EUR 850.00 For Business Accounts Only

Morningstar | Margins Hamper Nokia's 1Q, but 2019 and 2020 Guidance Reaffirmed; Dropping FVE to $7.20

No-moat Nokia's 2% year-over-year revenue growth in the first quarter beat our expectations, but myriad issues weighed on its margins. Gross and operating margins came in significantly lower than our forecast as Nokia pointed to the cost of 5G trials, competitive intensity, operational execution, product mix issues, and services cost overruns. The quarter was fraught with issues, but management reaffirmed its 2019 and 2020 guidance and expects to perform extraordinarily in the back half of 2019. We also view these items as short-term concerns and think the long-term picture for Nokia is still bright in 5G. After decreasing our margin profile for Nokia in the long term, we are lowering our fair value estimate to $7.20 per share from $8 (EUR 6.50 from EUR 7) and view the company as undervalued after the underwhelming quarter.

Gross margin declined year over year to 31.4% from 36.7% while operating margin declined to a loss of 10.4% versus a loss of 6.8% in the year before. Margin declines were predominantly due to higher product costs and trial costs associated with launching new technologies for 5G, legacy radio product pressures, not releasing software on time, and cost overruns for services, which we think are near-term headwinds. Nokia did reel in selling, general, and administrative costs, which fell 2.7% year over year, and research and development decreased 1%. Additional increased short-term costs are expected as carriers turn to Nokia to run trials due to security concerns (which we interpret as carriers contemplating Huawei alternatives). We expect Nokia to post gross margin improvements sequentially in 2019 as initial 5G hardware and software trials turn into approvals and start generating revenue to offset the up-front costs. In our view, Nokia can still achieve its 2019 and 2020 stated goals of non-IFRS operating margin of 9%-12% and 12%-16%, respectively, through further cost control, higher-margin software releases, and 5G infrastructure rollouts.

Nokia recently updated its segment buckets and now provides information on customer verticals. In the major verticals, communication service provider sales increased 3% year over year and made up 83.6% of total revenue, enterprises grew 5.2% and were 6.6% of total sales, and licensees grew 7.4% versus the previous year and were 6.0% of sales. As 5G is rolled out, we expect incremental growth from service providers and we believe that private wireless networks and patent licensing open up strong growth avenues in the second half of this year due to applications of 5G technology beyond smartphone usage. Management expects to benefit from North America, South Korea, and Japan ramping in the second half of this year; it is more cautious about profitability in China, given competitive intensity.

Network sales increased 4% year over year, software stayed flat, technologies increased 1%, and group common and other decreased 13%. Strong IP routing and optical networks growth (17% and 10%, respectively, year over year) buoyed the 4% annual decline seen in the fixed access division and 2% annual increase in mobile access. We expect mobile access to pick up as 5G build-outs occur; Nokia said EUR 200 million of North American 5G rollouts were not accounted for in the first quarter because of the lack of commercial availability and customer acceptance of its hardware and software at the time, and it expects the EUR 200 million to recognized in 2019. For software, Nokia expects solid growth in its applications, as seen by CloudBand in the quarter, and is improving its core networks software for profitability, with the expectation to be cloud native by 2020. Technologies sales were all related to licensing deals, and we've tempered our growth expectation for this division due to management commentary on losing some recurring licensing sales in the quarter. The group common and other division decline was mostly due to Alcatel Submarine Networks' lower level of ongoing projects.