Nokia (NYSE:NOK) shares plunged 12% on Feb. 1 after its long-awaited patent settlement from Samsung (NASDAQOTH:SSNLF) fell short of expectations. The two companies have been locked in a patent dispute since 2013, after Nokia asked Samsung to pay higher royalties for its patented technologies.
Nokia announced that the new Samsung deal will boost sales at Nokia Technologies to about 1.02 billion euros ($1.1 billion) in fiscal 2015, up from 578 million euros in 2014. The 2015 figure also includes "catch up" revenues from 2014.
This award will boost the annual run rate of Nokia's patent unit to about 800 million euros, which missed consensus estimate for sales of 900 million euros in fiscal 2016. Let's take a closer look at the deal's financial impact on Nokia Technologies, and whether or not investors overreacted to the smaller-than-expected settlement.
It's all about overtaking Ericsson
Nordea Markets analyst Sami Sarkamies told Reuters that investors had expected Nokia to "make more money with their patent portfolio than Ericsson (NASDAQ:ERIC)", the largest telecom equipment company in the world. However, Nokia's estimated run rate of 800 million euros falls short of Ericsson's patent sales run rate of about 1.2 billion euros.
This certainly isn't the first time Nokia has been directly compared to Ericsson. After Nokia closed its $16.6 billion acquisition of rival Alcatel-Lucent, Bernstein Research estimated that the combined company would claim 35% of the global telecom equipment market, making it the second largest player after Ericsson, which controls 40%. Chinese tech giant Huawei comes in third with a 20% share.
Bottom line blues
The lower-than-expected award also hurts Nokia's bottom line growth potential, since patent royalties are a high-margin business. Last quarter, Nokia Technologies had an operating margin of 58%, while Nokia Networks (the telecom equipment unit) had an operating margin of just 14%. Nokia Technologies only generated 5% of Nokia's net sales, but it brought in 20% of its operating profit.
Bank of America Merrill Lynch analyst Kai Korschelt noted that "growth in the high-margin Technologies division was meant to be a major driver of earnings," which justified Nokia stock trading "at a material premium to Ericsson." For reference, Nokia currently trades at 17 times forward earnings, while Ericsson has a forward P/E of 11. Korschelt also noted that "the risk is that this premium narrows as investors may feel less confident" in Nokia hitting its earnings growth targets.
But was a 12% drop justified?
Nokia downplayed the importance of the Samsung settlement, stating that "Nokia Technologies net sales for the full year 2015 are expected to increase year on year, even after excluding amounts related to the award".
During last quarter's conference call, CEO Rajeev Suri said that Nokia remained "quite bullish about future licensing opportunities and new development projects" for Nokia Technologies. This indicates that Nokia could license out its brand and design to other companies, as it did with Foxconn's Nokia N1 tablet.
After merging with Alcatel-Lucent, the weight of Nokia Technologies on the combined company's bottom line will also be reduced. Based on the combined operating income during Nokia and Alcatel's third quarters, Nokia Technologies' bottom line weight would drop from 20% to less than 14%.
Analysts currently expect Nokia to hit $13.9 billion in revenues in fiscal 2016. A 100 million euro ($109 million) reduction to that figure would only equal a 0.8% drop. Therefore, a 12% sell-off on the patent news seems to be a major overreaction. Nonetheless, investors should watch Nokia and Alcatel-Lucent's earnings on Feb. 11 to see if those estimates have shifted.
Tough times in the telecom equipment market
Investors likely overreacted to the Samsung settlement, but both Nokia and Ericsson still face tough headwinds in the telecom equipment market. Competition between the two giants, exacerbated by the growth of low-end Chinese rivals like Huawei and ZTE, could reduce prices and margins across the board.
As a result, analysts expect Nokia's annual earnings to decline 4% over the next five years, while Ericsson's are expected to rise just 7.5%. Those weak forecasts indicate that both stocks could continue underperforming the S&P 500, as they have over the past 12 months.
Leo Sun has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.