HOLD-rated Nokia Corp stock (NYSE: NOK). The company reset its guidance and announced a new operating model

INVESTMENT THESIS

HOLD-rated Nokia Corp. (NYSE: NOK). The company reset its guidance and announced a new operating model. Non-IFRS EPS of 0.05 euros were in line with expectations, while revenue missed consensus and slid 7% year-over-year.

The market did not provide a friendly reception for new CEO Pekka Lundmark, who took over on 9/1/20 from long-time leader Rajeev Suri. The new CEO had the unfortunate task of rolling back full-year 2020 EPS guidance, margin expectations for the company to 9% for full-year 2020, from an earlier 9.5%. Nokia also surprised investors by offering preliminary operating margin guidance for 2021 of 7%-10%, compared to Street expectations for a low-double-digit rate.

In mid-September, Samsung inked a massive $6.5 billion deal to supply Verizon with 5G radio access network (RAN) equipment. Running through 2025, the deal represents annual revenue of $1.0-$1.5 billion. Nokia is not only losing this business, it is losing the prestige of supplying giant Verizon – not a good look as it seeks to market its products and services elsewhere.

The missteps in 5G are tied to former management, but new CEO Lundmark needs to move forward from this setback. Nokia is looking to reduce product costs in the mobile access portfolio while improving performance. Profitability improved year-over-year across the portfolio, but lack of volume leverage could create margin challenges in 2021.

Nokia has extensive global presence, strong legacy customer relationships, leading technology and IP, and financial strength. The change at the top is positive, but is also an acknowledgment that Nokia needs to reinvigorate its 5G efforts. On balance, we believe that a HOLD rating remains prudent on the NOK ADSs.

RECENT DEVELOPMENTS

Nokia has multiple years of underperformance to catch up. 

For 3Q20, Nokia reported revenue of 5.29 billion euros, which was down 7% year-over-year in IFRS and down 3% on a constant-currency basis. The non-IFRS operating margin was 9.2%.

Translated into U.S. dollars, and assuming a blended exchange rate of US$1.18/euro, Nokia posted dollar-equivalent revenue of $6.19 billion, revenue missed the $6.29 billion consensus. Nokia on a non-IFRS basis had a profit of $0.06 per ADR in 3Q20, versus a profit of $0.06 per ADR in 2Q20 and a profit of $0.06 per ADR a year earlier. The dollar-based non-IFRS EPS consensus for 3Q20 was $0.07. 

New CEO Pekka Lundmark, in his first quarter as CEO, has identified ‘both opportunities and challenges,’ though investors are focused more on the latter than on the former. Nokia made progress on profitability, though its margin guidance suggests the fragility of those gains. The CEO acknowledged that Nokia’s financial performance in 2021 ‘is expected to be challenging,’ indicating that more change is needed. Nokia has lost share at a large North American customer and is experiencing margin pressure in this region. 

In mid-September, Samsung inked a massive $6.5 billion deal to supply Verizon with 5G radio access network (RAN) equipment. Running through 2025, the deal represents annual revenue of $1.0-$1.5 billion. Nokia is not only losing this business, it is losing the prestige of supplying giant Verizon – not a good look as it seeks to market its products and services elsewhere.

In light of this lost business and other missed or mishandled opportunities, Nokia has announced significant changes to its operating model. Nokia has provided end-to-end networking as a strategic principle; but equipping and servicing every part of the network is an expensive proposition that is not always validated in business wins. 

In future, Nokia will take a more focused approach, with each business group ‘having a distinct role in our overall strategy,’ according to the CEO. Each of four new business groups will have P&L responsibility and ownership of the responsibility to become one of the market leaders in their respective sectors. 

Nokia will also bring a more rigorous approach to capital allocation as part of its new strategic direction. In general terms, Nokia is looking to shift toward a ‘network-as-a-service’ business model for service providers and enterprise customers.

The business groups under the realigned operating model are Mobile Networks, IP & Fixed Networks, Cloud & Network Services, and Nokia Technologies. For 3Q20, Nokia reported according to its existing segment organization.

Networks segment profit of 263 million euros for 3Q20 more than doubled year-earlier profit of 128 million euros. Segment margin broadened to 6.5% in 3Q20 from 2.9%.

Within Networks, mobile access revenue declined 8% in constant currency year-over-year. Fixed access revenue decline in IFRS but grew 2% year-over-year in constant currency. IP routing revenue also grew 2% annually. Optical networks, which has struggled, bounced back with 25% constant-currency growth; we believe this business is gaining replacement wins against Huawei, which is being turned away in multiple regions. 

Growth in non-mobile businesses was insufficient to offset weakness in mobile infrastructure. Nokia is seeing lower network deployment and planning services revenue for legacy technologies, which are being displaced by 5G.

The outlook for mobile access was shadowed by a significant customer loss that occurred within weeks of the new CEO taking over, and likely hastened the former CEO out the door. In mid-September, Samsung inked a massive $6.5 billion deal to supply Verizon with 5G radio access network (RAN) equipment. Running through 2025, the deal represents annual revenue of $1.0-$1.5 billion. 

Nokia is not only losing this business, it is losing the prestige of supplying giant Verizon – not a good look as it seeks to market its products and services elsewhere. We believe this loss impacted the company sales outlook and contributed to the weak operating profit outlook for 2021.

Nokia software revenue (11% of total) fell 14% in IFRS and 10% in constant-currency, while segment operating profit fell 44% annually. The year-earlier sales comp was unusually strong. Management attributed operating margin weakness to a lower proportion of sales from North America.

Nokia Technologies revenue (7% of total) was down 8%, and segment profit declined 7%. With sales falling faster than profits, segment margin of 82.8% for this high-margined business was up 70 bps year-over-year. The business was impacted by lower brand licensing net sales as well expiration of some small licensing agreements. 

In his final quarter at the helm, the former CEO nudged up Nokia guidance for the full year to 0.25 euros per diluted share, +/- 0.05 euros. The new CEO has had to walk back that optimism, restoring guidance to 0.23 euros, +/- 0.03 euros. The non-IFRS operating margin for full-year 2020 is now forecast at 9.0%, +/- 1.0 percentage point, adjusted from 9.5%, +/- 1.5 percentage point. The company guided for a non-IFRS operating margin of 7%-10% for 2021, which disappointed investors expecting double-digit margin guidance for next year.

The missteps in 5G are tied to former management, but new CEO Lundmark needs to move forward from this setback. Nokia is looking to reduce product costs in the mobile access portfolio while improving performance. Profitability improved year-over-year across the portfolio, but lack of volume leverage could create margin challenges in 2021.

Nokia has extensive global presence, strong legacy customer relationships, leading technology and IP, and financial strength. The change at the top is positive, but is also an acknowledgment that Nokia needs to reinvigorate its 5G efforts. On balance, we believe that a HOLD rating remains prudent on the NOK ADSs.

EARNINGS & GROWTH ANALYSIS

Which was down 7% year-over-year in IFRS and down 3% on a constant-currency basis. The non-IFRS operating margin was 9.2% for 3Q20 compared with 6.3% for 2Q20 and 8.4% a year earlier. Nokia posted a non-IFRS profit of 0.05 euros per diluted share for 3Q20, vs. non-IFRS profit of 0.04 euros per diluted share for 2Q20 and 0.05 euros a year earlier.

Translated into U.S. dollars, and assuming a blended exchange rate of US$1.18/euro, Nokia posted dollar-equivalent revenue of $6.19 billion, which was down 2% from the prior year; revenue missed the $6.29 billion consensus. Nokia on a non-IFRS basis had a profit of $0.06 per ADR in 3Q20, versus a profit of $0.06 per ADR in 2Q20 and a profit of $0.06 per ADR a year earlier. The dollar-based non-IFRS EPS consensus for 3Q20 was $0.07.

For all of 2019, Nokia generated revenue of 32.32 billion euros, up 3% from 22.56 billion euros for 2018; and non-IFRS EPS of 0.23 per diluted share, flat with the 0.23 euro earned in 2018. On a dollar-denominated basis, 2019 revenue equivalent to $26.0 billion declined 2% from 2018, while non-IFRS EPS of $0.25 per diluted ADS for 2019 was down 6% from $0.27 for 2018.

After the head fake of a guidance raise from the outgoing CEO in August, Nokia in November cut its full-year forecast. Nokia now expects full-year non-IRFS EPS of 0.23 euros per diluted share, +/- 0.03 euros; that was reduced from 0.25 euros per diluted share, +/- 0.05 euros. The non-IFRS operating margin for full-year 2020 is now forecast at 9.0%, +/- 1.0 percentage point, adjusted from 9.5%, +/- 1.5 percentage point. 

We are maintaining our dollar-denominated non-IFRS estimate for 2020 of $0.26 per diluted ADS; that is based on non-IFRS profits of 0.23 euros. Given the margin headwinds, we are reducing our non-IFRS EPS estimate for 2021 to $0.261 per ADS, from $0.31.

FINANCIAL STRENGTH & DIVIDEND

Debt was 5.9 billion euros at the end of 3Q20. Debt was 3.8 billion euros at the end of 2018.

Net cash was 1.7 billion euros at the end of 2019.

Cash flow from operations was 360 million euros in 2018, 1.81 billion euros in 2017, 1.46 billion euros in 2016, 503 million euros in 2015 and 1.28 billion euros in 2014. 

Concurrent with its 3Q19 results release, Nokia announced it was suspending the dividend to devote all resources to investments in 5G technology and business development.

MANAGEMENT & RISKS

In March 2020, Nokia announced the appointment of Pekka Lundmark as CEO and president, effective 9/1/20. Kristian Pullola replaced Timo Ihamuotila as CFO in December 2016. Risto Siilasmaa remains chairman.

The new CEO has served as CEO at Fortum, an energy company and, before that, as CEO of a crane company. He also served in management roles at Nokia between 1990 and 2000. With 5G in a crucial development period, NOK stakeholders were likely cognizant that Nokia appears stalled with little sign of an imminent breakout and needed new direction from management. 

Nokia has eliminated its dividend, which will reduce its attractiveness to income-oriented investors. An additional risk in the NOK ADSs is that the price has now gone significantly below $5. Certain institutional investors are proscribed from owning shares trading below certain cutoffs, and $5 is a common threshold. That can shrink the pool of available investors and potentially further increase pressure on the shares. At the same time, Nokia has extensive global presence, strong legacy customer relationships, leading technology and IP, and financial strength. 

Nokia has put in place the top management team for the combined Nokia-ALU. Implementation of this team should facilitate integration of the two companies’ cultures. The two companies face risks related to the integration of two disparate cultures; the rationalization of two product portfolios and go-to-market organizations; and potential opposition from workers’ councils regarding layoffs in Europe. Both companies have pledged to learn from past mistakes, but that is no guarantee of a successful union. 

As a pure play on network equipment, Nokia can no longer count on the cash flow from its phones business. The cash infusion from the sale, however, will allow Nokia to reward its long-suffering shareholders, while also investing in the business.

NSN will face fierce competition from Ericsson and particularly from China-based vendors such as Huawei and ZTE. The restructuring of NSN and the focus on its core competency was overdue but is now proceeding. The long timeline for attaining cost-cutting objectives hints at the political sensibilities in navigating layoffs. We expect this drawn-out process to move much slower than mobile market dynamics, but nonetheless to continue. The NSN business is already showing margin progress. 

COMPANY DESCRIPTION 

Finland-based Nokia Corp. acquired a majority stake in Alcatel-Lucent in January 2016. Having completed the sale of its mobile device business to Microsoft in April 2014, Nokia is now primarily a network communications equipment provider. The company has realigned its operating model to four main divisions: Mobile Networks, IP and Fixed Networks, Cloud and Network Services, and Nokia Technologies. 

VALUATION

The following valuation discussion uses NOK financial data calculated in euros and translated into dollars at current exchange rates.

NOK trades at 12.9-times our 2020 non-IFRS dollar-based estimate and at 12.9-times our non-IFRS 2021 estimate. Those earlier P/Es were accorded at a time of growth optimism. Comparable price-based historical valuations point to a mid-single-digit value around $6.50, now moving lower. 

Once 5G begins to rev up in earnest, market winners and losers will be more clearly defined. Nokia appears to be lagging key rival Ericsson in the race to pick up Huawei displacements, while new kid on the block Samsung has bloodied Nokia’s nose. The outlook is uncertain at best. An additional risk in the NOK ADSs is that the price remains below $5. At the same time, Nokia has extensive global presence, strong legacy customer relationships, leading technology and IP, and financial strength. On balance, we believe that a HOLD rating remains prudent on the NOK ADSs.

On November 4, HOLD-rated NOK closed at $3.40, up $0.01. 

Source: Argus