To the Board of Directors:
Let me start by saying that I am very encouraged by recent events: Nokia's (NYSE:NOK) management team is doing an impressive job of redeploying the company's formidable research expertise and engineering excellence into opportunities that have been missed over the past five years. Marketing too, from being wastefully scattered is more focused. I am so encouraged that my money is with you (or rather, I have appointed you to look after my investment): I'm long Nokia.
The Financial Statements, however, remain among the most opaque and indecipherable I have encountered over a 20-year stock market career. I realize Nokia is a company under huge upheaval, that restructuring efforts will obfuscate underlying operations in the near term, but the fact remains that any potential reader of your statements will emerge far more confused than informed about the underlying health and profit potential of the company.
Allow me to elaborate. A key driver going forward will be the profit potential of smartphones. An investor considering Nokia today will want to make a careful assessment of how much profit will accrue if Nokia eventually gains 5% of the world smartphone market. What about 10%? This will probably be the biggest driver in his decision. Doubtless, he will need to input his own factors of some important variables (e.g., average selling price, split of models sold, split between unlocked sales and those sold through a mobile carrier with a longer revenue stream, etc.), but I'm convinced the information contained in your current financial statements makes this task impossible, even if one bears the burden of inputting some important variables.
I will explain myself using your most recent disclosure (that of Q2 2012, see link here) by attempting to show what was disclosed and ultimately what an investor would like to see:
The Devices and Services Segment
You provide the units of smart and mobile phones sold, the ASP and the gross profit in each sub-division. You then detail a 'contribution margin'. I'm not sure if this is the gross profit of the marginal phone sold, or the average profit of phones sold. There is no explanation, even in your detailed notes. In fact in your notes (see page 8 in the link above) you post a contribution margin in smart devices of -32.9%. Yet, stating a scalable business has a negative contribution margin - whatever your interpretation of the term - is patently misleading!
On the eighth reading, I realized this -32.9% was skewed by your internal allocation of restructuring charges to the Smart Devices segment.
Note 2 on contribution margin in smart devices from page 8: The year-on-year decrease in operating expenses resulted from the proportionate allocation of operating expenses being affected by the relative mix of sales and gross profit performance between Mobile Phones and Smart Devices, resulting in lower relative allocations to Smart Devices in the first and second quarters 2012.
My objective (as an investor in Nokia) is to determine the cell phone units required to break even, followed by the scale economies as Nokia exceeds that; I want to determine the operating leverage inherent in the division as Nokia gains market share. You need to specify precisely what you mean by 'contribution margin', which will allow me to make an informed assessment how this shifts (i.e., linearly at what rate, or exponentially) as volumes increase, excluding restructuring charges. I challenge you to show me how the information you provide enables an investor to infer this crucial piece of the puzzle.
The statements are further muddied by your attempt to allocate the fixed cost base between two segments, smart and feature phones. I realize the downsizing means this is a moving target, but I would like to know the total fixed cost base, before your internal transfers.
The division is made even less clear by including the 'Other Services' division within it. Included in this is IPR (Intellectual Property Royalties). As per your note 1 in the 'Smart Devices Summary' division:
"Note 1: Includes IPR royalty income recognized in Devices & Services Other net sales."
It would be relatively straightforward to isolate the segment if it this was a transparent number. However, there is so much confusion about how much IPR is received and paid (to Microsoft (NASDAQ:MSFT), et al.), and you do not specify. To support my point, here are some of the details on IPR:
In the cashflow section:
Year-on-year, net cash and other liquid assets increased by EUR 306 million in the second quarter 2012, primarily due to cash flows related to IPR, including a EUR 400 million receipt of pre-payments from existing IPR licenses, the receipt of quarterly platform support payments from Microsoft (which commenced in the fourth quarter 2011), a EUR 500 million equity investment in Nokia Siemens Networks by Siemens (received in the third quarter of 2011) and positive overall net cash from operating activities, partially offset by payment of the annual dividend totaling EUR 742 million, capital expenditures and cash outflows related to restructuring.
In the devices & services segment: "We estimate that our current annual IPR royalty income run-rate is approximately EUR 0.5 billion."
You later describe the platform service payments with Microsoft (page 5 of the link above):
We have a competitive software royalty structure, which includes annual minimum software royalty commitments. Minimum software royalty commitments are paid quarterly. Over the life of the agreement, both the platform support payments and the minimum software royalty commitments are expected to measure in the billions of US dollars. The total amount of the platform support payments is expected to slightly exceed the total amount of the minimum software royalty commitments. In accordance with the contract terms, the platform support payments and annual minimum software royalty commitment payments continue for a corresponding period of time.
Am I to infer that software royalty receipts are distinct from IPR, as one is to exceed euro 0.5 bn, and the other is just slightly positive? Yet, in the cashflow section, you lump the two together. Clearly, this is very confusing.
As far as I can deduce from the numerous notes relating to IPR, the revenue is classified in the Devices and Services 'Other' segment, but the income is classified in the Smart Devices division. Is this correct? Isn't this perverse?
My advice: make Intellectual Property Royalties and their nature far clearer. More preferably, exclude it from other segments, lump all the Intellectual Royalties together (received from, and paid to, various sources) and report the division separately. This would make life far easier for an investor to gauge the intrinsic value of the 10,000 mobile telephony patents Nokia has accumulated over its history.
The Nokia Siemens Network Division
This division is undergoing the most change, and I fully understand the results will be confusing through the restructuring. However, I'm under the impression it's a 50:50 joint venture with Siemens (SI). If so, is it fully consolidated (i.e., you have control) and then where is the minority interest? Or is just your share of revenue and profits you report? In any event, the reporting should clearly describe the above.
In the interests of not being overly critical, I should add there are aspects of your report that are commendable, e.g., the geographic split, but I have focused this letter exclusively on the disclosure's shortcomings.
I sincerely hope you can reconfigure the reporting for your forthcoming results (2H 2012), which have been pre-announced and reviewed positively by the market. The devil, however, is in the detail. I'm convinced you can do a far better job in the reporting. Nokia's share price suggests the risks of bankruptcy are now remote. It is now time to highlight the company's profit potential, in a manner that permits lucid and logical analysis.
In my opinion, a bad company may have a good financial report in that it highlights the recovery potential of a company's current problems. A 'bad' or opaque financial report, however, will always remain bad, however good the underlying company. I hope you'll agree.
Disclosure: I am long NOK. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.