Nokia's (NOK) second quarter results were met with a sell-off in the stock as it failed to meet market and sell-side expectations. Namely the Devices & Services business disappointed expectations. However on closer examination of the results it looks like this was a classic bear trap, with the predominantly bearish sell side setting Nokia up to miss their Q2 forecasts so that they could hit the stock today.
For the all important Lumia sales, the sell-side was disappointed by the 7.4m volume number for Q2. Even though this is +32% Quarter on Quarter (QoQ) vs. management guidance which was for growth of 27%. That is because the consensus had forecast 7.8m units sold or + 42%. Even the bulls on the stock were expecting a figure between 7 - 7.5m. It is somewhat analogous to be bearish on Nokia but also be forecasting its' lead product to be growing at 42% QoQ. The bears set the bar too high in order to disappoint. Also the product launch schedule meant a lot of the lead products did not get the benefit of a full quarter of sales. This should have been well known. Yet Nokia still grew volumes by greater than forecast 32%.
Coming to Average Selling Prices (ASPs) for smartphones. ASPs fell 18% QoQ to E157. This was partly due to pricing but also largely due to mix. Nokia's launches in the low to mid end smart phone market, namely the Lumia 520 & 720 during the quarter naturally lead to lower ASPs. Some of the high end launches such as the 1020 are coming in Q3 and will benefit ASPs in Q3. Again this mix shift had not been properly accounted for in the consensus forecasts.
The Mobile Phone division saw volumes decline to 53.8m from 55.8m in Q1. However the company did state it saw a pickup towards the end of the quarter. Flagship products such as the Asha 501 are only now just getting out in the channel. A higher proportion of sub E30 phones again impacted the mix and brought ASPs down and contributed to the 12% QoQ fall in the mobile phones division.
Despite the mix shifts the Gross Margin in Device & Services held up well, only falling 70 basis points QoQ to 24.4%. However interestingly in the conference call the CFO stated that the underlying improvement in the Smart Phone division's Gross Margin was actually 300 basis points accounting for one-offs. The Smart Phone business actually recorded a 100 basis points increase to 21.7% QoQ in the Gross Margin accounting for these negative one-offs.
Mobile Phones saw a 340 basis points decline in the Gross Margin QoQ due to a pick up in warranty costs from an unusually benign Q1. Additionally there was a 120 basis points headwind from currency to the Gross Margin in Q2, which management guided to reverse in Q3. As such can expect underlying Gross Margin trends in D&S to rebound significantly in Q3.
In terms of Nokia Siemens Networks (NSN), it delivered a very impressive 11.8% margin. The company recognizes the lumpy nature of this business and still guides to a 7% margin in Q3. However if look at SOTP valuation a sustainable margin at 7 - 8%, would warrant 0.7x EV/Sales. This compares to the 0.35x Nokia paid for the NSN stake from Siemens highlighting the value creation achieved.
In terms of the cash burn at E420m, it was in line with the guidance given by Nokia previously. However note about E250m of that was due to working capital increase, which the CFO said could be released in Q3 assuming their guidance of growth in D&S sales is met. Combine that with the NSN cash flow machine, the E4.1bn net cash on the balance sheet (this is pre-NSN completion), it is very likely that the cash burn bear story for Nokia vanishes over the next few quarters.
So with Nokia the investment case is very much intact and today's results showed continued and strong improvement, once investors ignore the unrealistic & badly modeled sell side expectations. The Lumia range is getting traction. Note that on the AT&T (T) website it is no longer possible to pre-order the Lumia 1020 as they have run out of stock. This is confirmed by this blog post.
The cash flow profile of Nokia is set to rapidly improve and the Sum of the Parts valuations put on NSN is too low. The Device & Services business is arguably in the stock price for very little or negative value. This is at a time when Nokia has teamed up with the giant that is Microsoft in both companies' definitive bid to create a third ecosystem.
Ignore today's bear trap and keep buying. This is the turnaround story in the European tech space over the next 12 - 24 months.