The following post was written by Peter W. Rudder, a graduate student at the University of Sydney Business School, who contacted me with some observations and potential conclusions regarding Nokia's share repurchase program and its earth-spanning patent litigation against Apple. I found Peter's analysis insightful, and the fact that Nokia put unusual pressure on Apple through litigation in numerous countries right at the start of a dispute (as opposed to escalating over time, which is the more common approach and also what Nokia did against HTC) could be attributed to some of what Peter has noticed.
Generally speaking, a share repurchase in a situation in which a certain percentage of a company's profitability is being renegotiated either means positive leverage (Nokia's stock would later be worth more that way) if the outcome is good or it can also make things worse (if the stock price goes and stays below where it was at the time of a buyback).
Now the actual guest post:
Nokia's aggressive patent suits and recent share buybacks; are they related?
Back in December Nokia launched several patent suits against long-time adversary, Apple. This was an event that drew much media attention to Nokia, with many calling it a return to their patent trolling days. What didn’t draw nearly as much attention however, was the commencement of a massive share repurchase program that began just over a month before the announcement of the litigation
The announcement came during Nokia's June, 2016 Annual General Meeting in which the board was authorised to repurchase a maximum of 575 million shares, with the authorisation set to expire in December, 2017. Large corporations repurchase shares all the time, most commonly to return capital to existing shareholders or to alter capital structure and almost always when it believes its shares are undervalued. Nokia has made no allusion that it believes its shares are undervalued, stating that the repurchases are only part of its ongoing capital structure optimisation program, which it has invested a total of €7 billion in since October 2015, mainly for de-leveraging purposes as a consequence of the Alcatel-Lucent acquisition.
While it is fair to assume Nokia did not believe its shares were undervalued at the time, the evidence tends to suggest otherwise. The actual repurchase of shares did not commence until November 16, 2016 when Nokia shares were at a 3-year low. This low can mainly be attributed to Nokia's poor Q3’16 earnings results announced in October 2016, compounded with a later announcement from CEO Rajeev Suri on November 15, offering an additional 2% decrease in Networks sales to the existing 2017 guidance figures. The market reaction was harsh, with Nokia's share price falling 18% after the Q3’16 announcements, and many writing off Nokia, saying poor global network sales would stifle any "catalyst for rebound". Despite the prophesised doom and gloom, from November 16, 2016 to March 17, 2017 (the date of the last recorded repurchase) Nokia purchased 93.1 million (€416.6 million in value) of its own shares and saw a 32% increase in its share price.
Even with poor Networks sales and a gloomy outlook from the market, Nokia went ahead with its ambition repurchase program, seemingly unfazed; why? Analysts had already priced in these revenue figures into their models, and concluded that Nokia's share price wouldn’t recover until there was tangible evidence that Networks sales could improve. From this, one could conclude that either Nokia believed it could quickly deliver these results to the market, or that it had an ace up its sleeve that could deliver value to shareholders another way. Sure enough, just over a month later, Nokia announced a slew of patent suits against Apple.
With the launch of these suits, analysts have estimated that Nokia has lost around €150 million in royalty revenues per year from Apple. On the surface, it seems like Nokia is taking an extraordinarily large risk to renegotiate a seemingly small amount of revenue, after all, €150 million is less than a percent of the almost €24 billion Nokia generated in net sales in FY2016. So why go to so much trouble over such little revenue?
Since the disputed patents are mostly to do with smartphone and other consumer electronics devices, all the lost revenue has impacted on Nokia’s Technologies segment. The Technologies segment, once the core of Nokia’s business, now plays a relatively small part, making up only 4.6% of revenues in Q4’16. When it comes to profitability however, the Technologies segment becomes a much more important part of the business, making up 14.3% of positive EBITDA and an EBITDA margin of 52.4% in Q4’16 (report). When compared to the backbone of Nokia’s business, the Networks segment, which has a much lower EBITDA margin of 16%, we can see why Nokia has taken this risk, as each Euro of revenue earned in the Technologies segment contributes to earnings over three times more than it would in the Networks segment. The reason for this is mainly that much of the revenues generated in the Technologies segment come from royalties which are very low risk, high margin cash flows. With an operating profit of €2.2 billion in FY2016, the €150 million represents approximately a 7% loss to Nokia's bottom line, which is a significant hit to its profitability.
The timing of the share repurchases and the announcement of litigation against Apple soon after, seems to suggest that Nokia is confident in its ability to quickly resolve the patent disputes and renegotiate its contracts on more favourable terms. This could possibly entail larger yearly royalty payments and a large sum paid as compensation for the alleged infringement, similar to the resolution of the Ericsson v Apple case in 2015 (Financial Times article; paywall).
The market tends to agree, although a little more conservatively. Analysts from JP Morgan stated that the €150 million in lost revenues should be returned by no later than the end of FY 2017, and are not factoring in the potential for greater royalty payments or a lump sum paid as compensation either. Surely, you’d think, by taking this risk, Nokia is aiming for a much better result than just the return of €150 million. The fact that the potential upside is not priced in to many analyst’s models tends to suggest that they believe future licensing revenues will not be significantly different from the past, and could mean they’re undervaluing Nokia somewhat. The continuing share repurchase and the ongoing litigation, which they are reportedly willing to spend €100 million per year to resolve, seems to support that Nokia believes the potential upside will far exceed the downside, and are expecting a successful result which will have a significant positive impact on their earnings.
Considering the recent share repurchases, the fact that Nokia is willing to spend €100 million per year on this litigation, the success it has had in settling patent suits in the past, and the broadening of Nokia's patents thanks to the recent Alcatel-Lucent acquisition, strongly suggests that Nokia is very confident that it will triumph over Apple. But are they being too confident? As Florian has written previously, Nokia may possibly not receive the outcome it evidently wishes to seek. Given Apple's vast resources, incredibly powerful market position and subsequent leverage over Nokia (see: Apple pulling Withings products from Apple stores), Apple has the potential to draw out this case for years. The longer the case goes on, the longer Nokia are without a significant portion of their earnings, and combined with a shaky outlook for its Networks segment, it could see a significant loss to its share price if shareholders are not delivered relatively quick results. Time is of the essence, so could Nokia's confidence be a risk to its investors? That remains to be seen, but what we do know is that there are certainly interesting times ahead for Nokia.
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