Nokia Receives A Fair Price For Its Phone Business And Improves Future Profitability

| About: Nokia Corporation (NOK)

Microsoft (NASDAQ:MSFT) is purchasing Nokia's (NYSE:NOK) Device & Services unit for $5 billion in cash. This includes Nokia's Mobile Phones business unit (Nokia's Asha line and feature phones), as well as its Smart Devices business unit (Lumia line, with past sales including Symbian). As well, Microsoft is paying an additional $2.17 billion in cash for a 10-year non-exclusive license to Nokia's patents.

This deal appears to be attractive to Nokia, as it is selling business units that have combined to lose $769 million over the past four quarters in exchange for cash (including the patent deal) that is equal to half of its current market capitalization, as well as keeping control of its most valuable patents. The new Nokia will be much smaller (losing about 45% of its revenue from last quarter), but should have improved profitability as well as a significantly improved balance sheet.

While the deal comes at a time when Windows Phone market shares (mostly due to Nokia) are increasing rapidly, the reality is that growth came from budget phones such as the Lumia 520 that contributed a limited amount to profitability. Combined with slumping sales of feature phones and their Asha line, it is probable that these business units would have remained unprofitable for the foreseeable future.

Although some writers have commented that Nokia's device business sold at a low price, the valuation of the deal appears to be in-line with the valuation of the comparable device manufacturer HTC, which is projecting similar losses and revenue declines.

Mobile Phones Business Unit

The Mobile Phones business unit has proved to be a reliable source of income for Nokia in the past, with massive volumes of feature phones being sold at respectable margins. Intense competition from low cost Android smartphones have caused this unit to show major declines recently, with revenues down 38% year-over-year, and the unit going from $131 million in contribution margin last year to $10 million this year. Within this unit, Asha smartphone sales of 6.5 million units in Q3 2012 had declined to 4.3 million units by Q2 2013. The trends show that it is likely that the Mobile Phones unit will lose money in any non-holiday quarter in the near future.

Q2 2012

Q3 2012

Q4 2012

Q1 2013

Q2 2013

Net Sales ($ Million)

2941

2961

3202

2099

1835

Volume (Million Units)

73.5

76.6

79.6

55.8

53.7

ASP ($)

31

31

31

28

26

Gross Margin (%)

24.1%

21.7%

22.2%

22.9%

19.5%

Gross Margin ($ Million)

709

643

711

481

358

Operating Expenses ($ Million)

578

492

449

353

347

Contribution Margin ($ Million)

131

151

262

128

10

Click to enlarge

Smart Devices Business Unit

The Smart Devices business unit has shown significant signs of growth lately, after completing the transition from Symbian to Windows Phone. However, much of the growth has been from budget phones such as the Lumia 520. While contribution margins have improved, losses remain substantial at $235 million during last quarter. At an estimated ASP of no more than $130 and gross margins of 20%, another 9 million Lumia 520s would need to be sold each quarter to reach breakeven for the Smart Devices business unit. Even with a similar mix of smartphone sales as Q2, an additional 6 million units per quarter would need to be sold to reach breakeven.

Q2 2012

Q3 2012

Q4 2012

Q1 2013

Q2 2013

Net Sales ($ Million)

1978

1222

1589

1537

1520

Volume (Million Units)

10.2

6.3

6.6

6.1

7.4

ASP ($)

194

194

241

252

205

Gross Margin (%)

16.0%

8.8%

18.0%

16.4%

19.4%

Gross Margin ($ Million)

316

107

286

252

295

Operating Expenses ($ Million)

693

552

624

555

530

Contribution Margin ($ Million)

-377

-445

-338

-302

-236

Click to enlarge

Note: Gross margins have been adjusted to exclude various inventory related provisions since those reflect issues from before the time periods assessed here. These include a $282 million charge in Q2 2012, a $150 million charge in Q3 2012, a $66 million reversal in Q1 2013, and a $26 million reversal in Q2 2013.

Combined Business Units and Valuation

The two combined business units have revenues of $15.97 billion over the last four quarters. This excludes IPR income since utility patent ownership isn't included in the sale, as well as other revenue sources from Devices & Services that may not be included in the sale. Contribution margin over the last four quarters is negative $769 million. The business is also in decline, with revenue down 32% year-over-year during the most recent quarter.

Q2 2012

Q3 2012

Q4 2012

Q1 2013

Q2 2013

Net Sales ($ Million)

4919

4183

4792

3636

3355

Gross Margin (%)

20.8%

17.9%

20.8%

20.2%

19.4%

Gross Margin ($ Million)

1025

750

997

733

652

Operating Expenses ($ Million)

1271

1044

1073

907

878

Contribution Margin ($ Million)

-246

-293

-76

-174

-225

Click to enlarge

The best comparable for valuation of Nokia's device business appears to be HTC. HTC has gross margins projected to be between 18-21% during the next quarter, with operating margins of between 0% and negative 8%. Revenues are expected to be down approximately 20% versus last year as well. That makes HTC's performance slightly better than Nokia's device business units, but roughly comparable. HTC's enterprise value is currently around 0.33 times trailing year revenues.

Microsoft is offering 0.31 times trailing year revenues for Nokia's device business, which appears to be in the fair price range given HTC's valuation, assuming there are no surprises in what is included in the deal.

Conclusion

The value of this deal to Nokia is clear. It gets market value for a business that has weighed on profitability and will continue to be unprofitable for the foreseeable future. The hardware business is a tough battleground with only Samsung (OTC:SSNLF) and Apple (NASDAQ:AAPL) making substantial profits. Nokia also retains control of its most valuable patents and can focus on the profitable Nokia Solutions and Networks business. While it did not receive a premium over market value for the business units, the deal stabilizes Nokia's future and makes good strategic sense for them.

As for Microsoft, it is paying a reasonable price for Nokia's device business in order to control the platform. Nokia represented 82% of Windows Phone sales during last quarter, and for all intents and purposes, is the only Windows Phone manufacturer that matters. Microsoft's presentation claims annual cost synergies of $600 million within 18 months after close, which if achieved would eliminate much of the contribution loss from these business units.

On the other hand, Microsoft's projections for long term value creation seem very optimistic. The presentation mentions a revenue opportunity of $45 billion by 2018 with 5-10% operating margin. Nokia's declining sales volumes, Microsoft's own struggles with Surface tablet sales, and the meat grinder nature of the smartphone market makes it likely that there will be many obstacles to reaching those targets.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.