Early this week, one of the analysts covering Nokia (NOK) claimed that Nokia's selling of 4.4 million Lumias was nowhere near good because in his estimate Nokia needed to sell 12 million Lumias in order to breakeven. Jeff Kvaal of Barclays Capital specifically said that: "Nokia requires 10-12 million Lumias per quarter to reach breakeven in Smart Devices, assuming a €225 (nearly $300) ASP, a gross margin of 20% and €2bn ($2.6 billion) in operating expenses." Is this really true?
Before I move forward with the argument, I would like to take a look at Jeff Kvaal and his past claims regarding Nokia. In 2011, Mr. Kvaal estimated that Lumia 800 costs $238 to build and Lumia 710 costs $167 to build for the company. Keep in mind that Lumia 800 sold for $560 and Lumia 710 sold for $360 at the time. He said that the company should cut costs on these phones and sell them for cheaper. Mr. Kvaal basically advocated replacing the parts in these phones with much cheaper alternatives and making the phones much cheaper to buy. He was arguing that Nokia should target the cheaper markets with cheaper phones. Well Nokia obviously didn't go that route. The company continued to build top quality phones that can easily compete with the top phones in the market. Nokia's Lumia 920 can easily compete with Apple's iPhone 5 and Samsung's Galaxy S3 in terms of overall quality, usefulness and attractiveness. If Nokia followed Mr. Kvaal's advice, it would have been very difficult for it to achieve what it achieved today.
Mr. Kvaal's opinion of Nokia hasn't always been bearish either. In 2010, when Nokia was trading for $10, he said Nokia was worth $14 per share. Next year, he said Nokia was worth $10 per share when the company was trading for $6. Right before last Christmas, he argued that Nokia was likely to follow Palm, a company that was acquired by Hewlett-Packard (HPQ) as it was on its way to bankruptcy. Shortly after buying it, HP discontinued Palm's operations.
Now we are back to Mr. Kvaal's argument that Nokia needs to sell 10-12 million Lumias per quarter with an average sale price of $300 and gross margin of 20%. We will dig through Nokia's last quarter's earnings report to see how true this is.
In the last quarter, Nokia sold 6.3 million smartphones out of which 2.9 million were Lumia brands. The net sales totaled $976 million euros, which can translate into $1.27 billion. This gives us an average sale price of $201. The company's gross margin was -3.5% with operating expenses of $575 million. The company's negative gross margin was mostly due to the Symbian phones. The good news is that Symbian phones make up a smaller percentage of Nokia's volume than they used to, which will reduce the effects on the health of the company's smartphones division. Also keep in mind that Nokia's smartphones division posted a quarter-to-quarter decline of 18% on its operating expenses.
Mr. Kvaal sees Nokia's annual operating expenses as $2.6 billion. If Nokia sold 12 million Lumias per quarter, it would sell 48 million Lumias in a year. Using the average sale price of $300 suggested by him, Nokia would be generating $14.4 billion from Lumias alone. Mr. Kvaal also used 20% gross margin in his calculations, which gives us $2.88 billion annually. It looks like Nokia will post a profit of $288 million based on Mr. Kvaal's calculations if it is able to sell 12 million Lumias per quarter. When you look at these calculations, it looks like the company's phone division would barely break even even if it sold 12 million Lumias every quarter.
Things are a little different though. First, when a product is introduced in the market, companies spend a lot of money on developing and marketing that product. For example, GM initially spent billions of dollars on multiple technologies that allowed the company to build Volt. As a result, the company reported a loss of $49,000 on each Volt sold in the first year. It goes like this: if you spend $20 billion on a new project that will last five years and sell $6 billion worth of products in the first year, it seems as if you lost $14 billion in the first year of the project, even though the project will more than pay for itself over the life of it. So Lumias will continue to pay for themselves over the years.
Second, I don't expect Nokia to report operating expenses as high as $2.6 billion once its cost cutting measures are finished. Given the trend in the last few quarters, the company's annual operating expenses in the smartphone division will look more like $2 billion. Remember, Nokia is getting leaner and meaner. Also keep in mind that the company's operating expense numbers will depend heavily on euro's strength as a currency because most of Nokia's operations are in the eurozone.
Third, this calculation excludes some of Nokia's profitable products such as the Asha line of products. In the last quarter, Asha phones had a gross margin nearing 20%. Reportedly, these phones are selling like hot cakes and Nokia will be able to get better margins on Asha series as time goes on and the phones become more widely available.
Fourth, this calculation also excludes the $1 billion Microsoft pays Nokia so that Nokia stays in this partnership. In Nokia's latest quarterly report, it says that the payments from Microsoft will be an ongoing thing rather than a one-time thing, which should help with Nokia's operations.
Fifth, we also need to keep in mind that Nokia receives around $1 billion from 40 different companies that pay it royalties and other license fees. This number is likely to increase significantly as we move forward because Nokia receives royalties per product sold. For example, if Apple is able to grow its sales volume by 20% year-on-year, Nokia will collect 20% more from Apple year-on-year. Considering that the smartphone market is expected to grow in double digits for the next decade, we can see a lot of royalty fee growth for Nokia as we move forward.
Excluding the partnership payments from Microsoft, Nokia's smartphone business should have an annual operating expense of $1 billion. If we go back to the drawing board, we find out that it will take Nokia only 4.2 million Lumia phone sales to reach breakeven. If the company sells 6 million phones per quarter, its smartphone division will see operating profit of $1.44 billion. Again, this doesn't include the company's highly profitable Asha phones and it doesn't include the royalty fees collected from other companies. Furthermore, the company's mapping business and Nokia Siemens Networks are also likely to be profitable.
In the fourth quarter, Nokia was able to sell 6.6 million smartphones and Lumias made up 4.4 million of this number. Nokia announced a small profit in the devices and services segment, which is responsible for developing, building and marketing phones for Nokia. Obviously, the company didn't need to sell 12 million Lumias to reach the breakeven point.
In conclusion, I think Nokia will do much better than analysts give it credit for.
Disclosure: I am long NOK, HPQ.