Recently, I wrote about Nokia, and highlighted some high level assumptions for a general investment thesis. I wanted to provide a quick update based on recently released Q4 2018 earnings, and see if any of those assumptions warrant a re-examination.
Q4 earnings were stronger than anticipated, but the stock has declined -7.69% since January 31st based on weak guidance for the first half of 2019. Here is the CEO's commentary during the earnings call:
Looking ahead, I expect those risks to carry over into at least the first half of 2019. To be clear, I have absolutely no doubt that a fast and meaningful shift to 5G is underway. But there are several factors that point to 2019 being very second half loaded similar to what we saw in 2018.
The first is the staggered nature of 5G rollouts. A small number of lead countries will start rollouts that accelerate over the course of this year. As is typical in large technology transitions, however, more general adoption will go at a slightly slower pace with a broader ramp-up starting at the tail end of 2019 and in 2020.
The second reason for a back half-loaded year is that the 5G ecosystem: standards, chipsets and devices, is still in its early days. We expect this to stabilize in the coming months, but it means that development and testing are operating under considerable time pressure.
The final reason is that while Nokia has a massive amount of 5G-ready hardware already deployed and we ended 2018 with a backlog considerably larger than the previous year, conversion of orders and backlog to sales could be somewhat slower than normal. Some of the hardware that has been deployed is waiting for the availability and acceptances of key 5G software releases. Those releases will come available as the year progresses.
When you put this all together, I think it is safe to say that 2019 will be one focused on full year results, not those of individual quarters. Despite these risks, I do believe that 2019 will be better than 2018 for both Nokia and the market. In fact, we expect conditions in our primary market to improve to being around flat for 2019 from being slightly down last year. We also expect Nokia to, again, outgrow the market on a constant-currency basis, given our strong early traction in 5G and progress in software and enterprise.
Nokia also had a weak first half in 2018, followed by a stronger second half. I believe that investors were anticipating that the growth in the second half of 2018 would continue into 2019, and were disappointed that momentum seems to have decelerated. This is especially true given that Huawei, their largest competitor, has had well-publicized headwinds on the political front.
While these concerns are valid, I think it's important to understand whether or not these trends and explanations are:
- Short term vs long term
- Plausible vs implausible
- Risky vs uncertain
And try to be as unemotional and fact-based in our decision making as possible.
Short Term vs Long Term
Short term, 5G adoption is still in its early infancy. It seems reasonable to expect that there will be stops, starts, and bumps along the way. Notably, Nokia still expects 2019 to be stronger than 2018, and 2020 to be stronger than 2019. The long term trend remains in place.
A reader (sounds fancy, but since only a dozen people know about this blog I guess it's safe to admit that it's my brother) pointed out a good overview of the 5G rollout process in Qualcomm's annual report (see page 6):
Initial commercial deployments of 5G, which will focus on enhanced mobile broadband services, are expected to begin in calendar 2019.
By 2025, global 5G connections are projected to reach 1.3 billion worldwide, representing approximately 15% of total cellular connections.
So broad industry growth prospects are strong, but it's important to: keep in mind that the story will be a very long term one (years, not quarters); focus on the long term competitive strengths and weaknesses of Nokia; and not get misled into thinking that this is a path to quick riches.
Plausible vs Implausible
Even if long term growth prospects are strong, does it make sense that Nokia would experience weak demand in 1H2019? Maybe they simply offer an inferior product, are rapidly losing market share, and these excuses merely hide some hidden danger lurking beneath the surface. Are mangement's explanations for a slow down in short term growth plausible?
My biggest concern about this projected slowdown was that their delayed growth timeline coincided suspiciously with Intel's manufacturing issues. Some of Nokia's products use Intel processors, and any weakness in Intel could cause a delay in Nokia's release schedule. I emailed Nokia's Investor Relations department with the following:
I'm an investor in Nokia and had a question about the ReefShark chipset.
It's been published that Nokia is working with Intel on the AirFrame, AirScale and ReefShark products, and the Nokia website indicates that ReefShark utilizes 10nm technology.
Intel's delays with 10nm have also been widely published.
Are these delays impacting your development or competitiveness in the 5G rollout with customers? And if so, is this part of the reason why management expects better performance in 2H2019 and 2020 versus the early part of this year? (inline with Intel's delayed 10nm release schedule).
I honestly wasn't expecting any response, but actually received a reply less than a day later from Ilkka Ottoila, a Director of Investor Relations at Nokia (emphasis mine):
Thank you for the email.
First of all, ReefShark is not one product or chipset, but rather a family of ASICs. As of now, we have announced four ReefShark chips. Our first ReefShark chips for baseband products started shipping in Q3 2018, as planned. The ReefShark chips for: a) RFIC based massive MIMO adaptive antennas (front end module and transceiver) and b) Digital Front End have always been scheduled later than the baseband parts, and will roll out during 2019 and 2020.
Thus, we do not see ReefShark as a key factor driving our 2019 expectations. Across our industry, in the first half of 2019, the readiness of the 5G ecosystem, as well as the staggered nature of 5G rollouts in lead countries are expected to be headwinds for revenue recognition. The industry, including chipset providers and handset makers, will be building out 5G based on the standards set in December 2018. Across our industry, this will impact the availability of 5G software and the ability to test that software. Therefore, in 2019, we expect a soft first half, followed by a strong second half, as our key 5G software releases become more widely available.
This added additional color to the CEO's comments that "standards, chipsets and devices, is still in its early days" and that "some of the hardware that has been deployed is waiting for the availability and acceptances of key 5G software releases", but was still frustratingly vague.
However, now that I had a better idea on what to look for, after some further digging I found an article that described how rapidly changing 5G standards were causing software and hardware incompatibility issues:
The radio access network equipment from vendors including Ericsson AB (Nasdaq: ERIC), Huawei Technologies Co. Ltd. and Nokia Corp. (NYSE: NOK) is based on 3GPP New Radio (NR) specifications that were finalized before September. However, silicon vendors such as Qualcomm Inc. (Nasdaq: QCOM) are designing chips for end-user gadgets in accordance with September updates that, it has emerged, are incompatible with the older specifications, according to industry sources.
In the worst-case scenario, 5G basestations already installed in networks would have to be ripped out and replaced. Equipment suppliers would probably bear the cost of that overhaul.
Vendors are hopeful they can tackle the incompatibility problem with a more straightforward software upgrade to the basestations already in telco networks.
Even so, one major operator relying on Huawei equipment is understood to be worried that a fix could hold up the rollout of 5G services.
Given the additional context above, these explanations seem plausible, largely outside of Nokia's control, but fixable - which brings us to...
Uncertainty vs Risk
Investors like certainty, but the world is not predictable. Industries that are in a cyclical, revenue that is "lumpy", release schedules that get delayed - basically, anything that can't be easily extrapolated into a smooth, straight line that invariably trends up and to the right - all seem to cause stocks to trade at disproportionately low valuations from time to time.
The issues described above certainly introduce much uncertainty to the short-term timing of Nokia's 5G rollout, but I don't think they introduce much additional risk.
The uncertainty among 5G standards should get resolved, and the risk that any operator is going to stop using Nokia because of an issue that affects the entire industry seems small. Worst case, Nokia might have to replace some hardware (in the event that a software update doesn't fix the issue), but again this is merely a short term headwind.
There is also considerable uncertainty about why Nokia hasn't been able to capitalize on Huawei's recent weaknesses. But they still increased their market share marginally in 2018, and expect to continue outperforming their addressable market. I also tried to be conservative enough if my modeling assumptions that any material uplift in market share would merely be a bonus, so again there is less risk than uncertainty here.
In my previous post I said that "I think I safe price (with a sufficient margin of safety) to pay for Nokia is around $5.60" and that "unfortunately, NOK has had a recent run-up of late, but there were multiple opportunities to buy at this price over the past few months and there may very well be good opportunities to buy in the future (assuming the fundamental story doesn't change)."
Based on the above, I don't think anything about the fundamental story has changed, and still stand by that assessment.
Disclaimer: I am long NOK.