It's no secret that Nokia (NYSE:NOK) has fallen on hard times recently. Once the largest mobile phone manufacturer in the world, it failed to keep pace with the rapid development of smartphones and saw its position in the marketplace quickly plummet. Today it stands as the second largest mobile phone manufacturer and the third largest smartphone manufacturer. To the dismay of many, time not only treated the company poorly, but its stock as well. Since its high of 2007, the company has depreciated by 91.6 percent; prices fell by 47 percent in the last two years alone, just months after the announcement of Nokia's partnership with Microsoft (NASDAQ:MSFT).
In recent months, however, Nokia seems to have adjusted to the competition. Nokia's partnership - which was originally viewed as such a disaster that it caused shares to topple 14 percent the very next day - seems to finally be yielding real results. Just half a year ago, Nokia introduced the world to the Lumia 920, which was met with critical praise and started the formation of the entire Lumia lineup. Nokia quickly followed up with the 925 and 928, and it is the introduction of these devices that act as a main catalyst to helping revive Nokia's bludgeoned share price and unlocking the full value of the company.
Devices and Services
Nokia is divided into three business divisions, devices and services being the most publicly visible of them. All devices the company makes are accounted for in this division.
This division's revenues have been collapsing since 2010, which is extremely unfortunate considering that they accounted for 69 percent of Nokia's total revenues in 2010. However, it consequently presents the greatest opportunity to grow the company and revive its share price.
The main reason for the fall in revenues, of course, is increased competition by Apple (NASDAQ:AAPL) and manufacturers of Google's (NASDAQ:GOOG) Android phones - most notably Samsung. The capabilities of those phones were far beyond those of the highest end Nokia devices, and therefore the company saw its market share dwindle.
That all started to change with the release of Windows Phone 8 (WP8). The first phones developed for the platform were the Lumia 920 and 820, and since then, the company has gone on to develop six phones that utilize WP 8, not including the Lumia 928 and 925. These phones - the first of which is available now and the second which is expected to hit markets this month - deserve individual attention, because they help clear one of Nokia's largest hurdles in a successful turnaround, which is market presence.
The introduction of these phones allows Nokia to get past exclusivity agreements with AT&T (NYSE:T) and sell a flagship phone on three major US carriers. AT&T will continue to sell the 920, while Verizon (NYSE:VZ) will sell the 928 and T-Mobile will sell the 925. The importance of this move cannot be understated. Currently, with only six WP 8 offerings, and only one really intended to compete with juggernauts like the iPhone and Galaxy S4, Nokia has already seen success beyond what many had expected. Market share in the US and UK stand at 5.6 percent and 8.4 percent, respectively; this is a monumental increase from the 3.8 percent and 4 percent share held just one year ago. While these are metrics for Windows Phone 8 and not Nokia, it just so happens that Nokia controls 80 percent of the Windows Phone market, making the metric a very good proxy.
Of course, the success cannot be attributed entirely to the 920, or even Windows Phone 8 for that matter. Two of the three most popular Windows phones worldwide, the Lumia 800 and 710, run on WP 7. Additionally, while the 920 accounts for 20 percent of Windows phones in the US, the number is beat by the 22 percent of phones that are Lumia 822s - Verizon's main Lumia before the 925. Part of Nokia's strength is its diversified offerings of phones. While this may seem troublesome in the United States, where iPhone commands a 41 percent market share, this becomes a distinct advantage in other countries. In Spain, for example, Sony (NYSE:SNE) and LG control over a third of the market, simply because there is a huge demand for cheaper sub-€150 (under $200) devices.
However, in the US, where carrier subsidies greatly distort the actual price of phones, high-end phones are of particular importance. It's for that reason that the 920 is the most popular Windows phone in the world, and for that reason that the 925 and 928 are so important to the company's success. Looking at various reported market shares from Kantar Worldpanel Com Tech and Windows Phone Daily, we can calculate that 4.1 percent of smartphones sold by AT&T happen to be the Lumia 920. In other words, the 920 alone commands 1.1 percent of the US smartphone market. Now, this figure certainly doesn't seem like much, but a few things must be considered. The first, of course, is that this is a six-month old phone made by a manufacturer that was all but left for dead. More importantly, there is an inherent "stickiness" in the smartphone market that typically causes a lag between product quality and market share. This is because phone preferences are heavily dependent on placement within an ecosystem, which is in turn largely dependent on a network effect.
The Network Effect on Nokia
A network effect describes a phenomenon where the quality of experience a product provides is directly related to how many people use it. A clear example would be a telephone - Alexander Graham Bell's first telephone was certainly useless until more telephones were manufactured and sold. The same phenomenon affects mobile phone preferences, for a number of reasons. One of the most obvious reasons is that a company with a successful product finds themselves with more funds available, which can be used to increase research and development efforts and create improved devices and services. Another reason is that, as more people adopt a new operating system, they form a larger market which appeals to app developers.
Nokia and Microsoft are already starting to see the advantages of their growing size, small as it may be. The number of apps available through WP 8 has increased from 7,000 to 145,000 in two years. While the number pales in comparison to the over 800,000 apps available on iOS, and some of the growth is due simply to the growth of the smartphone market and app market as a whole, that Apple grew their offerings by under 200 percent while Microsoft grew theirs by almost 2000 percent reveals that more and more developers are finding it worthwhile to develop for the platform.
We can therefore see that having a premium offering available on three carriers, or almost three quarters of the smartphone market, will only help exacerbate this. After all, Nokia has attained this level of success with a series of ads that focused almost exclusively on the Lumia 920. It is understandable that this much focus be given to the device. The 920 is among the most well-received phones on the market, having won Engadget's Reader's Choice Award for Smartphone of the Year and being ranked number 12 on Mashable's Top 25 Tech of 2012.
Having a flagship phone in three carriers will only help promote the image Nokia and Microsoft have been pushing to project. While sales figures may not rise immediately - both Verizon and T-Mobile have done relatively well selling the Lumias they currently offer - the move will cement Nokia's position as a competitor in the premium smartphone market and will greatly raise awareness and accessibility of the company's top products. Additionally, the 925 is free of some of the most criticized elements of the 920; it weighs a quarter less, at 139 grams and has significantly better battery life, which will help sway some customers who were less pleased with the 920.
HERE and Nokia Siemens Network
HERE and Nokia Siemens Network, or NSN, are the other two divisions of Nokia's business. While not as large as the Devices & Services division, no analysis of the company is complete without looking at the prospects of these groups. Furthermore, as revenues from Devices & Services decreased, NSN contributed to a larger portion of revenues, accounting for 48 percent of revenues (compared to Devices & Services 49 percent).
From an accounting perspective, HERE is almost irrelevant. Last quarter, it generated under €300 million for an operating loss of under $130 million in a company that had just under $7.8 billion in quarterly sales. However, HERE - the mapping and location-based products division - works to support and improve Nokia's smartphones. An excellent article published here discussed how Nokia and Microsoft are simultaneously seeking ways to compete in a traditional sense while simultaneously redefining a portion of the market to their benefit. HERE is a prime example of the latter strategy. While both Apple and Google make maps, one of Nokia's offerings (Nokia Drive) can work offline as well, creating a completely new experience. This is particularly useful for people in cities where subway lines or roads are underground, thus providing Nokia phones with a unique competitive advantage.
The more significant division, of course, is NSN. Jointly owned by Nokia and Siemens (SI), NSN works to provide telecommunications infrastructure, primarily regarding mobile broadband. Many may not realize that not only does Nokia have a business division dealing with something other than manufacturing phones, but that division is remarkably large. NSN is the second largest mobile infrastructure provider worldwide in revenues, and the largest by customers served.
NSN competes directly with Alcatel-Lucent (ALU) and Ericsson (NASDAQ:ERIC) in this arena. One of the biggest struggles faced by the entire sector has been the economic crisis of the last few years. The recession has led many telecommunication companies to postpone or cancel plans they had to expand or upgrade networks, causing a drastic reduction in business. Fortunately, as the economy slowly recovers and current infrastructure continues to age, mobile service providers will find it harder and harder to put off these network updates any longer. More importantly, global data consumption is expected to increase tenfold between 2011 and 2016, effectively guaranteeing growth for NSN as carriers struggle to expand and keep up with demand over the next few years.
Nokia's financials, like those of any company attempting a recovery from hard times, shows mixed signals. There are certainly a great many positive pieces of information to be considered. The first is that revenues, though well below their 2007 highs, are still quite lofty. With 2012 revenues of over $38 billion, the stock trades at a measly .34 times sales - the lowest that metric has been for the last five years - and 1.32 times book value. Additionally, the company has a rather strong balance sheet. Nokia has a current ratio of 1.29, a debt-to-equity ratio of .73, and has over $1.53 per share in cash.
Of course, there is some information that might paint a more pessimistic picture of the company's prospects. The clearest one is that, simply put, Nokia is losing money. In 2011, the company lost over $1.8 billion; this year that number has risen to a loss of almost $5 billion. Even more worrisome is that in 2012, Nokia was cash flow negative, with a net cash outflow of $374 million.
Nokia is certainly a risky investment, as its struggle to regain footing in an extremely crowded and competitive marketplace is far from certain. To better understand exactly what Nokia is facing, it is imperative to identify and analyze all possible risks to its business prospects.
The most immediate risk is the possibility that Nokia will fail to gain any market traction. Though revenues are still high, the fact that they're decreasing does have meaning that can't be entirely overlooked. Furthermore, a company cannot burn cash and report negative earnings indefinitely. However, the company's presence in the smartphone market has risen this year by market share. Reduced earnings are, in large part, due to the sale of older Nokia devices at discounted prices as the company tries to clear inventory of WP 7 devices. Nokia has disclosed that they are shifting their product mix to a higher margin one, and the Lumia 928 and 925 are excellent additions in helping achieve that goal - especially considering that the 925 will be sold worldwide. Unfortunately, to achieve that mix, Nokia has had to discontinue certain models and essentially dump their inventory. The Lumia 610, for example, was discontinued and replaced with the 620; the 510 was replaced by the 521. As Nokia starts developing a more regular consumer base, thus stabilizing their supply chain, the introduction of future iterations of devices and completely new ones should be smoother and such dumping should be reduced.
One of Nokia's strongest advantages is that its phones, with the exception of the HTC 8X, have become synonymous with Windows Phone. One major concern is that such position could quickly be challenged. Possible disruptors include current handset makers with Windows devices, namely Samsung and HTC. Both are very large manufacturers that have found enormous success, and if one chose to do so, they could easily build a competitive windows phone and destroy Nokia's positioning in the market. Fortunately, such an outcome is extremely unlikely to occur. Both Samsung and HTC are heavily invested in the Android ecosystem to great success; the Galaxy S4, for example, sold 6 million units in two weeks. It makes little sense for either manufacturer to risk upsetting Google and compromising their position in the Android market to develop for a platform with less than 6 percent market share.
There is one company that may well choose to develop phones running Microsoft's software, and that company is… Microsoft. Toward the end of last year, as Microsoft began reorganizing and redefining themselves, Steve Ballmer sent a letter stating that Microsoft is officially a devices and services company. He shortly confirmed his statement with the release of the Microsoft Surface. The question on many investors' minds is that, if Microsoft was willing to manufacture their own tablets, what's to stop them from doing so with phones?
On the surface, the suggestion is a completely logical one. Microsoft certainly has the financial resources to develop their own mobile phones, they have a huge incentive to do so in the form of getting their software and services in the hands of more consumers, and the prospect of a Surface phone is a very well-circulated rumor.
Yet I remain hesitant that Microsoft plans on making such a move. For one thing, Microsoft has stated they don't currently plan on making any such device. The prospects of such a device could better be understood through the circumstances that led to the original production of the Surface. At the time, iOS and Android (mostly in the form of the Nexus and Kindle) accounted for over 97 percent of the tablet market, and there wasn't a single Windows tablet that could compete. The Surface was Microsoft's attempt at developing a premium offering showcasing the brand new Windows 8 software, creating a quasi-flagship device that would spur creation among other manufacturers and raise consumer awareness. Manufacturers quickly followed suit, and Microsoft was able to successfully encourage the production of some remarkable Windows tablets.
Microsoft has no need to make such a mobile device, as the HTC 8X and Lumia 920 are extremely visible and are stellar products in their own rights. More importantly, Microsoft needs Nokia just as much as Nokia needs Microsoft. Many complaints people have with Nokia's devices are not with the phones themselves, but rather WP 8 - specifically the lack of a notification center. Nokia's hardware can go toe-to-toe with any other device, and if the threat of a Microsoft phone becomes too strong, Nokia could just as well product phones that run on Android.
The final threat that must be considered is, unfortunately, out of Nokia's control. As a Finnish company, Nokia's operations are funded by the Euro. With the growing threat that Federal Reserve will decide to reduce funding for its QE program sooner than expected, investors are expected to put their money in risk-averse assets. One such option would be the US dollar. As such, many expect the exchange rate to fall significantly from 1.29 USD/EUR. The consequences to this are much harder to determine, as it will have both a positive and negative impact. As the Euro depreciates, so will the value of Nokia's entire enterprise when measured in dollars. This will be at least partially countered with increased sales that come with such a favorable rate on international trade. To buy a €300 phone from Nokia, a retailer would today have to pay $388.89. If that rate were to drop to, say, 1.2 USD/EUR, a retailer would find instant savings of almost $30 on each device it buys.
Finally, it is imperative to address a scenario that has generated a bit of buzz recently; the notion that Nokia is primed for a buyout. Nokia has shown that it can make commercially successful phones with remarkable hardware. More importantly, Nokia has roughly 10,000 patents, which are becoming increasingly valuable in today's marketplace. The main problem is, with a market cap of $13 billion, the list of potential buyers is somewhat short. The two most likely suitors are Google and Microsoft.
Google has already shown a willingness for such buyouts with its purchase of Motorola Mobility Solutions. However, that purchase has already left Google with a substantial patent portfolio and a means of producing its own devices; Google's need for a similar company is rather unclear.
On the other hand, a buyout by Microsoft is actually plausible. The partnership between the two is extremely strong, and Microsoft has revealed a willingness to manufacture its own devices with the Surface. Buying Nokia outright instead of attempting to compete with them will prevent Microsoft from having to invest in developing brand new infrastructure - which may actually be more expensive than buying Nokia - as well as provide Microsoft with already stellar hardware, a global customer base, and remarkable patent protection. Additionally, as we've seen, Nokia has a rather strong balance sheet, which should only make such a buyout more favorable.
While Nokia may still have quite a few hurdles to clear, I can't help but think that the company is an extremely worthwhile investment. Nokia is simply priced to fail, or at least struggle greatly and achieve extremely limited success. However, their constantly-improving product line, their war chest of lucrative patents, and performance over the last few months paints a completely different picture. Furthermore, while a buyout is unlikely, it certainly can't be ruled out, making shares even more tempting. At their current price of $3.53, shares trade at nearly 30 percent below the 52-week high they reached in January, and the company's prospects have only improved since, suggesting that the stock is well poised for another run. For further information regarding NOK, please feel free to contact us at firstname.lastname@example.org.
Disclosure: I am long AAPL, GOOG, MSFT, 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.