Nokia: Focus on the margin of safety, not what you think you know.
Most people in North America (my main audience) have a mobile phone and at the very least a vague sense of what Apple is. Therefore most people have an opinion on the mobile phone market. You mention Nokia and they recoil in horror. This vague notion of what the company does and the associated behavioral tendencies have resulted in a truly outstanding investment opportunity.
By way of introduction, last year Nokia sold 417m handsets through over 850,000 distribution points (only 4m of those were in North America), they hold nearly 10,000 patents from which they earn €500m in recurring revenues each year, they own one of a few comprehensive local information and mapping databases globally upon which Microsoft are heavily reliant (and potentially Amazon), and they have a 50% stake in the world’s second largest provider of telecom equipment.
Most importantly, today Nokia is valued at between 120% and 77% of net cash plus patents depending on how you value those patents; you can forget the phones, the maps/data, and the networks business. Given that we know very little with certainty about the future the value on offer represents a very attractive margin for error.
It’s notoriously difficult to put a value on patents, some are essential, some are strategically important, and some are trivial. In 2011 Nokia effectively won its patent dispute with Apple which involved a “significant” lump sum payment for past infringement and “on-going” royalties, we have no details on what the numbers are but we do know that the overall annual royalty run rate for Nokia is touching €500m only three years after beginning to aggressively monetise their intellectual rights, this gives us a basis for determining their value.
If we assume €500m of royalty income per year for the average remaining life of the patents, tax this at the Finnish corporate tax rate of 26%, and discount the cash flows at Nokia’s WACC then the portfolio is worth €2.7bn. This is a very conservative scenario as it assumes no growth in royalty rates over the lifetime of the portfolio or strategic value but gives us the comfort of being based on cold hard cash flows.
If we add the net cash of €4.2bn to our first estimate of the patent portfolios worth of €2.7bn then the fundamental value of these two assets is €6.9bn, using instead the second estimate of patent worth we get a combined fundamental value of €10.7bn, the truth lies somewhere inbetween but they both compare favouribly to Nokia’s current market cap of €8.30bn. This alone makes Nokia an incredibly compelling investment prospect.
Nokia proved with their first Windows smartphone which was launched in only 10 months that they can still make good products (http://reviews.cnet.co.uk/mobile-phones/nokia-lumia-800-review-50005805/), and it has sold 7m units, nearly twice the number that the original iPhone sold at the same point in its lifecycle.
It's important to note that from a financial perspective that Nokia are far from turning the corner. This was evident in the most recent results where the operating margins in the combined devices and services business was negative 9% (there are inventory write-down and seasonal factors), but I believe that the building blocks are in place and the convergence of Windows 8 across platforms had the potential to drive significant success.
The success of Apples software/hardware integrated approach, Google’s acquisition of Motorola, Samsung’s intellectual property problems, and Microsoft’s choice of development path for the Surface tablet also suggest that Nokia could be an interesting strategic asset.
A vague notion of what the company does and the associated behavioral tendencies have resulted in a truly outstanding investment opportunity. There is compelling and definable value in the cash on hand and patents that Nokia hold which underpin the valuation today, and certainly a significant amount of less or undefinable value in the operating businesses.