Nokia Corporation (ADR) (NYSE:NOK)
Q1 2014 Earnings Conference Call
April 29, 2014 08:00 AM ET
Matt Shimao - IR
Rajeev Suri - President and CEO
Timo Ihamuotila - EVP and CFO
Alexander Peterc - Exane BNP Paribas
Mike Walkley - Canaccord Genuity
Kulbinder Garcha - Credit Suisse
Sandeep Deshpande - JPMorgan
Pierre Ferragu - Bernstein
Stuart Jeffrey - Nomura
Gareth Jenkins - UBS
Chris Hogg - Merrill Lynch
Francois Meunier - Morgan Stanley
Mark Sue - RBC Capital Markets
Itai Kidron - Oppenheimer
Ehud Gelblum - Citi Investment
Good day. My name is Carmen and I will be your conference operator today. At this time, I would like to welcome everyone for the Nokia First Quarter 2014 Earnings Release Conference Call. All lines have been placed on mute to prevent any background noise. After the speaker’s remarks, there will be a question-and-answer session (Operator Instructions).
Thank you. I will now like to turn the call over to Matt Shimao, Head of Investor Relations. Mr. Shimao, you may begin.
Welcome to Nokia’s first quarter 2014 conference call. I’m Matt Shimao, Head of Nokia Investor Relations. Rajeev Suri, President and CEO effective May 1st and Timo Ihamuotila, our CVP and CFO are here in Espoo with me today.
During this call, we’ll be making forward-looking statements regarding the future business and financial performance of Nokia and its industry. These statements are predictions that involve risks and uncertainties. Actual results may therefore differ materially from the results we currently expect. Factors that could cause such differences can be both external, such as general economic and industry conditions, as well as internal operating factors. We have identified these in more detail on the risk factors section of our most recent 20-F and in our Interim Report issued today.
Please note that our results press release, the complete interim report with tables and the presentation on our website include non-IFRS results information in addition to the reported results information. Our complete results report with tables available on our website includes a detailed explanation of the content of non-IFRS information and a reconciliation between the non-IFRS and the reported information.
With that, Rajeev over to you.
Thanks, Matt. And thanks to all of you for joining. As you might imagine we have a lot to cover today and I want to ensure I have time to take some questions. Thus I will try to be concise and to focus my remarks on two key topics; a recap of today’s announcement and a brief review of Nokia’s first quarter performance.
First, however a quick personal note. I am honored to have been named President and Chief Executive Officer of Nokia and I’m excited by what lies in our future. I have been with the Company for almost 20 years and the opportunities in front of us are as great as I have ever seen. When I look at how we believe technology will change in the coming years, I firmly believe that Nokia is in excellent position to benefit from those changes.
We can establish leadership in new areas while still maintaining the strong foundation that we have today. And to be very clear that foundation is strong. We start this new journey with an unparalleled IP licensing and creation engine that has new potential in a company without devices; a location and mapping business that is already an industry leader and that has strong growth opportunities, a networks business that is performing well and on a path to better topline performance and a deep innovation capability across all parts of the company.
We start with excellent growth prospects in emerging technologies in a strong customer base in more mature area, with a leadership team that combines discipline execution with the ability to respond quickly to market opportunities and I believe we have the most innovative, most experienced and most capable employees in any company anywhere.
We also start with a much stronger financial position. The Q1 number that we announced today and that Timo will talk about in more detail show a very different Nokia from the past. Our earnings profile strong, our financial foundation is robust and we have a clear plan to return excess capital to shareholder and way that will still give us the capability to invest, when and where we see the right opportunities.
And when we take a step back and consider the future of technology, it is clear that there are opportunities for a strong Nokia. All the changes in technology that we have seen in recent years, from lower cost computing and connectivity, to better network, cloud-based data and processing power. The increasing ubiquity of sensor laden smartphone and other devices are starting to come together and create something much greater than sum of those parts.
That something has been called the programmable world by some. And we like that dome. It is a world where physical objects of all kinds; cars, TVs, medical devices, wrist bands and more will have build in computing power, sensors and connectivity. These objects will become bound together with intelligence built on vast amounts of data that is processed in the cloud and used to automate and simplify, to creates new services and to improve people’s life’s in many areas.
Lots of things will be required to enable this world, including connectivity capable of handling massive numbers of devices and exponential increases in data traffic. The ability to make the real and virtual worlds with location intelligence as well as new innovation of areas such as sensing, radio and low power technologies.
For Nokia this means opportunities for all three of our businesses. It is now up to us to tap that potential. To do that we will focus on developing our three businesses, networks, HERE and technologies in order to create long term shareholder value. We intent to optimize the company so that each business is best enabled to meet its goals. Where it makes sense to do so; we will pursue share opportunities between the businesses, but not at the expense of innovation and focus in each. Given this, we have designed the structure of the company in a very pragmatic way, with a priority of keeping things lean and limiting layers in the organization. What this means that the leaders of the networks organization will report directly to me. No one should take away the notion that I will be less involved in our other two businesses. My focus will be on those areas where the greatest value can be created.
Nokia has appointed a strong group of proven leaders that is diverse in many ways, but similar in their commitment to innovation and superior execution. Among this group will be Timo, who has done a terrific job in both managing the purchase of 50% of NSN from Siemens as well as bringing the Microsoft deal to closure. And Samuel Hodge [ph] who has been an important part of the turnaround in our networks business. For HERE and technology we also have Michael Halbherr and Henry Tirri, both of whom being deep expertise in their respective areas. These appointments are effective from May 1st.
In the near-term, this team and I see five clear priorities; first, engaging and understanding so we have the right knowledge about each of our three businesses and where there are gaps or new opportunities. Second, moving rapidly from the high level strategy and vision that we are announcing today to bold and detailed execution plans. Third, developing and implementing T-Systems across our business including performance management, operational governance, talent, development and rotation focused growth practices, cost management models and more. Fourth, culture; where we will build on best practices across Nokia and ensure that each of our businesses is enabled for success. Finally, ongoing performance. While it is true that we are currently going through significant changes, we will remain focused on our operational performance and meeting the needs of our customers. This will include moving fast to capitalize on newer opportunities, particularly in IP licensing.
What I am sure that you will have questions on these topics, for the sake of time, let me now turn to the first quarter. From a continuing operations perspective, it was a good quarter particularly given the fact that Q1 is typically a seasonally weak quarter for the networks and HERE businesses. Although sales were down both year-on-year and sequentially, non-IFRS operating margin will be healthy 11.4%. Where the rubber really hits the road however is with our three businesses. So let me provide some highlights for each of them.
First networks; where we had a good quarter, particularly in terms of profitability. While net sales were down year-on-year by 17%, when you adjust for negative currency fluctuations, divestments and country and customer contract exits, the decline was approximately 6%. This was a significant improvement, when compared to the year-on-year decline of approximately 12% in Q4 2013 with the same adjustments.
While we’re not yet satisfied with where we are, I believe this is a clear signal that we are starting to turn the corner on the top line challenges we have seen in previous quarters. Based on the demand for our products we believe top line performance could have been modestly higher than we delivered, but we experienced some component shortages in the quarter. We expect those shortages to continue in the second quarter and are working aggressively with suppliers to address the issue. Fortunately, we believe that most of what we did Q1 will still be available to us in future quarters. Wins in the quarter included a five year contract with Vodafone as part of their Project Spring network upgrade, LTE contracts with Everything Everywhere in the UK, VimpelCom in Russia, Taiwan Mobile, TELE Greenland and Avantel in Colombia.
Our efforts to improve top line performance did come at the expense of weaker gross margin and overall profitability in Q1. As we have said in the past, we will continue to invest selectively in strategic deals that have the right long-term profitability profile even if they are margin dilutive in the near-term.
Networks non-IFRS gross margin in Q1 of 39.6% was up 560 basis points from the same quarter last year, supported by a higher proportion of software sales, significant efficiency improvements in global services and a higher proportion of mobile broadband sales. As a result we were able to deliver the strongest gross margin in our history, despite the impact of these strategic deals.
From a segment perspective, our mobile broadband unit continued to show robust growth in LTE sales on a year-on-year basis and we’re now seeing renewed momentum in our core business driven by demand for mainstream products, as well as our new cutting edge next generation and virtualized products.
We’re also seeing the small sales market beginning to move and we have a number of wins here as well. In global services, we continue to focus on delivering profitable growth and are expanding our portfolio to cover new areas, but we will not take deals at any cost and as I have said before, our focus will be on areas where we can add significant value and be adequately compensated for that value, while a relatively small business systems integration delivered year-on-year growth in Q1 of almost 60%, important progress, given the importance of systems integration in supporting customers with complex cloud and virtualized solutions.
From a regional perspective, net sales were down in all regions except Greater China. [Indiscernible] Europe and Latin America remain particularly challenging although we have a number of unannounced contract wins in Europe that should help to stabilize our sales in Europe later this year. The progress is slow but our win rate is high and we are building back in Europe. North America remains a priority although our Q1 sales declined, reflected the transition period between a very large rollout at one customer and an expected large rollout at another. Given some of our innovation in the area of virtualization and Telco cloud, we are also seeing early interest from some of the region’s largest customers.
Finally, our business in Asia and the Middle East has been performing well with good deal momentum. Overall, we see a significant lowering of the rate of sales decline across most regions. This progress makes us optimistic that we can return to growth in the second half of the year. Our order pipeline and recent deal wins also give us increasing confidence. HERE at a solid quarter with net sales of €209 million and a non-IFRS operating margin of 5%. External sales were up by 13% on a year-on-year basis reflecting the continuation of encouraging trends in the automotive market.
In particular HERE benefited from strong European auto sales as well as from the conversion of a contract to a perpetual license. We have a very strong position in the automotive market and we see continued opportunities to grow our business as the market evolves towards assisted driving and ultimately to automated driving. HERE is differentiated in two clear ways. First, we are the industry leader in advanced telematics delivered through the cloud. This is a critical building block for the next generation of location services and thus a strategic focus area for our customers. And second, unlike our main competitor HERE has a very flexible business model which enables HERE to bring the benefits of location intelligence to multiple customers in multiple industries across different operating systems, platforms and screens.
Over the course of 2014 our focus will be on making the right near term investments to capture the longer term transformational growth opportunities we see. We already have the world’s best map and we will invest to build further strength in technologies for smart connected cars, cloud based services to personal mobility and a wide range of device types and location based analytics for enterprises. While growth is our absolute priority for HERE, we intend to manage our R&D extremely effectively.
For example, we are leveraging automation in our map creation process to improve our R&D efficiency but to be very clear we will not manage the business with the top priority on near term profitability as we believe building for future growth is a better path to shareholder value. The opportunity to create further value for Nokia shareholders through technologies is both significant and absolute priority for us. Previously our mobile devices business shipped a large volume of products and we utilized our industry leading intellectual property rights primarily to obtain favorable net licensing fees which benefited our cost of sales.
Now that we no longer have a mobile device business, we no longer need to obtain licenses for mobile devices. But mobile industry participants still require licenses to our standard essentially patents thus we see a significant opportunity to grow our technology business as existing license agreements with mobile industry participants are renegotiated and as we seek to enter into new agreements with new licensees. In addition, we will move to expand our licensing efforts to cover customers in areas beyond mobile devices.
Within the next few weeks we expect to adjust our licensing offers in several ongoing negotiations to reflect the new situation and we’ll intensify our ongoing efforts as well as expand reach to new companies who need licenses under our patents.
Overall, we are in the early stages of properly licensing our intellectual property rights under the new Nokia structure without the mobile devices business and we will make the needed investments to build, strengthen and continuously renew our technologies business. While I am sure that all of you want to know more specifics about the size of this opportunity, we are not in a position today to provide that other than noting that we are on track to meet our guidance for technologies.
I would also emphasize that in the regulatory process related to the recent Microsoft transaction, there were no concessions made that limit our ability to monetize our intellectual property rights. We have a world class licensing team and we will ensure this team has the resources that needs to realize our ambitions.
Importantly, our licensing opportunities are not limited to our technology's business. In addition to the approximately 10,000 patent families originating from Nokia, Netbook is also a significant owner of intellectual property rights with approximately 4,000 patent families and its own independent licensing program. Beyond licensing of our existing intellectual property rights, we will also continue research and development into new areas that could lead to future products and services or new licensing opportunities.
The technologies team includes hundreds of world class scientists and engineers who have driven more than half of Nokia's recent patent filings and many are recognized as leading experts in fields that are essential for enabling the future. One of my top priorities in the near-term is to appoint a permanent head of the technology business who has both technical depth and the business skills needed to focus the organization on the right areas to best create long term value.
Before I turn to Timo, I just want to reiterate our starting position. Yes we have a lot to do to tap the opportunity in front of us, but we start on this new journey with many powerful assets. And among them three excellent businesses; Networks, HERE and Technologies, deep customer relationships, a stellar intellectual property position, a strong financial foundation, a position as one of world’s largest software companies, a proven leadership team, the most innovative employees anywhere and much more.
As I said these are exciting times and I look forward to engaging with all of you in the months and years to come. With that Timo, over to you.
Thank you Rajeev. Before I brief and take you through some of highlights for the quarter, I’d like to spend a few minutes discussing the main purchase price adjustments related to the sale of the devices business to Microsoft as well as today’s announcement for the planned capital structure program.
So turning to the purchase price -- price adjustments related to the Microsoft transaction. Last September when we announced the transaction with Microsoft, we stated that the €5.44 billion total consideration was subject to potential purchase price adjustments to protect both Nokia and Microsoft. At closing, the transaction price was increased by approximately €170 million as a result of the estimated adjustments made for net working capital and cash earnings.
However it is important to note that these adjustments are based on estimates which will be finalized when the final cash earnings and net working capital numbers are available during the second quarter of 2014. Over the course of 2014, our focus will be on making the right near-term investments to capture -- Based on this and other adjustments the gain on sale at closing is expected to be approximately €3 billion of which approximately €1 billion is expected to realize expected income in Finland.
As a result of the gain we expect to record tax expenses of approximately EUR180 million and utilize approximately EUR200 million of Nokia’s unrecognized deferred tax assets in Finland. In accordance with the agreement with Microsoft, the proceeds from the transaction have been partially offset by the repayment of €1.5 billion related to the Microsoft convertible bond. Related to this redemption, the accounting treatment of the equity component of the convertible bonds negatively effects Nokia’s net cash by approximately €150 million.
Additionally we expect to make a payment to Microsoft of approximately €250 million in Q2 relating to the timing of platform support payments received as part of the previous agreement between the two companies. Even after this adjustment the platform support payments received would still be higher than the minimal royalty commitments paid over the lifetime of the previous agreement.
Taking into account all the elements I have discussed we currently expect the proceeds from the sale to add approximately €5 billion to Nokia’s net cash. Adjusting for the repayment was the €1.5 billion convertible bond, we expect the proceeds to add approximately €3.5 billion to Nokia’s gross cash. Therefore if the transaction had closed before the end of Q1, Nokia would have ended the quarter with gross cash of approximately €10.5 billion and net cash of approximately €7.1 billion compared to the reported gross cash of €6.9 billion and net cash of €2.1 billion at the end of Q1.
Now turning to the capital structure program announced today. Having conducted a thorough analysis of the capital structure required to support our strategy, the Board has announced a planned comprehensive EUR5 billion capital structure optimization program, which focuses on recommencing ordinary dividends, distributing the excess cash to shareholders and reducing interest bearing debt.
I believe this plan will significantly improve our balance sheet efficiently while simultaneously reinforce the deployed capital for future value creation. Taking through the proposed program in more detail. There are essentially four parts to highlight of which €3 billion will be cash returns to shareholders and naturally subject to shareholder approval.
First, the plans announced for the recommencement of ordinary dividend payments for 2013 and 2014 totaling at least €800 million. For 2013, the planned ordinary dividend proposal is $0.11 per share, or approximately €400 million. For 2014 the planned ordinary dividend is at least $0.11 per share.
Second, a planned special dividend of $0.26 per share or approximately EUR1 billion. Third, a planned €1.25 billion share repurchase program and finally plans for debt reduction of approximately €2 billion by the end of Q2 2016.
Once complete, the debt reduction would be expected to result in an annual run-rate savings for at least €100 million related to recurring interest costs. Together with our continued focus on solid business execution, these capital structure enhancements put us on course to return to an investment grade credit benefitting which would further appear our long term competitive strength and support our strategic objectives.
Now turning back to the quarter and first some words on our cash performance in Q1. On a sequential basis Nokia’s gross cash has decreased by approximately €2.1 billion in Q1 with a quarter ending balance of €6.9 billion. Net cash and other liquid assets decreased by approximately €230 million sequentially with a quarter ending balance of €2.1 billion.
The sequential decline in gross cash was primary due to repayment of certain debt facilities, totaling approximately €1.8 billion during Q1. The sequential decline in net cash and liquid assets was primary due to cash outflows from discontinued operation which more than offset the cash inflows from continuing operations.
The cash inflow from continuing operations were primarily driven by networks, excluding approximately €110 million of restructuring related cash outflows at networks, continuing operations had inflows of approximately €260 million. Discontinued operations cash outflow totaled approximately €380 million in Q1.
Then turning to continuing operations in Q1. In the first quarter Nokia’s continuing operations generate the net sales of €2.7 billion, a decline of 15% year-on-year primarily driven by networks and lesser degree from HERE. Nokia’s continuing operations, non-IFRS operating margin of 11.4% increased by 330 basis points compared to the year ago quarter, primarily due to networks and to a lesser extent HERE on technologies.
Networks had a good quarter, with a non-IFRS operating margin of 9.3%, up 230 basis points year-on-year, supported by continued progress in these area of focus and significant efficiency improvements as a results of its transformation program. As Rajeev highlighted, networks gross margin in Q1 benefitted from higher than normal proportion of software sales which we currently do not expect to repeat in Q2. Cost control remains very high, very much in place with non-IFRS operating expense down 8% year-on-year despite ongoing increases to our built out capacity in R&D.
Turning to the segments, mobile broadband showed year-on-year growth for the first time since the first quarter of 2013. While the growth was small, it is important to note that in Q1 2013 mobile broadband had a very strong rollout in the U.S. and Japan.
Mobile broadband net sales in the first quarter were adversely affected shortage things of certain components which we expect to continue to impact our business at late through the end of Q2. Global services had its best ever first quarter non-IFRS operating margin, although net sales were down approximately 25% year-on-year reflecting HERE large scale networks rollouts and the continued impact from customer, contract and country exits.
Turning to HERE and technologies, reported net sales of HERE with €209 million, down 3% year-on-year. The year-on-year decline was due to significantly lower sales to our discontinued operations, partially offset by a 13% increase in external net sales. In Q1 HERE ad sales of new vehicle licenses of 2.8 million units up from 2.2 million in the year-ago quarter, an increase of 27% year-on-year and representing well over 50% of external net sales in the quarter.
HERE’s non-IFRS gross margin in Q1 was 77.5%, up 700 basis points compared to the year-ago quarter. The year-on-year improvement was primarily due to a benefit related to the conversion of a contract to our perpetual license and an overall positive mix shift toward sales to vehicle customers.
In Q1 HERE’s non-IFRS operating margin was, 4.8% up from negative 2.3% in Q1 2013. We are increasing our investments during 2014 in growth areas such as the connected car, autonomous driving and next generation maps in order to build on HERE’s industry leading position. While we expect to see some progress in 2014, the more transformational revenue and profit opportunities are expected to have a greater impact in the years to come.
And now, a few words on technologies. Q1 net sales were €131 million, compared to €123 million in the year ago quarter the year-on-year increase was primarily due to higher intellectual property licensing, income from certain licenses, primarily related to agreements.
This increase was partially offset by the absence of an intellectual property rights divestment transaction that benefited the first quarter in 2013 and declines in licensing income from certain licensees that experienced lower levels of business activity.
In Q1 technologies, not as far as our operating margin was 65.6%, an increase of 630 basis points year-on-year. The higher year-on-year non-IFRS operating margin was driven by higher net sales and lower operating expenses.
As Rajeev commented, our IPR licensing business is an area where we already have a proven track record and a successful business strategy that we will continue to build on. As an example of this, during the first quarter we entered into a patent and technology collaboration agreement with HTC. HTC is making payments to Nokia and the collaboration involves HTC’s LTE patent portfolio, further strengthening Nokia’s licensing offering. We believe this agreement validates our implementation patents and enables us to focus on further revenue generating licensing opportunities.
Going forward as our needs to cross license our patents will significantly lessen, our preference will be to reach agreements on a running royalty basis through negotiated agreements or arbitration rather than lump sum payments through more complicated expensive litigation processes.
Finally, now that Microsoft has become a more significant intellectual property licensee, we continue to expect technologies annualized net sales run rate to increase to approximately €600 million during 2014.
And then quickly a couple of words on financial income and expense. In Q1 this was an expense of €74 million compared to €111 million in Q1 2013. On a year-on-year basis, the improvement was primarily due to lower net foreign exchange related losses partially offset by higher interest expenses.
In conclusion, I’m pleased with the financial progress we have made in all three of our continuing businesses during Q1. We have three strong businesses and a solid financial foundation. In addition the announced plans for a €5 billion capital structure optimization program is expected to significantly improve our balance sheet efficiency while simultaneously reinforcing my commitment to continue to effectively deploy capital. And finally on a more personal note, I am committed to Nokia and think we have good opportunities to create further shareholder value with the asset base we have.
And now I will turn the call back to Matt for Q&A.
Great. Thank you, Timo. Just very quickly just wanted to say for the transcript that the HERE gross margins year-over-year increased by 200 basis points. With that -- so now for the Q&A session Carmen, the analysts, let’s limit yourself to one question only please. And Carmen please go ahead.
(Operator Instructions) Your first question comes from the line of Alexander Peterc with Exane BNP Paribas.
Alexander Peterc - Exane BNP Paribas
I’d just like to ask little bit about the geographic pattern of the recovery at NSN that you see mentioned, Europe being a little bit better into the second half. Do you see generally a more constructive approach of European operators towards that investment? And does the contract with Sprint also play a role in your recovery in the second half? Thanks a lot.
Thanks Alexander. So we see our win rate and deal momentum in Europe certainly point to one of the drivers of this potential growth in the second half, China being the other and Sprint you rightly pointed out is the third result.
Great. Thank you, Alexander. Carmen we’ll take our next question please.
Your next question comes from the line of Mike Walkley with Canaccord Genuity.
Mike Walkley - Canaccord Genuity
Great, thank you. Rajeev congratulations from me for your appointment to the CEO position. I just want to follow up on the networks business, for the second quarter with supply constraints, should we expect below normal seasonal patterns and can you discuss with a greater coverage mix would operating margins fall below your target of 5% to 10% in Q2 and then recover in the back half of the year given stronger growth expected later in the year? Thank you.
Thank you, Mike, and thanks also the personal congratulations, appreciate it. No, I think we’ve not given any guidance specifically to Q2. So I wouldn’t necessarily conclude on the fact that it would fall below 5%. That’s all I could say for Q2.
Yes, maybe for the Q2 -- so we simply said that we are expecting to have bit less proportion software sales compared to Q1 and we expect that all other things to be equal to be a negative driver but we are definitely not seeing any particular level of profitability with that.
Great, thank you Mike. Carmen, next question please.
Your next question comes from the line of Kulbinder Garcha with Credit Suisse.
Kulbinder Garcha - Credit Suisse
Thanks and like to add my congratulations to Timo and Rajeev. My question really is how you came to this conclusion that this was the right level of distribution, and the reason why I'm asking the question is that by my math, probably in a year’s time you’re going to have about €5 billion of net cash in your balance sheet which is ballpark about 25% of your market cap. So, why is that the right number? I understand that in the some comments you made this morning about being crisis more and looking all the commitments done but Nokia don’t seem to be in a crisis mode and you’re now highly profitable. As Rajeev said you’ve got some very strong assets you’ve got some very -- your dividend policy actually suggest you have confidence in the future. So why not distribute more or would you be revisiting this on an annual basis. How should we think about that?
Thanks Kulbinder. So first of all as I have said earlier as well, so the Board has conducted a very, very thorough analysis on the capital structure, returns to equity holders, but also on reduction of credit. And we really have gone through this basically four ways. So we have tested for Microsoft, we have tested for an industry …
And your next question is from the line of Sandeep Deshpande with JPMorgan.
Sandeep Deshpande - JPMorgan
I have a quick question on the networks business itself. You’ve talked about the abstract growth that you’re going to have in networks and clearly second half you’re talking about growth in networks. Can you talk about the non-organic growth in networks in a sense that are you looking at investing in particular areas of networks in terms of M&A, because what you have at this point is mainly a radio business? Hello?
Please go ahead.
Hi, it’s Matt Shimao. We’re just going to resume answering Kulbinder’s question.
Again thanks Kulbinder for the question. And as I said the Board has conducted a thorough analysis on the capital structure optimization program. And as part of that analysis, we have looked at possible industry shocks, also possible macro-shocks like you then compare these to maybe what happened in the industry on the early 2000 or what happened on the mark of 2008, 2009 timeframe. And we have built in some room for M&A and then as we have said earlier we have also taken into account the credit rating and our aspiration to longer term return to an investment grade rating. And with all these parameters, we think that for this point in time, the capital structure optimization program strikes the right balance. And that’s why we’re going ahead with it or proposing it to the shareholders.
Thank you Kulbinder. Carmen, next question please.
Your next question is from the line of Sandeep Deshpande.
Sandeep Deshpande - JPMorgan
Just a quick question on the networks business itself. The majority of the business you have in networks today is a radio business. You’ve talked about growth overall. In terms of the non-organic growth can you make comments on where you think that Nokia has its own capabilities or it may like to tap external capabilities in growing outside radio?
Of course we have the radio business. We also have the core business including the next generation core and of course we have the services business just to sort of clarify that point. We haven’t yet pin pointed where necessarily we would look at M&A and at what point we’ve tapped inorganic opportunities. We do get probably small things that would be disruptive and could add fine revenue synergies to the scale of our channel. So that’s what our thinking is but I wouldn’t pin point yet, because our [indiscernible].
Thank you Sandeep. Operator, next question please.
Next question comes from the line of Pierre Ferragu with Bernstein.
Pierre Ferragu - Bernstein
I have actually a follow up on the previous questions to loan growth in equipment. I sort of remember Rajeev hearing you talking about an addressable market in mobile that is more or less grows, that doesn’t grow much. So I was wondering beyond this year if you think you are able to with your position in the market to actually gain market share in a flat market and that’s where you would see your top line growth coming from. And I’m not talking about this year, I am talking about like on 3 year to 5 year horizon, or whether it’s more that actually expanding your addressable market. Or lastly if you think you are like better exposed to higher growth drivers than your peers?
And then maybe one additional question on your core business. We see divergence strategy between you and your main competitor today where they seem to be spending much more on research and development, trying to expand the product portfolio, capture growth in new areas. Could you please maybe give us your perspective on how you’ve made choices in terms where you invest, where you don’t invest in terms of R&D? Because today you have, like a much lower R&D than your main competitor?
Thanks. Just in term for the R&D, I’ll answer that one quickly. I think we had 16% all the networks business as a percentage of net sales that we believe is competitive. We have a higher ratio of low cost heights in the world that have been transitioned to, from three years ago and I’m quite productive now that gives us more capacity. We have had a higher focus on automation and expanding through agile R&D development to get more productivity and capacity. So I think when you look at the manner of the [indiscernible] that is really the metric to be focused on.
For growth, yes, we’ve said flat to modest growth [indiscernible] the market for networks and into the CapEx, but we think that, we have the required scale. And then I think Q1 proved that again. Even in a seasonally low quarter, we have, in fact, some dilutive deals that we deliberately choose to go for. We could have absorb that and yet produce a good gross margin, as well as good operating margin. So we have that operating leverage. And we have the scale. And as I pointed to in the past, Radio is the biggest driver of mobile broadband. That is the most sticky piece. And that brings in core and the rest of trade [ph] and services with it.
And if you look at the market, the top three players hold their commanding share of their markets. So I believe, we are enthusiastic that we can continue to get share even in a low growth market. And if I point just a couple of things, the rate of decline is slowing. We’ve seen in the current quarter, MBB is back to work, the mobile broadband business, even though at just 100%. We have a strong win rate, which will not just impact the second half, but longer term as well. And we have an improving pipeline of opportunities.
Thank you very much Pierre. Carmen, we’ll take our next question please.
Your next question is from the line of Stuart Jeffrey with Nomura.
Stuart Jeffrey - Nomura
On IPR, I know Rajeev said you have limited scope. Just talk about numbers and things like that. But I was wondering, if perhaps you could just shed a little bit of light on implementation patterns. I think we want to assume that most of the revenues right now come from standard to central patterns? On the implementation side, I’m assuming it’s the large consumer electronics companies that you would chase after. I guess my initial reaction would be, I had struggled to see an Apple or Samsung, materially license some of those implementation patterns. So perhaps you could just give us a bit more sense of the addressable market? And perhaps the timeline around when you might be in a position to sign material contracts and how that might affect you on the financials, even if you can’t quantify it? Thanks.
Thanks, Stuart. We will, as I said rapidly cease the opportunities for increasing licensing deals particularly, now that the devices and services businesses is not with us. So there is no need for these cross licensing deals. We will do so both on standard essential patents and implementation patents and this HTC deal is one example of that. And of course, the third area is we’re to utilize our strong brand to extend that to a reach of certain devices that might be profitable as well. So, but much of it is going to be longer term, our cash flow to be realized. So the guidance that we have given that we continue to expect technologies, annualized net sales run rate to increase approximately €600 million during 2014 remains. Yeah, Timo.
Yeah. Maybe Stuart, if I make a quick comment here. So basically, majority they compare in CapEx is what we have from the innovation which we -- we’re building for our own devices business and which we now know more will need to utilize more differentiation. And of course we will try to make strides into consumer electronics as well, but I think it would be incorrect to assume that this implementation patents would not be valuable possibly for companies like Samsung and Apple as well, the one, of course, other ones. And we think that the HTC deal which we announced during this quarter really validates the value of our implementation patterns and we will of course have a then - a licensing program available for essentials, but also for implementation patterns.
Thank you, Stuart. Carmen next question please.
Your next question comes from the line of Gareth Jenkins with UBS.
Gareth Jenkins - UBS
You kind of called out some software sales in Q1, and I just wondered whether you could talk about the sustainability of gross margin through the networks in light of that, maybe give us a sense of how much software was as a percent of your revenues in Q1 and what you expect for the rest of the world? Thank you.
Gareth, if we may, we weren’t able to make out much of that? Can you please repeat your question?
Gareth Jenkins - UBS
Yeah. Can you hear me now, Matt?
It’s better, yes.
Gareth Jenkins - UBS
Okay. So my question is on the software and on sustainability of gross margins. I think in Q1 you called out that software was very strong? And I just wondered whether you could give us a sense of how much software was in the mix? And how much do you expect it to be in the mix going forwards?
Yeah. Thanks, Gareth. Yes it had, Q1 had benefit of unusually high Japan software sales with excellent margins but even without that, it was better than the run rate and we have seen also the impact of some diluted deals from China and we might see an impact of handful of other strategic and again selective diluted deals to come that may have some cumulative impact in future quarters. But as I’ve said before, we will go for those in a very targeted way. They must have good long term profitability profile. We seek to manage those very carefully to limit impact on profitability and if we take a few handful, the rest of the machinery around our pricing controls will work efficiently because that’s what we continue to be focused on and so with those factors in mind, we’ve given the guidance that we think that yet we feel that profitability towards the higher end of the range of our long term target of 5% to 10% is achievable.
Thank you, Gareth. Carmen, next question please.
Your next question comes from the line of Chris Hogg with Merrill Lynch.
Chris Hogg - Merrill Lynch
Thanks for taking my question and congratulations again to Rajeev. So just sticking with gross margins and in a sense that these were obviously very strong, despite a strong year-over-year growth in China, you obviously benefited from the strong software sales in Japan and better gross margins and services. And so whilst you’ve guided to a lower proportion of software sales impacting margins in the second quarter, to what extent do you see profit efficiencies and services as a structural tailwind for your gross margin profile?
Thanks Chris. So as I said that we have seen some impact from diluted deals from China and we might see an impact of a handful of other strategic deals that we have take a little impact in the future quarters but of course we will seek to manage price erosion in the rest of the world. And to your point on services, we see continuous improvement there as well that might support us, such as in expanding the scope of what we do remotely, all the percent of share of goods it will be in our [indiscernible] operation.
Thank you, Chris. Carmen, next question please.
Your next question comes from the line of Francois Meunier with Morgan Stanley.
Francois Meunier - Morgan Stanley
Actually I’d like to follow up on the Pierre’s very good question about the long term strategy vision for NSN. It feels really like the market is really moving more towards software, software defined networks, IMS application more IP. Through that you have a partnership with Juniper but you don’t really own it. And also I think in your introduction Rajeev you were talking about the Internet of Things driving growth for data, that’s probably not driving growth if you do it right. So I mean I think -- do you have enough R&D budget, do you have enough scale to invest in all those new things and also as Internet of Things really take for take of operators, maybe it’s going to be more but 5G which is going to cost a lot as well to develop for you. So do you have the same -- I mean you don’t have the same budget basically as Ericsson or as Huawei. So what can you do really to compete? I understand you want to be in the top three but is there room for another three players in these markets really?
Thanks Francois. So, yes there is room for three players and we emphasize the percentage of our low cost R&D as a percentage of total R&D and I think in terms of the man hours, that’s a significant number. It’s over 50% of our R&D and it’s even over that that we have a low cost site. So we’ve always been focused on capacity rather than share R&D dollars because we knew we have to compete differently. I think that’s what worked out well for us. So, and then on your specific comment on spending in virtualization, in fact as you look at our R&D budget, we are increasing our spending in LTE small cells, virtualized goal, IMS customer experience management new areas of OSS liquid applications and all of that whilst reducing some of the legacy budget and that’s very descent offset to do all the time. So we’re not budget constrained. We’re not even capacity constrained as such to play in that market and I will just give you one example, IMS. In fact we have the world’s biggest IMS installation in the U.S. with a long term capacity on it that nobody comes even close to. So we’ve invested there and it works very well. So then there are other areas of the portfolio that we need to partner for and we will do so as I said also in my remarks back in Barcelona. We will do so to make sure that we play the ecosystem game in places like Telco cloud and virtualized growth.
Thank you, Francois. Carmen, next question please.
Your next question comes from the line of Mark Sue with RBC Capital Markets.
Mark Sue - RBC Capital Markets
Thank you. Maybe just on advanced technology, the €600 million, I guess the thought is that there is some nonpayment or underpayment. So how should we think of the ramp of legal expenses on a going forward basis to enforce collection? And then likewise there a lot of patents are which are being used which you want to monetize, for example the NSN patents. Should we think of a ramp in R&D to drive this business going segment forward and then conceptually how we should think about cash flow overall for the business? Thank you.
Okay, so on technologies. So first on the legal expenses. It’s true that the OpEx was down year-over-year on technology that was driven both by actually legal as well as timing of certain R&D projects. Clearly as Rajeev, says we are willing and able to invest more to drive higher value from the technologies licensing business and we are planning to expand that the team accordingly. Then what comes to the cash flow -- I mean in this business it is quite typical that there are payment for when you make the deal from the past and in that sense cash flow can be lumpy from that perspective. So I don’t think I have much more color to give on that. And then on the actual patent portfolio, so yes it is correct that we actually have three portfolios. We have the let’s call it Nokia portfolio coming from devices and services. We have NSN portfolio but HERE has also patent portfolio and we will of course do our best optimal utilize these there and one example for example is that there can be a situation where networks would require a cross license but one would definitely not require cross license for against the Nokia portfolio, just to give you an example.
Thank you, Mark. Carmen, we’ll take our next question please.
Your next question comes from the line of Itai Kidron with Oppenheimer.
Itai Kidron - Oppenheimer
Thanks. I have a couple of questions. First Rajeev you talked about some -- that you’re getting share in the marketplace. Maybe you can talk a little bit from a competitive standpoint, who are you seeing more vulnerable right now or little bit on the weaker side in the marketplace against which you’re having success? And then a question to Timo on the interest expenses. You’re now clearly have paid down debt and you have the Microsoft cash coming in. How should we -- and your hedging activity, I would assume will have to significantly decline now that you don’t have a handset business. What would be the best way to model going forward interest expense income?
Yes. So first to the network expansion, so we’re bouncing back in Europe based on our deal momentum and the win rate that we have. And then China of course, in terms of the auto started better than we’d expected in terms of the LTE share and of course Sprint, as we already commented is a meaningful driver for us in the second half. So there’s a total sum of the share opportunities that we’re building back on.
Okay. And then Itai on the interest expenses, so first of all you’re right, we paid down debt about -- or not about, exactly €1.75 billion during Q1 and then in addition we said that we are expecting to reduce to gross debt by about 2 billion during the coming two years on this capital structure optimization program. That would be approximately 100 million down on interest cost. And then if we look at this from hedging. So yes we have less hedging happening but we will still have hedging both against our balance sheet items as well as mainly against NSN business and there will be some volatility on the finance and the income on hedging but I would expect that to go down a bit. Another way to look at it is that if we reduce with this €2 billion, we now have about €3.5 billion as a rate about €3.5 billion left so then we would have about €1.5 billion after that and you can then model interest cost maybe somewhere around that kind of amount after we complete the debt reduction on the capital structure optimization program.
Great. Thanks Itai. Carmen, we’ll take our next question.
Your next question comes from the line of Ehud Gelblum with Citi Investment.
Ehud Gelblum - Citi Investment
So, just quickly on the advanced technology and IPR side, aside from adding in Microsoft, which happens and now as we go forward, are there any other large ins or outs that happen this year if you can comment on was HTC unusually large for some sort of catch up or something in the first quarter or is that already at run rate. So basically I’m looking for aside from Microsoft, any large ins or outs that we should be looking for the rest of this year as well as next year aside from Samsung again, which is a separate issue that we seem to at least have our arms around.
On the network side Rajeev, you were talking about share gain opportunities. Do those in your mind require you to have a larger presence at the two largest wireless carriers in North America down the road or are you looking at share gain opportunities that you can do without necessarily having to crack into those two? And then finally again on the network side, I have one more that I thought was interesting but I [indiscernible]…
[Indiscernible] I think we’re going to go with your too.
Yes, okay thank. On the technology side IBR we can’t give any exact guidance on certain deals happening or not happening but what I can say is that now when we have exited the device and services business, we will plan to go more after variable rate deals and we will try to do this more by being able to agree, call it Nokia trend rate, maybe with certain kind of volume adjustments. So it will be a cleaner business model in that sense and that is what we are aiming to do with the new licensees, which will come through either renegotiation or through negotiation with the companies with whom we would look at have a license.
Yes, thanks Ehud and for the networks question, indeed if we can return to growth in the second half of year, then that would come with share gains and it will be achievable even without a stronger presence at the two carrier deals we specifically mentioned.
Thank you. We’ve used our time for this quarter for the Q&A session. So ladies and gentlemen, this concludes our conference call. I would like to remind you that during the conference call today we have made a number of forward-looking statements that involve risks and uncertainties. Actual results may therefore differ materially from the results currently expected. Factors that could cause such differences can be both, external, such as general economic and industry conditions as well as internal operating factors. We have identified these in more detail in the Risk Factors section of our most recent 20-F and in our Interim Report issued today. Thank you.
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