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We suggested in June last year that one should buy shares in Nokia (NYSE:NOK) then at $2.75. This was a rather risky bet. So far, it has paid off, but this isn't guaranteed. Nokia, after dominating mobile phones for a decade or so, famously hit a wall when Apple (NASDAQ:AAPL) introduced the touchscreen smartphone.

Now, Apple itself is somewhat struggling, as the Android platform usurped much of the smartphone space and rapid growth is starting to run out of customers able and willing to spend $600+ on a mobile phone. That is, the next phase of growth must mainly come from emerging markets, and that, grosso modo, requires cheaper phones, hence the entry of the Chinese, both as consumers and producers.

The first thing one should realize is that smartphones, for all their cutting-edge technology they contain, consist of relatively standard parts that are available to many would be manufacturers. The CPU's that are running them work on designs by ARM (NASDAQ:ARMH) and are manufactured by the likes of, Qualcomm (NASDAQ:QCOM) with their Snapdragon series, Nvidia (NASDAQ:NVDA) with their Tegra chips and Samsung (OTC:SSNLF).

Intel (NASDAQ:INTC) is trying to make inroads as well here, and there are quite a few lower-tier chip backers with cheaper offerings (but the performance of these is usually one or two generations behind the CPU's in the top-end phones).

All other parts, like the screens, the protective gorilla glass, the memory and signal chips, the gyroscopes, etc. can be sourced from one or several players at roughly equal terms. So basically, smartphone manufacturers can differentiate their phones on:

  • Software
  • Design
  • Features
  • Price
  • Innovation

Software platform

Apple (and Blackberry (NASDAQ:BBRY)) are unique in the sense that they have created the software platform in-house (iOS, BB10), and Apple at least has built a thriving ecosystem on the basis of that. Nokia actually had software platforms (Symbian, Meego, Maemo), but these were caught rather flat-footed by iOS (although some former Nokia employees are trying to revive one of these).

Most mobile phone companies simply go with Android, because it's free. And because it's free, there has been a bit of a virtuous cycle working, where more users attract more application designers, and more applications attract more users. Many mobile phone companies try to differentiate by building their own 'skin' upon the Android platform (like Samsung's 'TouchWiz').

Although the idea behind this, differentiation and especially introducing some switching cost (that is, making it more difficult for users to change to a different branded phone), the success of these is rather mixed, and further undermined by the emergence of cheaper 'pure' Android phones like Google's (NASDAQ:GOOG) own Nexus 4, usually introducing the latest version of Android.

Nokia has chosen a different route and went with Microsoft (NASDAQ:MSFT), in all likelihood because their finances were getting dire and the Microsoft tie-up supposedly got Nokia something in the order of $1B a year. Although Microsoft's mobile operating system is generally well received, it's running behind in terms of available apps compared to the two main competitors, iOS and Android.

However, Microsoft might be embarking on something, which we first suggested for Apple, the creation of a unified operating system for mobile phones, tablets, hybrids and PC's. Why is this important? Well, this would pave the way for your mobile phone to become truly your personal computer.

Basically, the hardware part of this is already there, or thereabouts. There are already USB stick-sized devices, like the MK802, that you stick in a USB port and hey presto, it turns your LCD screen into an Android PC. Android, of course, runs tablets, and hybrids (like the excellent Asus Transformers) as well.

Intel already had its own version, the Intel MUC, running a third generation i5 processor. It's still a bit bigger than the Android version (based on ARM design chips), as the chips are a bit larger and in need of fan cooling. But with Haswell chips, the difference will shrink, although these will still need a fan, apart from the next generation Atom chips.

It is simply a result of Moore's Law, ever shrinking transistors, so ever more can be placed on chips and/or ever more chips can be made from the same wafer, reducing the cost. We're not quite there yet, but getting mighty close.

The limiting part is actually the software. You see companies like Samsung and Asus coming with hybrid devices that work on two operating systems (Android in tablet form, Windows 8 laptop form). This is still in part the hardware limitation (Intel iCore chips still needing a fan, even the Haswell ones), but this will soon be a thing of the past.

Which will leave the software as the only remaining limit. If Windows could unify Windows Mobile and Windows 8, that could remove that limit and give mobile phones running on Windows a leg up. But don't get your hopes up too far, as:

  • This isn't something that is going to happen anytime soon (probably at least two years off, it's not even certain it is going to happen)
  • By then, it's likely that more phones will run on Windows (this is already the case), so Nokia won't have that much of an advantage, if any.

But still, this is quite an interesting development. Your mobile phone becoming your computer, plug it into a screen and add a (Bluetooth) keyboard, and you always have your PC with you. Data mostly in the cloud. In fact, this is already happening slowly. Many people in developing countries don't have computers, but cheap smartphones and tablets already form something of an alternative.

The jury is still out whether Nokia is burdened or profits from the relationship with Microsoft. It does have an 80% market share in the Windows Mobile market, so it is likely that Nokia will be identified with this operating system. It could very well be that Nokia benefits from enough curious people, egged on by positive reviews, simply to try the system out.

The tiles are nice enough, and although not all main applications available on other platforms are available on Windows mobile (yet?), it has a few tricks of its own up its sleeve. How many more Lumia phones Nokia would have sold if they were running on Android is anyone's guess.

Our own guess is not more, and quite possible less. At least Windows enables Nokia to differentiate itself from the competition. Besides Samsung, not that many mobile phone makers enjoy much success in the Android space, that's something to keep in mind as well.

John Dvorak is considerably less optimistic, he argues that as long as Windows Mobile is run by corporate headquarters it doesn't stand a chance, as it won't have enough room to experiment. Comparing the iOS/Android duopoly with other duopolies (game consoles, Wintel), he argues:

All three of these duopolies exist because there is a very limited number of people who can develop for these systems and those people want to get paid as much as possible. Those developers cannot afford to work on an also-ran platform. Developers work for a dominant platform and the almost competition, period. That's how you get a duopoly computers, game consoles, and phones.

We're not that pessimistic (by December last year, there were already 150,000 applications in the Windows Mobile space, not quite the 740,000 for iOS, but nobody can argue there are no application developers interested in Windows), but Windows Mobile, and hence Nokia, do face an uphill battle, there is no doubt about it.

Design, features, price

The next plank of competition is the design/features/price nexus. Apple used to be king, but they're losing out a bit because they offer a one-size-fits-all phone, while the Android world has a good deal of variety. For instance, many users seem to prefer phones with bigger screens. The second generation Lumia phones are quite well received, design/features/price wise, and have had decent sales (5.6M), but these are way off pace setters Apple and Samsung.

However, as the shift from iOS to Android shows, the smartphone world is quite competitive and switching cost are fairly low. This means that one or a couple of good designs can create something of a buzz and get sales going. For instance, HTC's fortunes could very well turn on the highly praised HTC One Smartphone, currently in third place of smartphone sales (behind the Galaxy S4 and Apple iPhone 5, according to Barron's)

Many reviewers rate the HTC One as a superior product to Samsung's Galaxy 4 phone. The latter created a surprise hit with its Samsung Note phablets, not to speak of the tens of millions of Galaxy line smartphones they sold. We're quite curious about upcoming phones that seem to have an excellent mix of design/features/price.

For instance, the Alcatel One Touch Idol X, just 7.1mm thick, but with a 5 inch full HD screen and an 1.5GHz quad core processor with a potential price at under 250 pounds, half the price of the iPhone and the Galaxy S4. Or an even slimmer phone, Huawei's Ascend P6, the world's slimmest smartphone at just 6.18mm.

These are phones from hitherto second or third tier players that can compete with the best on features, have notable designs, and are significantly cheaper than the high-end smartphones. If the likes of Alcatel, HTC, and Huawei can pull it off, there is no reason to assume that Nokia, with their track record can't.

Having said that, so far they haven't. The Lumia phones have nice designs, but are quite heavy and bulky, almost twice as bulky as the upcoming phones just mentioned. While the new Lumia 925 cuts the weight to a more reasonable 139 grams and has ditched the distinctive polycarbonate body (that self-repaired when scratched) to use an aluminum, much skinnier (8.5mm) body.

That's better, although the screen is a little bit of a letdown, with sub-HD resolution and PenTile, which makes pixelation a little bit of a problem, although really only when you look up close or compare it to full HD screens from the competition. It isn't cheap either, Trusted Reviews rated it as a 499 pound (UK) phone, which is a top-end price.

While that matters a bit less in the US, where prices are heavily subsidized by carriers, in much of the rest of the world this could be a serious problem, it could very well struggle against cheaper, but equally capable alternatives like the upcoming phones just mentioned.

Then there is the Lumia 928. Solid, especially the camera, but certainly no cut above the competition, unlike if you're a fan of Windows Mobile. Here is GSMArena:

The measures of the Nokia Lumia 928 are 133 x 68.9 x 10.1 mm, while its weight tips the scale at 162 grams. While the considerable thickness of the handset is easy to forgive, considering the solid camera hardware, we couldn't help but notice that the Lumia 928 with its 4.5" display has the same footprint as a 5" Android flagship.

These phones at least establish Nokia as a contender again in the smartphone business, and the importance of the 925 and 928 is probably more in the fact that they allow Nokia to get past the exclusivity deal with AT&T (NYSE:T), giving them a much wider footprint (at least in the US).

Innovation

What would really help is a truly distinctive phone. Nokia used to be able to make these. But since they have no longer much input from software, this has to come from hardware innovation. The present slab-like phone design, enabled by gorilla glass, seems pretty much the dominant design these days, so no sliders, flip phones or other classics, although flexible screens might enable a new wave of design innovation.

This limits Nokia further, however, they have at least one ace up their sleeve, in the form of the PureView camera technology that they applied to a Symbian phone. Now, the arrival of a Windows 8 based PureView camera phone, supposedly the Lumia 1020 seems upon us. Indeed, as Trusted Reviews notes:

The EOS/Lumia 1020 is the most eagerly anticipated device since Nokia and Microsoft joined forces in 2011 and perhaps represents the best chance for the pair to gain ground on Apple and Android manufacturers like Samsung.

A 41-megapixel cameraphone is certainly an eye catcher. But whether it sells on this number alone remains to be seen. It has to be said that the earlier (Symbian) version of the cameraphone really did impress, the camera part, not the phone part, needless to say.

And, of course, the competition doesn't rest in this hypercompetitive marketplace. Samsung has just announced a hybrid smartphone/camera, the Galaxy S4 zoom, one part Galaxy smartphone, one part point and shooter (and, unlike the Nokia, actually looking like one) with a 10x optical zoom and a 16 megapixel CMOS sensor.

Some bloggers, like Natasha Lomas, went already overboard in the title:

Samsung Just Killed Nokia's 'True PureView' Windows Phone And It's Not Even Unboxed Yet

The technology might be less revolutionary (although the Samsung device integrates the two devices in a pretty clever way), but not all that many consumers worry about the technology. Unless Nokia can achieve a reputation for having the must have camera phone, this might very well not deliver the benefits management surely is hoping it will. Jury is still out here.

The low-end market

Nokia's strength traditionally was to make phones for the masses, with the masses now distinctly residing in emerging economies. As SA contributor Abiola argued, this requires being able to produce smartphones that sell for $150 or less. The market may be large and growing rapidly, the margins are not, as the capabilities for producing cheap smartphones are hardly exclusive.

While Nokia will likely benefit from this market, one should keep in mind that a considerable part of the sales will have a cannibalizing character, that is, people buying smartphones instead of a simple mobile phone, in which Nokia was the dominant player.

Nokia has the capabilities to do well here, the brand recognition and the distribution networks, but the way they lost out to Apple and Samsung could have hurt some of their brand equity, as they're no longer considered as cutting edge. They do have several products that can compete in this space, but they're up against the Chinese here, this is a very tough market as well.

Finances

One thing to keep in mind is that margins are usually considerably slimmer in the lower end segment, and the phones in the top end suffer from the twin problems of lower selling prices and higher cost, at least the Lumia 900 did.

The company is expected to move back to profitability late this year (from CNBC):

(click to enlarge)

And indeed, there is a fair bit of momentum behind the smartphone sales though

At the close of the three-month period ending in April 2013, Android represented 51.7 percent of all smartphones nationwide, up from 50.3 percent in the year-ago period--a change of 1.4 percentage points. iOS remained in second place at 41.4 percent, increasing from 39.1 percent at the end of April 2012--a jump of 2.3 percentage points. Windows Phone followed at 5.6 percent, compared to 3.8 percent a year ago, an increase of 1.8 percentage points. [Fierce Mobile Content]

That is encouraging. One should also keep in mind that handsets consist only half of Nokia's revenue, the other half consists of network equipment (a JV with Siemens) and that division has recently turned around after some heavy restructuring, restoring EBITDA margins to more healthy levels (from 2013, these are Trevis projections, but the improvement in the last three years is clear).

It also has a substantial amount of net cash, $5.7B to be precise, or $1.5 per share.

A division that generates large free cash flow. Of the $1.9B that Trevis projects for this year, a whopping 82.9% comes from the network division.

Conclusion

If you buy Nokia shares based on this you basically assume that Nokia will be able to repeat some of the success they achieved in the mobile phone market before smartphones came around. But they are hobbled by the fact that they have little control over the software part (which is mostly in the hands of Microsoft), some reputational damage, and the emergence of alternative platforms like Android and iOS, which enjoy network effects.

The present hardware offerings do not really stand out from the competition. What distinguishes Nokia from the other mobile phone offerings is the software, it's reliance on Windows Mobile. The rumored Lumia 1020 could change that. Buying the shares now does constitute a bit of a gamble on Windows 8 and the Lumia 1020, but there is a fair bit of momentum behind Windows Mobile. We think the upside exceeds the risk, but only just.

Source: Is Nokia Still A Buy?