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In this article we intend to point out the reasons why Nokia (NYSE:NOK) -- and in particular the devices division -- and its highest margin smartphone will not be as profitable as some hope in early 2013. In effect, we will argue how the earnings call could be different, and why it will still be negative. After the initial euphoria, we see clear, longer-term usability issues that have currently been unaddressed.

Can these drawbacks be overlooked? Possibly. What does it take for consumers to overlook bugs and failings? A benchmark product.

With these questions in mind, let us consider Nokia Lumia 920 again.

Drawbacks Vs. Critical Shortcomings

Nokia has been in mobiles for over 25 years, and Apple had no experience. So how did Apple (NASDAQ:AAPL) take over Nokia in smartphones? Innovation alone? Was the iPhone bug free? That is where we as investors must distinguish between bugs that are inconvenient vs. bugs that are critical shortcomings. The original iPhone had issues and drawbacks but no critical shortcomings compared to the competition at that time (Windows Mobile, Blackberry). It was so innovative, as it was the first smartphone with a touch screen that did not need a stylus pen. The Nokia Lumia 920 has minor glitches (camera, microphone, noise cancellation) and clear OS shortcomings while at the same time having significant advantages (optical stabilization in camera, pureview screen, etc.). Lest we become prejudiced by our own exposure, we reread historical reviews. Take a look at these excerpts:

iPhone 2G Review Verdict: Five-Star

Despite some important missing features, a slow data network and call quality that doesn't always deliver, the Apple iPhone sets a new benchmark for an integrated mobile phone and MP3 player. (CNET, June 2007)

What stops Nokia's innovations from beginning a similar assault with the new Nokia Lumia, despite the bugs (like occasional echo in the voice call quality)?

Lumia 920 -- Advantages/Disadvantages

The Lumia's (920) innovations:

  • Pressure and capacitive touch -- has the ability to sense fingers even with gloves on. Very handy in ice cold weather.
  • High resolution IPS display -- better readability in sunlight.
  • Downloadable and free international maps -- no need for the Internet via Google maps.
  • Optical Image Stabilization -- clear, un-blurred pictures and movies.
  • A pretty and sturdy design.
  • Wireless charging -- simple convenience.

The drawbacks:

  • Highly sensitive to water -- immersion in rain damaged our unit.
  • Echo prone phone conversations due to occasionally problematic noise cancellation.
  • Occasionally unstable operating system prevents phone waking up from sleep. It seems the OS is not fully protected from badly behaving apps. This issue is more evident after installing a free online Chess App.
  • Heavy phone not preferred by women.
  • BBC iPlayer (HLS/flash) based streaming does not work.

Unfortunately, when reflecting on the advances, it seems they are mostly incremental rather than benchmark-setting. Despite the fact we like our Nokia 920, it is not the iPhone at version one.

To be sure, we reread the Lumia 920 verdicts again:

CNET Review Lumia 920: 4+ Stars

... the Nokia Lumia 920 is the phone to get. With a stunning screen, smart design and some great included apps, it's the best way to experience the new operating system. Windows Phone isn't for you if you like apps though, and the 920's battery life is less than impressive. (CNET, October 2012)

For another example, see Independents nomination of Nokia as the top smartphone for 2012.

The troubling aspect from an investment view, is that currently no one has put forward that the Lumia 920 is a new benchmark. It's a great phone but not so great such that it can redefine smartphones much like what the original iPhone did. This bodes badly for sustained interest into 2013, especially if the critical shortcomings are not addressed by Nokia/Microsoft.

Are Any of These Critical Shortcomings? Maybe

Nokia's new Lumias have to contend with some drawbacks in the WP8, so it's at a disadvantage relative to iOS as they don't control the OS. Windows Phone 7, after being around for 2 years and the recently launched Windows Phone 8, do not support HTTP Live Streaming (HLS). HLS is a critical media streaming standard for consumers, originally proposed and implemented by Apple and now supported by most mobile platforms and even Microsoft's (NASDAQ:MSFT) IIS Server platform. It is also supported by the defunct PalmOS 3.0, Android since 3.0 and Linux, of course. Even Adobe is in on this standard. The only one who did not have time has been Microsoft for Windows Phone?

HLS is important for consumers because, after Adobe Flash, many broadcasters, for mobile devices, such as the BBC, CNN and Channel 4 use HLS to operate video streaming services; in the case of the BBC it is called the iPlayer, a very popular service in the U.K. as it is free for domestic audiences. The iPlayer has apps for PS3, Xbox, Wii, iPhone, Android, and just about any descent flash or HLS enabled browser. The trouble is, these services do not work with Windows Phone. Not Windows Phone 7 nor 8, and the reason, BBC says is lack of HLS support, and related DRM technology for HTML 5 streaming, to prevent recording, in the operating system.

Now, if this was teething problems from a new phone and OS, I would be inclined to dismiss it. Rather, it could be part of Microsoft's confusion. Is Microsoft targeting the home user crowd or the corporate IT departments? In general, being corporate focused is a good thing for profitability, but for mobile phones it might not be so due to the size of the consumer market versus the corporate market. Microsoft needs to make that choice particularly for the smartphone platform as the corporate requirements are vastly lower in number and there is entrenched competition with RIM in that space. It is arrogance, if Microsoft expects broadcasters the likes of the BBC to redo their solutions to support Silverlight instead of HLS or Flash. This is a big issue and can draw attention away from the Windows Phone ecosystem, in the consumer space. These forums provide some interesting user feedback for relevant discussion.

If these issues are resolved in timely fashion, Nokia will have a blockbuster phone, if not, it could be just another great phone. This subtle factors could be the difference between the smartphone division being profitable in Q2 2013, or loss making. Now is the time to make your investment decision. In the short term though, we see more pain ahead, irrespective of how many Lumias were sold in December 2012.

Device Division Profitability

Let us assume the Nokia 920 has a profit margin of euro 100-150 per device. This is not unreasonable due to the higher marginal cost Nokia would have due to new technologies (floating camera lens) and lower volume than Apple. If it sold a top line estimate of 2.5m phones last quarter, that would amount to 0.25-0.37 billion euros additional operating profit. If everything else remains as it was in the last quarter (and being optimistic that no other devices saw declines) the total net profit of the smartphone group would still be -683m + 370m = -313m euro. That is most likely, thus even with good sales Nokia will turn a loss in Q4 2012 in its handset division. Now, on the contrary let us assume Nokia has a blockbuster and it sells 6m Lumia 920s meaning that it sold as many premium Lumias as it sold general smartphones in Q3. That would result in 600m EUR and if all else is equal still a -83m euro loss. Just make sure you do not get caught out on the hysteria. Nokia's recovery is for the long term.

Conclusion

Nokia is unlikely to make a profit in its handset division in Q4 2012 as the Nokia Lumia 920 has not set a iPhone like game changing benchmark allowing consumers to ignore its deficiencies. The new Lumias, and Windows Phone 8, have the innovative technology, simplicity and aesthetic appeal, but lag in usability issues because of missing features (DRM, HLS streaming support) in the OS, and bugs (over zealous noise cancellation). In light of these things, no matter how much we like our Lumia 920, we doubt it provides enough benchmark setting novelty to keep the momentum in 2013, overcoming the glitches.

From a engineering perspective, the good news is that most of the known issues are resolvable via software updates. What we are unsure of is the resolve of Microsoft and Nokia to deal with these issues in a timely fashion. As a result, Nokia devices division (its biggest loss-making drag), we predict, will not be profitable in the short term. Thus, we recommend you take your profits if you bought when we did. It appears to be the best risk reward strategy for mid term Nokia shareholders. That is what we have already done. We will look to buy back after the earnings report. Longer term, we still believe in Nokia.

Disclaimer: We take no responsibility for your gains or losses if you follow our advice. Please speak to a financial advisor if you are unaware of the risks inherent in algorithmically traded markets.

Source: For Nokia Earnings, Don't Expect Surprises Based On Handsets