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This week Nokia (NOK) announced they would exceed Q4 guidance when they report full year results early in February. Nokia also gave a quick and short summary of their outlook for 2022 which included an 11%-13.5% operating margin. Management claim this number is adjusted based on management’s expectation for cost inflation and ongoing supply constraints.
The improved guidance for Q4 is mainly a result of venture fund investments which accounted for a 1.5% improvement in operating margin compared to Q3. This is likely a one-off improvement coming from ‘other income’, so this news is neither positive nor negative.
Like I mentioned in my last article on Nokia, it’s difficult to know to what degree supply constraints are impacting sales. However based on consensus revenue guidance of €23 billion for FY22, operating profits could be anywhere between €2.53 – €3.1 billion this year.
Inflation and Rates
Currently, in markets, we are seeing some weakness in richly valued tech, small caps and negative-yielding companies. This comes as markets expect further liquidity tightening as a result of higher interest rate expectations from investors. No matter which angle you look at it, rates need to increase (fast or slow). 2022 may be a year of 4-6 rate hikes from the Fed with the ECB lagging behind, as this happens investors will demand higher returns in order to compete with a higher 10-year treasury yield.
So what does this mean for a company like Nokia, luckily Nokia is positioned well in its market and has the valuation to shrug off moderate rate hikes – from a modelling perspective. Meaning even if rates increase to 3-4% (unlikely this year) then the valuation is still fair based on WACC calculations and the fact Nokia has a long growth runway as 5G spending continues. However I agree that the Fed is behind the curve and recessionary pressure is building – also China is maintaining a zero Covid policy doing further damage to supply chains meaning an inflation slowdown is not around the corner.
During the 1970s, valuations were very attractive (some might say) at very low multiples, however, this was because inflation was climbing over the decade hitting over 14% by 1980. After an economy policy change at the Federal Reserve (new chairman) interest rates reached a peak of 20% before prices stabilized. During this period P/E multiples in equities needed to be low in order to have an attractive enough return for investors, therefore single-digit P/E multiples were very common as investors demanded double-digit returns to account for high rates/inflation. This partly occurred as the Fed prioritized full employment over stable prices. I mention this as Nokia is already priced attractively, therefore if rates increase faster than expected Nokia’s drawdown will not be nearly as large compared to other sectors.
In fact, value names could rally as the bull market shifts into value and strong free cash flow. Nokia is valued around a 7x EV/EBITDA (LTM), however FY21 EBITDA will go down slightly when management report full year results as Q4 2020 was more a profitable quarter giving Nokia an LTM EBITDA of $3.83 billion whereas I expect EBITDA to be around $3.4 billion for FY21.
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Furthermore, Nokia is still improving, since 2016 Nokia’s EBITDA margin has grown from 7.83% to 14.95% based on the last 12 months. Pekka Lundmark has shown early signs that he is on track to transform the company over the next few years. Return on invested capital (ROIC) is still expected to be in the high teens further demonstrating Nokia’s earnings potential and favorable valuation.
What to Look Out for in 2022
My expectation is that guidance from analysts is still conservative, and I believe estimates would need upward revisions to truly reflect Nokia’s potential. Revenue is guided to increase yet free cash flow conversion is forecasted to decrease (based on consensus) how does that work exactly? Clearly, analysts are being conservative or there is a big variance amongst the analysts covering Nokia.
A Nokia DCF will need to be updated with new guidance from management in February with multiple scenarios for interest rates (10yr yield = 3%, 4%, 5%). As for the 5G story, companies are very well capitalized meaning spending on 5G infrastructure will likely not slow down in 2022 if the macro environment remains favorable. This means improving supply issues, particularly shipping and port bottlenecks, semiconductor manufacturing to catch up with new car manufacturing and increased E&P in oil/gas.
Ultimately I think these supply issues are deeper than the Fed realizes as wage inflation is also a key driver as to why supply issues remain. Although I expect an improvement in most of these supply side problems, I do not think they will be fully resolved by the end of 2022. Particularly, semiconductor manufacturers need years of CapEx spending to increase capacity. Unfortunately, until wage inflation plays its part the end of inflation isn’t in sight and the Fed risks inducing a recession too early if rates take-off faster than we expect.
So I agree with Mohamed El-Erian that ‘transitory inflation’ is the biggest policy mistake ever from the Federal Reserve in recent history. That being said 4-6 rate hikes in 2022 isn’t very much (FFR 1-1.5%), banks will still be very profitable in this environment. It’s only when we see a real pivot point from the Fed that is willing to fight inflation head-on – ‘by any means necessary’ which translates to ‘we don’t care if rates have to go to 6% and cause an 18-month recession we have to stabilize prices’.
Until then I remain long in value names like Nokia as long as the bottom-up fundamentals remain.