Expectations reset, 1H margin trough

• We had previously highlighted that we expected one more ‘reset’ in consensus expectations for Nokia’s Networks business, principally due to ‘conscious’ share loss to a price-aggressive Ericsson for new 4G contracts. Following recent downgrades and an – in our view – derisked Networks margin guidance, we believe investor expectations have materially reset.  

• As we lay out in this note we expect Networks earnings/margins to improve meaningfully off the 1H16 trough. This should be driven by stabilising wireless revenues and cost synergies beginning to ramp from 2Q16 onwards. We expect Networks margins to improve to 12% by 2018 and to 14% by 2019.  The stock has underperformed

• Below we show Nokia’s share price performance ytd vs European equity markets and European Tech. The stock has underperformed by 23% and 20% respectively particularly since the disappointing Samsung intellectual property rights (IPR) arbitration outcome was announced on 1st February and 1Q16 results earlier this week.   

Margin trough likely behind us; floor looks conservative

Management's Networks margin guidance of a floor/minimum of 7% for this year was in our view the main reason for the sell-off since results. However, given its track record of guiding conservatively and our analysis below, we believe management has merely become a “victim” of its own conservativism. In fact we believe guidance is conservative and 1Q16’s 6.5% Networks margins likely marked the trough:  

• Seasonal margin upswing: The first quarter is typically the seasonal low point for Networks margins, with typically materially higher revenues and margins in the second half. In 1Q16 Nokia delivered 6.5% margins. We estimate that for management to deliver 7.5% margins in the FY16, ie above the 7% floor, margins in the remaining three quarters would need to average <8%. We view this scenario as unlikely given stronger revenue seasonality in 2H and deal-related cost synergies ramping from 2Q16 onwards.  

• Synergy ramp: Management does not appear to waste any time to extract deal savings/synergies (we provide more color on the opportunity below). On the 1Q16 earnings call Nokia’s CEO suggested he expects first synergy benefits already in 2Q. This should help to stabilise margins in 2Q16, accelerating into 2H16 and 2017. 

CEO Rajeev Suri: “… we have already taken action to reduce personnel in a number of countries. While some of these reductions take time, given negotiation processes, others can move quite quickly. In fact, we expect employees in several count ries to start moving off payroll towards the end of May. ”

• US improvement likely: The US remains a key high-margin market, contributing ~30% to Networks revenues. In 1Q16 the large US carriers AT&T and Verizon seem to have underspent relative to their FY capex guidance. Sprint’s recently announced capex cut had in our view already been reflected in 4Q and 1Q16 revenue run-rates. We believe its Capex will need to pick up at some point – management mentioned 2017 on its earnings call as current spending is limited to capacity additions (Carrier Aggregation deployments) and small cell rollouts. We expect any pickup into 2H to benefit mix/gross margins for Nokia and potentially 2017.