Back in August 2018 in an article entitled, Nokia: A Leader In The Sprint To 5G, I first laid out my bullish thesis on Nokia (NOK). In that piece, I highlighted the company's multi-year 5G build-out which would begin to hit the top line in 2019. I lauded Nokia's end-to-end 5G portfolio of solutions, software, chip technology and services which will enable the company to take full advantage of our increasingly connected society and the emergence of the IoT (Internet of Things).
Since then the stock has continued to underperform and I have been added to the list of the many investors impatiently waiting for management's R&D and acquisition spending to pay off.
The stock market is designed to transfer money from the active to the patient.
- Warren Buffett
Despite the lack of capital appreciation over the past year, I continue to hold Nokia as my investment thesis hasn't changed despite delays. Nokia has now spent billions of dollars and several years on the 5G roll-out. In that time the company has also focused on efficiency with a large cost reduction program that is seeing great results. Only just last quarter did we see 5G revenues begin trickling in. Patience is a virtue.
Even when discounting management's EPS estimates for year-end 2019 and 2020, fair value is well over current share prices. NOK is a Buy.
Winning Contracts, Despite the Competition
As of the end of Q2 2019, Nokia had won 45 5G contracts, slightly lagging leader Huawei, but well in front of competitor Ericsson (ERIC). Nokia's approach to 5G has been slightly different from its peers in that NOK has focused on software and an end-to-end, cloud native experience that has been optimized for the leading cloud platforms, including Amazon (NASDAQ:AMZN), Microsoft (NASDAQ:MSFT) and Google (NASDAQ:GOOG) (NASDAQ:GOOGL). This approach has been winning customers consistently in 2019.
Nokia has also realized the importance of winning in 4G LTE in order to win 5G contracts that come with both needs. The Finnish company is gaining business because according to RootMetrics, an independent network testing company, once again NOK is the owner of the highest scores for 4G network performance.
Nokia isn't just winning contracts due to superior technology, however. In fact, the recent US flagging of Huawei as a national security threat due to concerns over potential Chinese cyber-espionage has helped Nokia win contracts over the aggressively priced competitor.
Take the recent joint declaration signed by the United States and Poland this week, which pledges to keep so-called 'bad actors'(aka Huawei) out of next generation infrastructure. French researcher Julien Nocetti of the Paris-based foreign policy think tank IFRI (L'Institut français des relations internationales) said of the Huawei pressure:
The fact that there is criticism of Chinese Huawei benefits Nokia. Of course, Nokia's rival Ericsson will also benefit from this situation.
Although the trade war and its impacts on Huawei have helped Nokia win contracts in Europe and the US, in other ways the trade war has hurt NOK's bottom line. Firstly by helping rival ERIC compete, but also in the greater china operating region which still represents almost EUR 600 million in sales. NOK has been pressured by uncertainty from the trade war, causing China sales to fall 2% in Q2 vs. strong results across the rest of the world.
However, I do believe the good outweighs the bad when it comes to China tensions and NOK. We have seen evidence of this over the past few weeks as the company continues to win contracts:
- July 30th, T-Mobile US agrees to $3.5 billion deal with NOK
- September 2nd, Iliad agrees to deal with Nokia for France and Italy 5G push.
The road hasn't always been a smooth one for NOK in this 5G push and 2019 has been no different. Nokia recently made news for all the wrong reasons when the company was blamed for delays in Sprint's (S) 5G roll-out. This comes after NOK shipments of 5G equipment to South Korea were three months behind schedule as well. These issues would concern me if it weren't for the continued contract wins despite the challenges.
A new technology roll-out takes time, money and patience. New tech inevitably faces challenges and it's only the companies (and investors) willing to stick with it that see the returns. In my view NOK has faced the 5G roll-out challenges as well or better than its peers and is set to profit going forward. Now it's time for investors to listen to Mr. Buffett and practice patience.
- Non-GAAP EPS of €0.05 beats by €0.02
- GAAP EPS of -€0.03.
- Revenue of €5.69B beats by €290M.
Nokia saw mixed results in Q2 2019 although revenues did jump some 7% (5% on constant currency basis) YoY as the company began recognizing its first 5G revenue from North America in the quarter. All three major business segments saw both revenue and operating income growth, although sales for 5G have yet to take off.
|Revenue Growth YoY|| |
Operating Profit Growth YoY
By region, greater china was the only decline in revenues, falling 2% due to trade war tensions. However, the North America region continues to outperform with revenues up 13% YoY. YoY revenue growth also would have been better if it weren't for the poor basis of comparison caused by the 2018 sale of Nokia's digital health business.
Another positive of the quarter was operating margins continue to improve as Nokia focuses on efficiency, Q2 2019 85% vs. 81% in Q2 2018. The cost savings program is paying benefits for the bottom-line even in 2019 and Nokia expects a €700 million reduction in non-IFRS operating expenses in 2020 vs. 2018.
The major blemish of Q2 was the weak cash position. Net cash decreased by around €1.5 billion to just €500 million as Nokia awaits its 5G savior. That is not a good sign when you realize Nokia has to pay €300 million in Q3 to pay its dividend.
€900 million of the sequential decline in cash was due to performance-related incentives from 2018, the first quarterly dividend payment and the restructuring of cash outflows.
Although €350 million of the decline in net cash is considered temporary in nature and will reverse in the second half of 2019, the cash position at Nokia is troubling.
Free cash flow was also a poor negative €1 billion in Q2, primarily driven by the working capital performance which generated a decrease in net cash of €1.2 billion. This performance was hurt by delayed receivables from a large contract and increasing inventory build-out in preparation for 5G; nevertheless, this is a poor performance and something management noted would need to improve.
Cash taxes were also higher than expected in Q2, totaling €160 million, which hurt Nokia's cash position, although this impact will normalize in Q3.
Overall, Nokia's cash problems are worrisome, but the company continues to manage its debt well despite the issues.
I do, however, expect Q3 2019 to be a rough one as the company waits for its capital spend to start being accretive.
In the Q2 report Nokia says Q3 may be soft on revenues:
We expect full year 2019 will have seasonality characterized by a particularly weak first quarter, a strong second quarter, an expected soft third quarter and an expected particularly strong fourth quarter.
This revelation does mean in the short term more pain for shareholders may be coming. However, given management's guidance for a strong fourth quarter I don't see there being much use in waiting until after the soft Q3 to acquire shares.
As long as Nokia continues to win 5G contracts I believe 2020 will be a strong year for the company, despite continued quarterly woes.
Using management's outlook to value Nokia will, I'm sure, be widely criticized by NOK bears. And for good reason, Nokia has, in the past, been guilty of over-promising and under-delivering when it comes to investor outlooks. With that in mind I'd like to take a look at potential year-end 2019 and 2020 values, with a steep 20% discount on EPS to take into account a management that has, again in the past, seen its future with rose colored glasses.
Discounted EPS estimates:
YE 2019: EUR 0.20 - 0.23
YE 2020: EUR 0.30 - 0.34
Historically, Nokia has traded at around 25.6x earnings and the communication equipment sector trades at over 28x earnings, according to CSI market data. However, the Nokia of today is very different than the Nokia of old so once again being very conservative here I will use the average of the S&P current average P/E ratio of around 20x earnings and the above figures for a P/E of 24x.
YE 2019: EUR 1.2 billion for a market cap of EUR 28.8 billion=$32.06 billion
YE 2020: EUR 1.8 billion for a market cap of EUR 43.2 billion =$48.09 billion
So, even taking a steep 20% discount off management EPS expectations, then further discounting the P/E ratio past historic valuations, we see Nokia still represents significant value. By year-end 2019, I expect shares to be worth well over $5.68/share and by 2020 that should go up north of $8.52/share.
Raymond James recently upgraded NOK to a Strong Buy, from Outperform, setting its price target at $7.50. Since then shares have fallen down to just $5 and hit a bottom, creating a distinct buying opportunity in this growing company set to benefit from a major, global technological advance.
Despite the recent hiccups with Sprint and South Korea, NOK is still a leader in 5G. Setbacks are a part of new technology roll-outs and I believe NOK will move past these and finally be rewarded for its 5G spend in the second half of 2019 and 2020. I also believe NOK's cash problems are more of a result of the ongoing spend than mismanagement.
Of course NOK comes with plenty of risks, but given the size of the runway the company is standing on I'd rather jump aboard than watch it fly off without me. Long NOK.
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.