Why Merrill Lynch Sees Nokia and Rio Tinto Much Better in 2016 International Picks List

It is a new year and Wall Street forecasters have been busy in recent weeks updating their best ideas for the year ahead. One new view has come from Merrill Lynch’s Top 10 EMEA Ideas List, for Europe, Middle East and Africa. It turns out that these changes involve two key players: Nokia Corp. (NYSE: NOK) and Rio Tinto PLC (NYSE: RIO).

Where this report gets interesting is that Rio Tinto was added to the first-quarter Top 10 EMEA Ideas List as an Underperform-rated stock. On the other hand, Nokia was signaled to have over 40% upside, if the firm’s analysts prove to be right.

When Rio Tinto was added to Top 10 EMEA Ideas List for the first quarter, Merrill Lynch said that it is cautious on the outlook for iron ore, Rio Tinto’s key commodity for about 64% of expected 2016 EBITDA. The firm thinks that iron ore can trade below $40.00 per tonne for extended periods. This is due to growing supply, falling costs and soft China demand. Its shares outperformed peers by 9% to 41% in 2015, with a relatively stronger balance sheet, but the team feels that it will de-rate on lower iron ore.

Merrill Lynch said of Rio Tinto:

We think that Rio Tinto is a well-run company and will likely maintain its dividend this year while others cut. … From our discussions with investors, we think that in an “underowned” sector, Rio Tinto is a consensus “relative long.”

Rio Tinto’s earnings are a function of the price of its main commodities: iron ore, copper, aluminum and coal. Pricing tends to mirror broad economic trends. In our view with iron ore in oversupply in the medium term and with average prices set to fall we be believe that Rio shares are likely to underperform.

Nokia was added to the Top 10 EMEA Ideas List, as its first-quarter catalyst is the Samsung IPR arbitration, where consensus expectations of cE300m p.a./E1.5bn 5yr royalty payment seem conservative. Merrill Lynch also believes that Nokia’s management team may raise Alcatel-Lucent S.A. (NYSE: ALU) deal synergy guidance from €900 million and could increase expected cash returns.

Merrill Lynch said of Nokia:

The balance sheet should remain overcapitalized — assuming the Samsung patent arbitration materializes at least inline with our expectations and all ALU convertible debt is converted into equity, we see end-2016 net cash of approximately 10.5 billion euro or 1.8 euro per share. Our 12-month price objective of 9.3 euro implies 44% upside potential. Our scenario analysis over a 18 month to 24 month view of potential deal synergies suggests further upside: should Nokia execute on deal synergies, we believe the market may pay 14 times ex-cash P/E on 2018 EPS in 2017.

The firm also offered three main drivers for its solid views in 2016 under its investment rationale:

  1. Assuming its acquisition of Alcatel materializes, Nokia could be a diversified top 3 global network equipment supplier, well-positioned across several key product verticals.
  2. Upside scenarios for the combined entity are exceeding on cost synergies and cash returns to shareholders due to its overcapitalized balance sheet.
  3. Nokia’s Technologies division should provide meaningful upside from better monetizing its IPR going forward.

The weakness in the financial markets was uncanny on the first trading day of the year. This was the worst start of a trading year in what appears to be since the early 1930s.

On Monday, Rio Tinto shares closed down 2.4% in New York trading to $28.41. These ADSs have a 52-week range of $27.32 to $50.07 and a consensus analyst price target of $38.95.

Nokia stock closed up 2.2% at $7.18 in New York. These ADSs have a 52-week trading range of $5.71 to $8.37, and the consensus price target is $9.10.

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