratio of 11.35 anyway, using the 2020 earnings outlook. Hence, no matter to what extent R&D cuts are included in the earnings outlook, the fact remains that R&D cuts are an easy way for Nokia to meet its earnings target and that it will be utilized.

Price-to-Book Value insight

Nokia’s price-to-book value is at 1.8, below the industry average of 3.30. Hence, the stock price has a major upside relating to its below average P/B ratio. A price-to-book value of 3.30 for Nokia is equivalent to a 183% increase in the stock price.

Dividend insight

The company continued to pay a high dividend even during years of negative earnings, which is also a signal to investors that Nokia is not and has not been in a situation of financial distress during the last years. Instead, well-targeted R&D investments in 5G was strategically initiated by Nokia which is now starting to reap what it sowed.

The expected dividend yield of Nokia is currently at 4.31% (NYSE) and 4.15% (OMX Helsinki). This is impressively high compared to the industry average of 2.5%. Furthermore, Nokia’s dividends record shows that the company’s payout policy is consistent across Europe and the United States.

DDM: Fair Value Simulation

Input:

Average yearly dividend growth (2014-2018) = 9.33%

Assumed long-run dividend growth = 0.01%

U.S., latest dividend payout (NYSE, 2018): $0.22

Europe, latest dividend payout (OMX Helsinki, 2018): $0.19

10-year treasury yield (2018.05.06): 2.54%

Formula:

Stock Value = Dividends per Share / (Discount Rate – Dividend Growth Rate)

Chart constructed by Jacques Georget

Results:

Assuming a long-run dividend growth rate of 0.01%, I get a Fair Value of $8.70 (€7.51). A near zero dividend growth rate is in line with economic theory of a steady state economy.

Conclusion

Due to heavy investments in R&D, Nokia has been struggling with negative earnings for several years. These investments are now starting to pay off and Nokia’s future success depends on their continued ability to lead as a 5G solutions provider to CSPs around the globe, as the world's transition to 5G continues. Nokia is the only end-to-end 5G solutions provider with a global cover and major deals have been made with key customers which supports the anticipation of continued success.

I view Nokia's stock as bullish in the intermediate time frame. With improved gross margins, a cost savings program in place, the possibility for management to cut down on R&D expenses and major deals landed in 5G, Nokia stands firm as competition intensifies.

Both P/E forecasts and the low price-to-book value reveals a large potential upside in the stock price. Finally, Nokia's stock has an impressive dividend payout and my DDM simulation suggests a Fair Value of $8.70 (€7.51), which I find plausible.

Please note that growth rates are calculated using Nokia’s functional currency, the euro. Due to changes in the EUR/USD exchange rate over time, it may differ to the USD equivalent growth rate.

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