Roughly a week ago, Seeking Alpha author Jacob Steinberg wrote an article where he dismissed an analysts claim that Nokia (NOK) needed to sell 12 million Lumias for its Smart Device Division to break even. He argued that 6M is a more realistic number, but as I will argue in this article, his estimate is based on invalid arguments.
Before I begin my article I would like to disclose that I actually do own a Lumia phone, and I am yet undecided of whether Nokia is undervalued or overvalued. So this article will not attempt to convince you that you should not buy/short Nokia. Instead, I just want to get the facts straight as I believe there is too much bias in most of the articles involving Nokia.
Argument 1: Lumia phones are still relatively new, which means that R&D and Sales and Marketing expenses will likely decline over time.
Jacob uses General Motors as an example of why OPEX (operating expenses) as a percentage of revenue will decline over time, but rather than use a different company in a different market, why not just analyze what happened to Apple's operating costs when revenues of the iPhone grew?
If we look at Apple we do indeed notice that R&D and SGA declined as a percentage as revenue, but isn't it likely that Mr. Kvaal already has taken this into account in his estimations?
By looking at Nokia's historical OPEX/revenue ratio and comparing it to Mr. Kvall's implicit OPEX/revenue ratio I believe that we can get a better understanding of whether this is the case.
In the below graph, we can see that OPEX has increased over time, and in the most recent quarter they totaled 45% of revenue.
Mr. Kvaal on the other hand estimates that if Nokia sells 12M Lumias, then operating expenses will total 500M, which is equal to an OPEX/revenue ratio of 18.5%.
This seems like a relatively low ratio and suggests that Mr. Kvaal actually has taken into account that Nokia will become more efficient in the future.
Argument 2: Nokia is getting meaner and leaner which will reduce the OPEX/revenue ratio.
Again, how does Jacob know that Mr. Kvaal hasn't taking this into account? It's possible that Jacob is correct and Mr. Kvaal is wrong, however, he definitely needs to do a better job of quantifying the "leaner" effect. Until he has done that, I have to conclude that this argument is non-valid as well.
Argument 3: Asha phones are very profitable as well.
Indeed, Nokia seems to do very well with its Asha phones. However, Jacob shouldn't have mentioned this in his critique of Mr. Kvaal, as these phones aren't a part of Nokia's Smart Device Division.
Argument 4: Microsoft pays Nokia $1 billion so that Nokia stays in the partnership.
This is the only relevant argument Jacob presents. However, even here Mr. Kvaal is still technically correct as Nokia doesn't include the royalties in its Smart Device Division. But I do admit though, that assuming we want to estimate the profitability of the Lumia phones, then it doesn't make sense to exclude them.
By adding $250 million per quarter to the equation, I have estimated that Nokia's smart device division can break even by selling roughly 7M Lumia phones on a quarterly basis.
Argument 5: Nokia receives royalties from other sources as well.
This argument is irrelevant as well for the same reason as I dismissed argument 3.
As investors we probably shouldn't rely too much on trying to estimate the amount of Lumia phones that is needed for Nokia to break even. Instead, it is probably more relevant to estimate how many Lumia phones are needed to be sold for Nokia to be a profitable investment for shareholders. While this goes a bit beyond the scope of my original intention for this article, I have actually made a rough estimate of this number given the below assumptions:
- Nokia's future earnings on an annual basis must be at least 10% of its current share price for Nokia to be a profitable investment for shareholders.
- Earnings of Nokia's other divisions are unchanged (I am using non-IFRS numbers)
- Tax rate of 30%
- Gross margin of 20% on Nokia Lumia phones.
- Smart device operating expenses of 2B Euro per year.
- Average revenue per Lumia of 225 Euro
Given those assumptions I have estimated (in the below table) that Nokia at some point in the future needs to sell roughly 59M Lumias on an annual basis to be a profitable investment for shareholders. Take these numbers with a grain of salt, as some of the assumptions may not be very realistic, however I still believe that these numbers indicate that Nokia has a tough road ahead as Lumia sales of 4-7 million per quarter simply isn't enough.