Telecom Valuation Discrepancy: Long RIMM, Short NOK
In discussing the state of the tech economy with an associate recently, the conversation quickly turned towards smartphones, and two of the most hated tech stocks of the last year, Nokia and Research in Motion.
The chart above shows the Nasdaq-100 Index in green, RIMM in white and NOK in amber. As can be seen, both RIMM and NOK have drastically underperformed the index since the Nasdaq-100 bottomed in early 2009. Both of these stocks have been heavily weighed upon by concerns that they have not yet properly innovated to keep pace with rival smartphone platforms such as Apple’s iPhone and Google’s Android. Because of this innovation gap, RIMM and NOK have underperformed the technology sector.
However, comparing RIMM to NOK reveals RIMM’s relative undervaluation compared to NOK that should converge over time and produce profits for a pair-trade strategy. In a pair trade, an investor buys a certain dollar amount of one stock and sells short the exact same dollar amount of a different stock. The reasoning behind such a strategy is that if an investor can identify a superior company over an inferior one within the same industry, the investor can profit from this valuation discrepancy. This is an especially popular strategy among professional investors because it removes so-called “macro” risk, meaning that the investor is not as subject to the whims of the market at large, and is focused on the relative performance of the two companies in question. The advantages of such a strategy can be observed during a market collapse, whereby the company that the investor owns shares in decline by 25% and company that the investor has shorted falls by 50%. In such a scenario, the pair trade strategy would produce a gain of 25%, even though both stocks have declined. The key to this strategy is the performance of the companies in relation to each other and not in relation to the stock market at large.
The following table shows key ratios and financials for each company.
|Current Price to Earnings:||10.49||12.24|
|2011 Estimated P/E:||8.63||12.38|
|Price to Free Cash Flow:||10.20||12.10|
|Return on Equity (Last Filing):||40.90%||7.33%|
|1 Year Return:||-16.60%||-12.60%|
|Average EPS Growth, last 5 years:||47.40%||8.80%|
RIMM is a cheaper stock to own than NOK on almost all valuation metrics. RIMM’s current P/E and Price to Free Cash Flow are 2 multiples lower than NOK. Also, RIMM’s earnings are projected to grow in the next 12 months, as opposed to NOK’s which are projected to decrease slightly. This produces a very low forward P/E of 8.63. RIMM’s earnings have demonstrated significantly more growth in the last 5 years, growing at an average rate of 47.4% as compared to NOK’s earnings growth rate of 8.8%. The only area in which NOK is beating RIMM is in its hefty dividend yield of 4.36%.
While both companies trail the leading competitors, NOK trails RIMM significantly. Both RIMM and NOK have been called out for their slow adoption of newer smartphone technologies. However, RIMM already has significant penetration of the smartphone market, whereas NOK has virtually none.
NOK’s insistence on developing a proprietary interface instead of using the Windows or Android OS has put it at a significant disadvantage. For years, NOK dominated the regular handset market, and the high margins that those cheaply produced phones yielded. However, consumer preferences have shifted drastically towards smartphones, and NOK has been extremely slow to react.
RIMM continues to profit from its position as the leading corporate smartphone provider. Long before the first iPhone was released, corporations were buying Blackberries en masse to keep their employees within reach. While recently many corporations have begun to support the iPhone for corporate applications, Blackberry still reigns supreme among corporate clients.
Additionally, RIMM has finally begun to revolutionize their OS and provide the modern features that consumers love about the iPhone and Android. With the new OS 6 and the Blackberry Torch, the Blackberry now has a global search function, a full web browser, and a touch screen along with a full QWERTY keyboard. RIMM is also releasing a next-generation flip phone on Monday that will be exclusive to Sprint customers that also runs the new OS 6.
While RIMM has been slow to provide the high-tech functions that tech-savvy consumers crave, NOK is much worse off, having no penetration into the smartphone market, and a proprietary operating system that will not be adopted by others. RIMM’s new OS 6 and range of new hardware offerings will help RIMM keep their loyal customer base, as well as stem the flow of users who previously had been switching to Android or iPhone.
Because of RIMM’s relatively better position than NOK going forward, we recommend a long RIMM, short NOK position. Such a position should profit as the valuation discrepancy between the two companies converges, and as the market prices in NOK’s lack of growth compared with RIMM’s impressive earnings growth.