Tech

Leila Abboud is a Bloomberg Gadfly columnist covering technology. She previously worked for Reuters and the Wall Street Journal.

Revolutions can be unfair and their results unexpected. The smartphone has changed way we work, communicate, inform and entertain ourselves. But it hasn't been such a boon to the companies making the gear that shunts all the data created around.

Ericsson AB and Nokia Oyj, which finalized its takeover of rival Alcatel-Lucent in January, are getting pummeled by investors. Nokia fell to a three-year low on Tuesday after predicting margins in 2017 that disappointed investors eager for early cost-savings from the deal.

Collateral Damage
Nokia's shares have underperformed since Ericsson's third quarter profit warning.
Source: Bloomberg

The deal still makes strategic sense for Nokia -- it will add products for broadband and fixed line networks the company previously lacked and also bulk up its mobile operations. Ericsson, by contrast, remains largely dependent on mobile gear.

Unfortunately, Nokia is having to integrate Alcatel-Lucent against a backdrop of falling demand for both wireless and fixed equipment that's panning out worse than anyone had expected.  

Nokia CEO Rajeev Suri deserves investors' patience -- today's networks are more reliant on software these days, making it easier to adapt them to work with other companies' products. That should mean the Alcatel deal stands a better chance of avoiding the value destruction of past deals in the industry. And Suri has proven an able cost cutter and manager during his tenure.

But so far, investors aren't giving Nokia the benefit of the doubt. Since Ericsson's October 12 warning that exposed just how sluggish sales are for mobile gear, Nokia's shares have under-performed its peer. Nokia's enterprise value to forward Ebitda ratio now trails Ericsson. This reaction looks excessive.

Wrong Way
Nokia's 12 month forward enterprise value to Ebitda ratio has fallen and is now just below that of Ericsson.
Source: Bloomberg

Suri's job has indeed gotten harder because of sluggish demand from his global telecom customers. But some of that's natural in an industry that requires big cyclical investments; spending was always going to decline once operators largely completed their 4G networks.

Nokia said on Tuesday sales in its "primary addressable market" will shrink 2.2 percent next year, while Ericsson has predicted a 2 to 6 percent decline in demand for mobile equipment after a 15 percent fall so far this year. Meanwhile, Nokia's gross margins are showing signs of improvement, unlike Ericsson's.

Different Tracks
Nokia's gross margins have been improving in recent quarters, while Ericsson's worsen.
Source: Bloomberg

It's not encouraging the restructuring charges from the deal are rising: Nokia added 500 million euros to its estimate on Tuesday, bringing them to 1.7 billion euros. But it's too early to consign the benefits of the Alcatel deal to the scrap heap. Cost cuts from the combination should total 1.2 billion euros by 2018, taking operating margins to 10 to 15 percent in the medium-term. The savings are coming through, but will boost 2018 earnings more than next year's.

For Suri, dwindling revenue risks leaching away the benefit from the cost savings from the Alcatel deal. A similar dynamic of brutal competition from Chinese competitors like Huawei helped to doom the industry's last round of mergers in 2006. Suri's execution is going to have to be perfect from here if he is to survive this revolution.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Leila Abboud in Paris at labboud@bloomberg.net

To contact the editor responsible for this story:
Edward Evans at eevans3@bloomberg.net