NOK reported Q3 2019 results today, and the stock is experiencing a spectacular one day drop for a large, mature company (-23.53%). Q3 results were actually inline, but the following actions have indicated a significant, material decline in the business:
- Dividend has been paused due to poor cash position and inability to generate sufficient cash flow
- FY2019 (non-IFRS) operating margin guidance reduced from 9-12% => 7.5-9.5%
- FY2020 (non-IFRS) operating margin guidance reduced from 12-16% => 8-11%
- Topline revenue is expected to grow "inline" with the market rather than "outperform" the market during 2019-2020
- Additional investment is needed in improving product roadmap and cost competitiveness, particularly around 5G hardware (more on this below)
Overall, it's an incredible about-face from the guarded optimism of only a quarter ago, and completely contrary to Ericsson's optimistic guidance from only a week earlier. Elusive profits from the 5G ramp-up seem to be perpetually delayed, and a shaky, increasingly untrustworthy management team is, yet again, pushing out expectations for a turnaround (last year: 2019; earlier this year: late 2019; now: 2021).
Root Cause: Intel 10nm?
This is pure speculation, but all the pieces seem to fit.
Intel's next generation chipset manufacturing process, 10nm, has been continually delayed. There have also been rumors that dependence on Intel 10nm would sink a "$20B+ market cap" tech giant. Both Ericsson and Nokia fit the bill, but it seems probable that both were highly dependent on Intel 10nm for 5G hardware rollouts.
During a conference call in Oct 2018, Ericsson's CEO denied this, saying:
...we, of course, work with multiple partners. So for us, we are not relying on the single vendor for a strategic component. And we feel quite comfortable that we are in good shape on the future development and the future roadmap.
Yet, in subsequent calls, when asked if the hardware they were shipping was "dedicated" 5G, he was ambiguous:
...the bulk of the business is actually 4G. But that's upgradable into 5G when they get the right frequencies, the right demand, et cetera. So our base business in North America is much more modernizing 4G.
This seems to imply that they are shipping older, 4G hardware, that while technically "software upgradeable" to 5G, might not be utilizing Intel 10nm technology.
Nokia's CEO has also hinted at this, in a not so subtle dig, claiming:
...software-only upgrades are meaningless unless your hardware has the right capacity. After all, you could, in theory, upgrade an old laptop to the very latest version of Windows but the end result would be lousy performance. Doing something similar when it comes to base stations does not make any sense to us, and we do not think it makes sense for our customers either.
Unfortunately for him, Nokia also seems to be in the same boat; "10nm" was also previously mentioned on Nokia's ReefShark website, but has since been removed. More notably, Nokia has updated its outlook to reflect increased investment needs into its chipsets:
Additional 5G investments [are needed] focused on accelerating our product roadmaps and cost competitiveness. Investment areas include System on Chip based 5G hardware, including diversifying and strengthening the related supplier base.
Nokia's CEO also let slip that "admittedly one supplier let us down" - likely hinting at Intel 10nm's failure.
Theories and Implications
Again, this is just my personal speculation, but my theory is that:
- Both Ericsson and Nokia have been heavily hit by Intel's 10nm delays. This has contributed to reports that both companies are "1-2 years" behind Huawei in their technology, despite healthy ($4-5B / year) R&D budgets.
- Ericsson has handled the issue by shipping older, "software upgradeable" 4G base-stations that are not dependent on Intel 10nm
- Nokia has been shipping costlier, newer generation FPGA's purpose built for 5G; the plan was to migrate these FGPA's to more specialized ASIC's / SoC's over the next 1-2 years, resulting in 2-5x unit cost savings
- This gradual migration from FGPA's to ASIC's / SoC's (based on Intel 10nm) was expected to drive margin improvements in 2019 - 2020.
- (An alternative explanation, with the same implications, might be that Nokia is shipping with Intel's 10nm, but performance is poor and / or costs are higher than expected)
- Either way, Intel hasn't sorted out its issues, so Nokia is now scrambling to "diversify" and "strengthen" its supplier base. Management was hoping that Intel would fix its issues before the end of the year, but eventually threw in the towel, and had to issue a "shocking" and unexpected update to guidance
- This will require increased investments, with uncertain outcomes, resulting in reduced market share gains (or potentially losses) and lower margins for the next 1-2 years (hence the updated guidance).
These issues might also explain why Huawei hasn't suffered as much as might be expected, given US sanctions; its main competitors are still scrambling to put a working, next-generation product together, two years too late.
However, it doesn't explain why Ericsson has been able to grow revenues and offer a rosier outlook, given that they likely suffer from the same 10nm dependencies. Are they really only deploying older hardware that is merely "software upgradeable"? Why are telco's fine deploying it? Did they simply have better backup plans and contingencies? This is a big unknown.
Here is an updated valuation, that utilizes the following assumptions:
- Nokia will merely hit the bottom range of their operating margin forecasts over the next two years, and settle below their long term target of 12-14%. Some of the assumptions for this are listed in the first tab of the spreadsheet; but, more importantly, management keeps changing its targets, doesn't seem to fully know what's going on (or does and won't say), and has lost significant credibility.
- Topline growth will be muted over the next 5 years, and top off at GDP'ish levels. At best, NOK will maintain existing market share, not grow it.
This results in a valuation of $6.23 / share, implying that the company is trading at only 62% of fair value. This may strike some as overly optimistic, given today's results and the dramatic market reaction, but some other things to consider:
- There are few players in the telecom infrastructure market. Due to sanctions or security concerns, many telcos will not be able to use Huawei. This basically leaves Nokia and Ericsson, and telcos appear to desire at least two vendors for diversification.
- Despite the fact that these problems have (likely) been widely known within the industry for the past year, Nokia is still growing (albeit modestly) and winning contracts. It has a lot of issues, but the other options might be equally bad (Ericsson) or politically impermissible (Huawei, ZTE).
- Even at reduced margins over the next two years, Nokia should still be profitable. They need to work on their cash flow, but stresses should ease with more flexibility in the dividend payments and as investments in alternatives to Intel bear fruit.
- The technology / licensing portfolio generates €1.4B in annual recurring revenue at a ~80%+ operating margin, which will provide an important buffer of safety (and arguably justifies a large portion of their current valuation on its cash flows alone)
- Management team still holds a significant amount of shares, likely accounting for a significant portion of their net worths (let's see if they buy more shares in the next few weeks).
With that said, they face significant issues, amplified by the erosion of the credibility of the management team. What would convince me I'm wrong?
- Deceleration of contract wins vs peers, implying declining market share
- Endless cost savings "restructuring" rounds after current round is done, resulting in never-ending "one-time" charges omitted from non-IFRS margins
- Failure to hit "turnaround" targets by 2021, and continued excuses for a sunnier horizon ever out of reach
- Continued or accelerating revenue recognition issues due to delayed software / hardware acceptance, implying that their products are hopelessly broken
I can't say I'm too bullish on Nokia's business prospects or management team after this report...but it still does seem significantly undervalued, even with this increased pessimism.
Disclosure: I am long NOK.