Why Nokia Stock is a Buy Ahead of Q2 Earnings (NYSE:NOK)


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Investment thesis

Nokia Oyj (NYSE: NO) managed to recover its activity. The company faces significant headwinds. These include supply chain issues, an uncertain economic environment and declines in its most profitable segment.

However, the company is improving its margins and publishing promising forecasts. The company’s management highlighted a strong order book and strong demand for its products. The company is also trading at a cheap valuation. I think the risk-reward ratio is favorable and I’m bullish on Nokia shares.

Margins continue to rise

One of Nokia’s main growth drivers is the expansion of its margins. The company has continued to improve its profitability. This is one of the main reasons I’m bullish on the stock.

Nokia cloud services margin growth

Presentation of the Nokia Q1 2022 results

Nokia has improved margins across all of its segments since beginning its turnaround at the end of 2020. The mobile networks segment increased its operating margin by 4.1 percentage points year-on-year. Cloud services margins increased 5.7 percentage points year-on-year. Slight weakness in network infrastructure margins was offset by revenue growth.

Nokia Network Infrastructure Margin Growth

Presentation of the Nokia Q1 2022 results

The company generated its largest profit increase in its mobile network segment. The company improved gross margins by 6.6 percentage points, even as constant-currency revenue fell 4% year-over-year. The segment’s operating margin more than doubled.

Nokia Mobile Networks Operating Margin Chart

Created by author using data from 10-K and 10-Q repositories

Nor do I believe that segment revenues are in secular decline. It is common for companies with declining revenues to increase their margins. But Nokia attributes the segment’s negative growth to a difficult supply chain situation. On their latest earnings call, management pointed out that their products have a strong backlog. Their products are always in high demand. I think it’s good that Nokia is able to increase its margins now. This will likely allow the company to generate even more profit from these orders as the supply chain catches up.

Sales were disappointing in optical networks and enterprises. But these declines are also tied to supply chain issues. These should create a tailwind as the situation normalizes.

Product segment Orientation for the whole year First quarter results
Mobile networks 6.5 to 9.5% 7.5%
Network infrastructure 9.5 to 12.5% 9.9%
Cloud and network services 4.0 to 7.0% 2.7%

From the company forward margin orientation is promising. Management’s outlook suggests there is much more room for margin growth across all of their product segments.

Will Nokia Technologies bounce back?

Another segment to watch is Nokia’s patent and intellectual property segment. Nokia calls it Nokia Technologies. It is Nokia’s most stable and profitable segment. In the past fiscal year, the segment accounted for just under 7% of revenue. However, he was also responsible for nearly 43% of the company’s operating profit. Operating margins are consistently close to 80%.

Nokia Technologies segment revenue and profit

Created by author using data from 10-K and 10-Q repositories

During Nokia’s last quarter, the segment took a hit. Its revenue was down 17% year-on-year at constant currency. The segment was the only one to decline year over year in terms of sales or operating profit. Management responded to this on its earnings call:

And then the fourth of our activities, which is Nokia Technologies. Here you see the quarterly revenue of Nokia Technologies. And yes, there was a 17% year-over-year decline in the first quarter. It was above all a question of timing. We had two contracts that expired last year that are currently in litigation and obviously in renewal discussions with these customers. So that affected the top line of the quarter. Another factor was that there is another customer whose license expired, but left the smartphone market. So obviously it’s not going to continue. But we remain confident in the strength of our portfolio.

Thanks for the question. We think we’re back to 1.4 billion, 1.5 billion run rate and that’s in our forecast as well. Don’t forget that we also had a customer who left the device side, but we were very successful in the automotive side. Also, if you look at the consumer electronics side and we are also working on the IoT side to attract new customers, to see what opportunities we have in the future. And we guided on the tech side that it would be stable year over year. And we believe that will be the case this year as well.

This is an important segment to anchor Nokia’s turnaround. I hope to see segment revenue and profit rebound as management expects.

What are Nokia’s guidelines?

The company discussed in detail its long-term directions on its Q4 2021 report. The company expects long-term operating margins in excess of 14%. About 55% to 85% should be converted into free cash flow. All other things being equal, these margins would increase Nokia’s operating profit by more than 50%. Free cash flow would jump 70%. This margin expansion would be exciting for a company trading at such a cheap valuation.

However, the company’s more immediate advice concerns me.

Nokia Q1 2022 Guide

Presentation of the Nokia Q1 2022 results

This guidance is very vague and has a wide scope, especially for free cash flow (“FCF”). These results put the company’s comparable FCF between 630 million and 1.79 billion euros. This would place the company’s FCF futures price between 14 (cheap) and 40 (expensive).

I expect more clarity on this in the next earnings report, expected on July 21, 2022. I think the types of products sold by Nokia are more resilient in times of recession. Internet infrastructure and 5G are long-term growth trends. But there is a risk that cost inflation and supply chain issues will put pressure on margins.

Nokia’s valuation is cheap

I think Nokia’s current valuation is cheap. The company trades at a GAAP price to earnings ratio of 15 and a price to free cash flow of 12. However, I have to take into account that Nokia’s revenue is not expected to grow much in the course of the next few years. The company’s only long-term revenue direction is to “grow faster than the market.” According to Nokia’s latest quarterly presentation, market growth is expected to be around 4% in constant currency.

I think increased adoption of 5G will create a long-term opportunity for revenue growth. But it’s too early to tell when that will happen or how profitable it will be.

I think the main driver of increasing free cash flow at Nokia will be increased margins. Revenues should be at least constant, given Nokia’s large order book. The company is also making progress in its turnaround and improving its capital allocation.

Nokia ROI graph

Created by author using data from 10-K and 10-Q repositories

The company has become much more efficient over the past two years. The return on invested capital has increased significantly. Based on that and the company’s cheap valuation, I think Nokia shares are undervalued.

Contrary currencies

International businesses experience headwinds due to fluctuating exchange rates. The US Dollar (USDOLLAR) has been very strong, briefly reaching parity with the Euro last week. This will affect Nokia, which manages its finances in euros. I think it’s important to watch how Nokia management updates its guidelines to account for these headwinds.

In terms of company revenue, I think Nokia has strong geographic diversification. During the last quarter, sales in Europe constituted less than 30% of Nokia’s turnover. Detailed discussions of forex markets are beyond the scope of this article. However, I think some investors may be able to gain international exposure at an additional discount.

final verdict

Nokia executes its turnaround. The company becomes more efficient in allocating capital and its margins increase. There is a strong demand for its products which will only increase as 5G adoption accelerates.

There are short-term headwinds on some of its segments. I’m keeping an eye on the Nokia Technologies segment as well as management’s comments on supply chain issues. But I think the company will be able to increase earnings and free cash flow in the long run. I think the risk/reward ratio is very supportive of such a cheap valuation, and I’m bullish on the stock.


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