Despite the 7.4M sold smartphones, Nokia's (NOK) smart device division still lost 160M Euro (non-IFRS) in the quarter, and it hasn't had a profitable quarter since Q1 2011.
So I start to wonder, what exactly is required for Nokia to break even in the division. To be more specific, how many phones does it need to sell?
How much does Nokia earn per sold smartphone?
To answer that question, we need to look at two variables; 1) the average selling price of its smartphone devices and 2) The cost of producing a smartphone.
So let's begin with the former. In the below graph, you can see the historical average selling price (ASP) for Nokia's smart device division.
After the introduction of the Lumia phones in Q2 2012, the ASP increased as Symbian phones are less expensive than Lumia phones. However, in the last quarter we actually saw a significant ASP decline, despite the fact that Nokia barely is selling any Symbian phones anymore. I see two possible explanations for this development;
- Consumers are preferring the lower-end Lumia phones (5xx, 6xx, 7xx range)
- There has been a significant price reduction on the Lumia phones in the last quarter
Nokia guided for smartphones sales of over 7.1M, and I believe it is likely that it wouldn't have met the target, if the price reductions had not been carried out. So rather than face humiliation of not meeting the target, Nokia prioritized "sales momentum" over short-term gross profit. In my opinion, it was the right choice, but it's not a strategy that can be relied upon over the long haul.
With the introduction of the Lumia 1020, one could be inclined to think that its ASP would increase. But in general, it seems that the lower-priced phones are becoming increasingly popular among consumers, and the 1020 seems to target a small niche group (camera enthusiasts), which means that the ASP of the segment is likely to decrease further. Over the next twelve months, I therefore estimate that the ASP will decline by 5%.
In the graph below, we can see that the cost per smartphone declined as well in the last quarter, which probably is a consequence of consumers preferring the cheaper Lumia Phones, but it's also very possible that Nokia has benefited from increased scale, which has made it more efficient in producing the phones.
Over the next 4 quarters, I believe that the current cost per smartphone of 124 Euro, is likely to decrease slightly further for two reasons;
1) Consumers will be increasingly interested in the low/mid-end smartphone range.
2) Skipping Symbian production entirely, and instead scaling up Lumia production, is likely to put a downward pressure on production costs.
How many phones for Nokia's smart device division to break even?
This question can be answered by solving a relatively simple equation;
Operational costs/ Profit per smartphone = Smartphones sold*.
So to estimate the required amount of smartphones sold, we need to come up with an estimate for the future operational costs of the smart device division.
By taking a quick look at the graph below, you'll notice what a great job Nokia's management has done of slimming down the organization. Nokia is aware that it won't reclaim its former sales any time soon, and to have any hope of becoming profitable in the future, it has therefore found it necessary to restructure its organization by reducing fixed costs.
Over the next 4 quarters, I estimate that Nokia's operating expenses will total $430M per quarter. Given that assumption, Nokia needs to sell roughly 44M Lumias (below graph) over the next twelve months to break even. This seems quite unlikely to occur as Nokia only sold 26.5M smartphones over the last twelve months.
Final remarks - Why this is relevant for investors
Admittedly, this is a hypothetical exercise, but I believe it is important that potential Nokia investors ask themselves questions such as;
- In order for my investment to become profitable, what must occur?
- What is(are) the probability of the desired scenario(s)
- What happens with the stock price if the desired scenario(s) doesn't occur?
While this article came to the conclusion that roughly 44M Lumia phones need to be sold over the next 12 months in order to break even, I think it is more reasonable to use the 44M figure as an end-goal. Nokia doesn't need to sell 44M smartphones within the next year or two as its other divisions are still providing positive cash flow.
But that's not to say that its current results are acceptable. As you can see in the table below, its non-IFRS P/E ratio is 149. If the smart device division managed to break even, the P/E-ratio would be reduced to a more acceptable level of 13.
Note: Taxes in the desired scenario is calculated as: Taxes in TTM + 0.25* ("TTM earnings" - "Desired Scenario earnings")
The all-important question that (potential) Nokia investors need to ask themselves can be phrased in this way;
What is the probability of Nokia selling 44M Lumia phones annually within five year time frame?
In my next article on Nokia, I will try to answer that question.