Last week, Nokia (NYSE:NOK) stock skipped 5% higher after reporting an expanded patent licensing arrangement with Samsung. As reported on TheFly.com, Nokia's deal with Samsung will "cross-license" important patents owned by each company, to the other. It will "positively impact" Nokia technologies' revenue, and secure it north of the $1 billion level annually (Nokia's technologies segment did $1.1 billion in sales last year, but only $700 million the year before that).
And the deal had one other effect: It has prompted an upgrade from Goldman Sachs.
This morning, Goldman took its buy rating on Nokia stock and transformed it into a conviction buy, arguing that investors reacted positively to the patent licensing news -- but not positively enough. Priced south of $6 a share today, Goldman says this deal makes Nokia stock worth at least $7.20 a share.
Here are three reasons why.
1. Earnings loom
Nokia stock rose 5% higher in response to last week's patent news, but as Goldman Sachs points out, the stock is still down 21% year to date, and "among the bottom three performers in EU Tech."
Goldman blames the stock's weakness on investor concern about how Nokia's Q2 numbers will come out. It's not certain yet when Nokia will report, but Q1 results came out three months ago to the day -- so Q2 news should arrive any moment now. Until it does, investors seem to be standing pat, fearful that any buy orders they enter might result in them buying right before a big drop in stock price.
2. They're right to worry
That's not at all an illogical action, by the way. As confirmed in a write-up on StreetInsider.com, analyst estimates for Nokia's Q2 earnings look pretty pessimistic, and are being held down by worries over the cost of integrating Alcatel Lucent into Nokia's business.
For that matter, Goldman itself says it does "not expect the 2Q16 top line to be strong." Rival Ericsson (NASDAQ:ERIC) just told us the European telecom market is "challenging." And that suggests that what's bad for Ericsson could be bad for Nokia, too.
3. This, too, shall pass
But these are short-term concerns. Q2 might be rough, but it will soon be history. And looking forward, Goldman sees a bright future for Nokia.
Current estimates for Nokia's revenue imply a growth rate of less than 4%, whereas Goldman notes that historically, Nokia has grown its revenue at closer to a 10% annualized rate -- a norm it could revert to going forward. Helping to grow revenue will be the Samsung deal, which Goldman estimates will grow patents revenue for Nokia by 25% in 2018, 23% in 2019, and 21% in 2020.
Meanwhile, Nokia is making progress in "its most intensive cost-cutting phase." While Goldman notes that other analysts' "2H cons. margin estimates are low vs history," this could actually be a positive for Nokia shareholders, as it opens the possibility of Nokia delivering an upside earnings surprise -- if not in Q2, then perhaps as early as Q3.
The most important thing: Valuation
Such a surprise would surely be good for Nokia stock. But if you ask me, it may not even be necessary for Goldman Sachs to be right about that for Nokia investors to do well.
Consider: With $2 billion in trailing earnings and a market capitalization of $33.4 billion, Nokia stock costs 16.7 times trailing earnings today. That sounds kind of rich, given that analysts polled on S&P Global Market Intelligence see Nokia growing profits at no better than 11.2% annually over the next five years. Then again, though, if you factor the stock's 5.1% dividend yield into the picture, Nokia's total return is closer to 16.3% -- not too far off from the 16.7 P/E.
Moreover, Nokia is carrying a lot of cash on its balance sheet -- $9.4 billion more cash than debt. Factor that into the valuation, and Nokia's ex-cash market capitalization is more like $24 billion. Its ex-cash P/E therefore drops to just 12, and weighed against 16.3% combined return from profits growth and dividends, the stock's total return ratio is a lowly 0.7 -- which seems to me eminently buyable.
Bonus final thought: Did Nokia make the right decision in buying Alcatel? Is it not possible that the absorption of that bad business into Nokia's good business will sink the ship, derail profits growth, and eat up all of Nokia's spare cash? Sure it is. In fact, no sooner did Nokia buy Alcatel than Nokia's free cash flow numbers did dip immediately into the red.
It will probably take a few quarters for FCF to stabilize, and for investors to get a good clear look at how profitable Nokia can be going forward. For now though, I'm inclined to agree with Goldman Sachs. Most of the numbers here already look pretty good, and Nokia stock looks like a pretty good buy as well.
Fool contributor Rich Smith does not own shares of, nor is he short, any company named above. You can find him on Motley Fool CAPS, publicly pontificating under the handle TMFDitty, where he currently ranks No. 284 out of more than 75,000 rated members.
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