EUR 850.00 For Business Accounts Only

Morningstar | 5G Network Demand, Software Focus, Additional Cost Savings Reaffirm Nokia Investment Opportunity

Nokia's third-quarter results were slightly below our expectations, but we retain our longer-term thesis on the no-moat firm. We believe Nokia is poised for strong operational growth through 5G build-outs, a growing software portfolio, the broadening of its revenue stream, and a newly announced cost-reduction program. Management reiterated it is on track to achieve its 2020 targets through productivity improvements and a focus on next-generation products. We reaffirm our $7.60 fair value estimate, while foreign exchange effects increase our European fair value estimate to EUR 6.70 from EUR 6.50. At the current price, we believe Nokia provides an investment opportunity.

Net sales decreased 1% year over year, but we are encouraged that Nokia's consolidated operating loss improved to EUR 54 million from EUR 230 million. On a year-over-year basis, Nokia decreased R&D outflows to 20.5% of revenue from 22% while keeping SG&A expenses relatively flat. Nokia benefits from small-cell antenna demand for North American 5G networks, but price-sensitive geographies limited operating margin expansion in the quarter. Of its networks unit's sales pipeline, 43% consisted of cross-business deals, and we think Nokia is realizing the benefit of investing in an end-to-end portfolio. The newly announced cost-saving program is expected to reduce non-IFRS operating expenses and overhead by EUR 700 million annually by the end of 2020. Nokia also announced that Samsung has extended its patent license agreement, which reaffirms our belief that Nokia's up-front 5G development costs will pay off as 5G smartphones proliferate.

We believe Nokia is in a favorable position as carriers upgrade their networks to 5G, and we still expect Nokia to meet or exceed its stated 2020 non-IFRS operating margin goal. In our view, the recently announced productivity improvements, although costly at EUR 900 million, will strengthen Nokia's performance as 5G networks spread to cost-sensitive economies.

Nokia's ultra broadband networks' sales increased 1% year over year. The mobile networks division grew at 2% due to small-cell demand, and the fixed networks division stayed flat with last year. Gross margin declined to 42.6% from 44.2%, on an annual comparison, as the mobile networks division suffered from cost pressures outside North America and Europe. Operating performance declined to EUR 75 million from EUR 78 million on a year-over-year basis, mainly due to lower gross margin. However, Nokia's R&D and SG&A cost-reduction efforts are setting the stage for operational expansion, since we expect top-line growth to outpace costs from strong 5G network infrastructure demand.

The global services business increased revenue by 2% year over year due to demand for managed network services and network planning. However, gross margin decreased to 17.2% from 20.6% a year ago as implementation and service costs increased. Combined with increases in SG&A and R&D, operating profit dropped to EUR 58 million from EUR 110 million the year before. We expect gradual operating margin improvements as Nokia reels in cost through implementing more higher-margin software solutions.

Nokia's IP networks and applications posted 1% top-line growth year over year, but operating profit declined to EUR 113 million from EUR 146 million. In this segment, the IP routing division declined 11% due to component shortages in Nokia's supply chain; however, optical networks and Nokia software increased 25% and 3%, respectively. Gross margin declined to 44.2% from 47.8% as IP routing and optical networks suffered from costs not eroding with price pressure. Operating profit declined to EUR 113 million from EUR 146 million, but we believe the software division will help turn around this segment.

Nokia's software division is benefiting from the trend of software-defined networks in cloud-based ecosystems. We believe software is a huge growth engine for Nokia, and the firm confirmed our belief by stating it is investing in a dedicated software sales team. Additionally, Nokia is focused on developing its software on a common platform to make the customer's experience consistent across its entire network. We believe this commonality will help lower Nokia's development costs and increase operating performance as software-defined networking becomes commonplace in wireless networks.

The technology division's sales decreased 27% year over year to EUR 351 million. The large decrease is attributed to Nokia receiving EUR 180 million of nonrecurring catch-up licensing in the third quarter of 2017 and shedding its digital health and digital media businesses over the last year (which provided EUR 9 million the previous year). Operating margin performance increased to 82.6% of revenue versus 80.7% in the previous year as Nokia benefited from not investing in its previous ownership of the digital health business. We believe this business unit will post strong growth as Nokia seeks licensing revenue from smartphone manufacturers; additionally, we believe that licensing for "Internet of Things" applications in automotive and industrial markets provides Nokia with nascent revenue streams.