There's not much to smile about when looking at Nokia (NOK) right now. For Q4 Nokia reported a massive loss of $1.4 billion (1.07 billion euro), compared with a profit of 745 million euro during the same period a year ago. So should investors panic, or is Nokia ripe for a turnaround? To find out, let's take a closer look at its current situation.
Nokia's operating profit, its raw ability to generate profits from sales, was actually 478 million euro, compared with an average analyst estimate of 320 million euro. The loss was caused by 1.43 billion euro in charges and write downs. These numbers are not actually that bad. Let's not forget that Nokia was expected to do badly in 2011, as it was at the beginning of what management calls a transition period. Now let's look at what Nokia has going for it:
Any sound investment in Nokia at this point is a bet that the transition period will cause a turnaround to a major smartphone contender with higher margins (they're terrible right now, and still declining). In order to make this judgment, we must look at what companies need to do and have in order to conduct a large-scale turnaround and transition into a new kind of profit-making machine.
- The first thing that such a company needs is a unique, competitive product that plays into a market that's seen as the future of the industry, since this is where the company is trying to make a new name for itself. Nokia's Lumia line fits perfectly. When Nokia chose to go with Microsoft's (MSFT) Windows Phone instead of Android, it received a lot of criticism, but I see a company that's looking for dominance in the future instead of quick success in the short term. There is no doubt that Nokia would be doing better right now if it had gone with Android. But its potential would have been limited. Nokia took the tougher but more ambitious route by choosing Windows. As a result, its Lumia line is unique and has a chance to grab significant market share in the future and own the Windows Phone market if it becomes successful in the next couple of years. As a buy-and-hold investor, I look for companies that seek success in the long term and that have enough ambition to take on risks that could have huge payoffs instead of picking the easier routes.
- The second requirement is cash that will last long enough to completely avoid bankruptcy. Nokia excels in this department. Even with its recent decline, Nokia has a healthy balance sheet and decent cash flows. Its declining but still healthy sales of cheap phones is capable of keeping it afloat for the foreseeable future, and gives Nokia an ideal situation for a transition period. I'd say that Nokia's situation is very similar to Netflix's (NFLX). Netflix still has its DVD business generating cash, which is allowing it to spend big on the development of its future (online streaming). Both Netflix and Nokia are using cash from transactions that are not sustainable in the long term to invest in their future, and both recognize that an eventual full transition will be necessary. To me the main difference that gives Nokia an edge is the fact that it has a unique product in its Lumia line, while Netflix's business could easily be reproduced by a large company with cash, making Netflix a much more risky bet. Let's not forget that Nokia's feature phones actually did quite well in less developed markets.
- Another thing to look for is internal confidence for a bright future. Nokia slashed its dividend in half when most investors expected a complete removal of these payouts. When a company running a loss still pays out a 5% yield, you know that it must be forecasting brighter days in the near future. This dividend announcement also shows Nokia's confidence in its cash flows and financial position, another positive. Hopefully those who predicted bankruptcy a couple months ago realize that they don't know what they're talking about.
- It helps a lot to have a large, successful company with both expertise and a lot of cash backing you up. This is the case with Microsoft. Because investors want to see Microsoft position itself for the future, the software giant desperately needs to break into smartphones and gain market share. Its hope seems to rest on Nokia, and it's ready to back up its plans with plenty of cash. Because Microsoft cannot let Windows Phone fail, it also cannot allow Nokia to fail. That's why it's been throwing so much cash at Nokia to help it in its transition. In addition, providers such as AT&T(T) and T-Mobile are pushing for a third player to take some market share away from iOS and Android, as these platforms have gained too much power over carriers. Who do you think dictates the terms in the Apple (AAPL)-Sprint (S) contract?
- Pricing. As unique as Nokia's Lumia line is, a smartphone is a smartphone and existing players have an advantage in both ecosystem and customer loyalty. The best way to break in is to undercut the others and take over the bottom line to grow initial market share. This is exactly what Nokia is doing. Rumors have it that Nokia's Lumia 900 will sell for $99 in the U.S. with a contract. Such a price will make the phone very competitive in the market and will give customers significant reason to go with Nokia and Windows Phone.
- Perhaps the must crucial factor is the market's response to the company's initial attempts to break into the market. For months there have been rumors of Nokia selling 200-300 thousand Lumia phones. Had these rumors been true, I would have been very worried and would have considered decreasing my position in Nokia, or even completely getting out, as a dying company has no worth if its turnaround plan is not generating success. However, reports indicated sales of well over 1 million Lumia devices, and considering the toughness of the competition and the fact that there were no U.S. sales, the numbers are impressive. Once the Lumia 900 enters the U.S. market and if it sells at near $99, I can see sales growing fast. Nokia's strategy to focus on Europe first was frowned upon by many investors, but it was pure genius: sell a quickly designed phone (only developed in a few months) in Europe first where you already have market presence and a strong brand. Create as much buzz as possible with this initial device (mainly the Lumia 800) while working on a superior device to hit markets in the U.S., where trends are usually made. Then release this device at a cheap price when U.S. customers have already heard plenty of talk of the Lumia line coming from abroad. Let's not forget that a year ago nearly nobody in the developed markets wanted a Nokia smartphone. Look around now and you will find plenty of people, even in the U.S. where Nokia has only released one new phone (Lumia 710), that are getting excited about Nokia's products. Focusing on brand image and interest first and then coming out with a superior product was a good strategy, and it will pay off by the end of 2012.
Looking at what Nokia has got going for it makes you realize that it's actually very well positioned for a turnaround. Once it attacks the U.S. market, Lumia sales will at least double, and will probably dwarf Q4's numbers by the end of 2012. It is rare for a company at this low of a price to have this much support for a turnaround, and as a bonus, a dividend has been confirmed. For long-term buy-and-hold investors that ignore most volatility, this is a great 2-3 year investment that could pay off significantly. For those looking for less risk, Microsoft is a safer play with the same prospects. I am still long Nokia and am reassured that my thesis for a turnaround is still sound (read my previous article on Microsoft and Nokia to see why I think their collaborative product will be successful).