Nokia's (NOK) revenue decline, over the past year, has been steady and dramatic. From Q1 of 2011 to Q1 2012, revenues have fallen steadily, each and every quarter on a year-over-year basis, culminating in a staggering decline of 29% for Q1 2012. These declines have resulted from increased phone competition (both for low and high-end phones), the company's transition away from the Symbian operating system platform, and the fact that the Lumia (the line of Microsoft (MSFT) Windows' phones replacing the Symbian smart phones) only recently launched at the end of 2011.
While overall revenue trends have been very poor, over the past year, it should also be noted that the most recent quarter did reflect some positive signs. Specifically, from Q1 to Q2 of 2012, revenues improved by 3%, sequentially, while the rate of the y-o-y decline finally fell (from 29% in Q1 2012 to 19% in Q2 2012).
|Source: Company reports|
|(1) Euro millions; IFRS revenues|
While a large part of this quarter's sequential revenue improvement is from the Nokia Siemens division (up 13% sequentially; primarily due to industry seasonality), the trends for Nokia's phone sales also provide some reason for optimism.
For Q2 2012, device and services revenues fell only 5% sequentially (versus a 23% sequential decline in the prior year period; Q2 2011) and year-over-year sales for the division were down 26% (a substantial reduction from the previous quarter's figure of 40% in Q1 2012). To be clear, Nokia's D&S revenues are still declining at a concerning rate, but it is positive to see that the rate of change has actually improved this quarter.
Initial Lumia Trends Are Positive
The impact of the Lumia launch, and gradually expanding list of markets and carriers offering the devices, also seems to have taken some effect. For the second quarter of 2012, sales trends for the company's Lumia line were, again, positive. In fact, sales have effectively doubled each quarter since the Lumia launch in Q4 2011 - reaching 4 million units sold in the most recent quarter (about 40% of Nokia's smart phone units sold for the quarter).
To put this in perspective, Apple (AAPL) sold only 2.3 million iPhones in its fiscal Q1 2008, their third quarter after launch. Granted, the initial iPhone launch was only in 1 market, and the broader launch of the newer 3G iPhone model in July 2008 (in 22 markets) resulted in sales of 6.9 million iPhones (Apple’s fiscal Q4 2008). Two quarters after the broad 3G launch (Apple’s seasonally weak fiscal Q2 2009), sales were back to 3.8mn and then expanded substantially from there.While these comparative early trends may favor the iPhone, the differences are not that great, and they illustrate that expanding sales for a new product and new platform takes time. Longer-term, a lot remains to be seen, but there is certainly a case for optimism from Lumia sales' results thus far.”
Going forward, Lumia's sales should benefit from the continued expansion of markets and carriers (as was the case with the iPhone). Furthermore, the launch of the Windows 8 phones (expected this fall) should be a substantial additional catalyst for the Lumia line. As personal computer users, as well as "Surface" tablet and other new Windows tablet users, become comfortable with the Windows 8 format, the familiarity with the interface should contribute to greater user acceptance of the Lumia's Windows 8 operating system (providing a "coat-tail" benefit).
Recent Sell-Off Seems Overdone
There have been three recent news items that have weighed on Nokia's shares. First of all, there was concern about the fact that existing Lumia phones will not be able to upgrade to Windows 8. While there will be a software update for existing Lumia phones - which will include many of the features of the Windows 8 - it will not include the improvements relating to updated hardware specifications, for obvious reasons. The looming Windows 8 launch and the inability for current Lumia users to upgrade to the full platform should negatively weigh on Q3 sales, but this is only a short-term issue which all manufacturers face prior to a new phone release.
A secondary concern was with respect to AT&T's (T) retail price reduction of the Lumia 900 from $99 to $49.99. Some people mistakenly took this as a dramatic 50% reduction in the cost of the phone and a resultant sign of a serious weakness in sales. While there could be some truth to the latter concern, it may also be just a normal short-term sales incentive to maintain sales momentum 3 months after the initial Lumia 900 launch and before the upcoming Windows 8 release.
With respect to the 50% price reduction, this is only what the end-customer pays. The total cost of the phone, without a contract/subsidy, declined from $450 to $400 (an 11% reduction). To me, this does seem like a prudent short-term move to maintain sales momentum for the platform during the months until the Windows 8 phones are released. Also, bear in mind that this was a cost reduction by one carrier in one market (AT&T in the U.S.) and the U.S. is a very small market for Nokia's phone sales (the U.S. comprised just 3% of device and service sales for Q2 2012). We may not know exactly what is happening with AT&T's Lumia 900 sales and the precise reason for the price reduction, but we do know that this is a small market for Nokia and, overall, Lumia sales trends have been very positive.
The third concern was Friday's credit rating downgrade of Nokia from Fitch (corporate rating from BB+ to BB-). If there was ever convincing evidence that the equity markets are inefficient, share price movements based on lagging credit rating actions makes a strong case for the inefficient market theory. While the ratings action was completely warranted - given Nokia's risks, the prior corporate rating at one notch below investment grade was totally unjustified - bond prices/spreads already recognized this reality, which should have been completely obvious to anyone with any knowledge of the situation.
Cash Position Buys Substantial Time
At the end of the most recent quarter, Nokia had Euro 9.4bn in gross cash and Euro 4.2bn in net cash. Going forward, forecasting cash burn for Nokia is a very difficult exercise, given limited sales visibility, many moving parts, and the uncertain timing of restructuring costs versus the benefits expected to accrue from these expenditures.
For Q1 and Q2 of 2012, Nokia's discretionary free-cash-flow (DFC) was fairly stable at negative Euro 588mn and negative Euro 518mn, respectively. I define DFC as cash generated that is available for shareholders for discretionary purposes (e.g. dividends, share buy-backs, acquisitions, early debt retirement, etc.). I also exclude working capital movements, which fluctuates back and forth between quarters and (for any given quarter) isn't very indicative of the underlying cash flow generating capacity of the company.
|Cost of sales:||(29,456)||(27,288)||(7,318)||(5,320)||(6,417)||(5,706)|
|CFO (before w/c):||3,962||2,322||857||(47)||347||(173)|
|Change in w/c:||2,349||(638)||(675)||(134)||(513)||505|
|Cash flow from operations:||6,311||1,684||182||(181)||(166)||332|
|Financial expense and taxes:||(1,537)||(547)||(355)||(409)||(10)||(230)|
|Net CF from operating activities:||4,774||1,137||(173)||(590)||(176)||102|
Source: Company reports
Notes: Results are in Euro millions and income statement data are normalized/non-IFRS as reported by the company.
Assuming no improvement or deterioration in FCF over the next two years, the current quarterly burn rate of Euro 518mn would imply that the company would not deplete its net cash position for a full two years (taking them through June 30, 2014). This would give the company over a year-and-a-half of time, post the Windows 8 launch (expected this fall), to gain traction with its new line of Windows 8 Lumia phones while operating the business with the balance sheet strength of a net cash position. Furthermore, Euro 1,689mn of Nokia's gross debt matures from 2019 and beyond, implying that the total gross cash and liquidity position could last for over 3.5 years at the current burn rate.
With any stabilization of revenues and conditions (as we've begun to witness with recent revenue improvements), I would expect cash burn to actually improve considerably - as the company's cost base is brought more in line with the reduced size of the business. In that regard, the company has two major restructuring initiatives in place, which the company expects to deliver billions in annual savings by YE 2013. While these programs may be a net drag on cash flow in the near term, the longer-term implications for FCF should be substantially positive.
Microsoft and Carrier Support Should Help
In addition to Nokia's sizeable liquidity cushion, the company also benefits from the support of a deep-pocketed partner with a substantial vested interest in Nokia's success. With the rapidly increasing influence of smartphones in the computer world, Microsoft has a lot riding on Nokia, and the success of Windows smart phone platform. As a result, I believe that they will continue to provide substantial support and resources to ensure that Nokia and the Windows phone platform succeeds.
It is also in the different phone carriers' best interest for a third mobile phone ecosystem to succeed. Not only does this reduce the pricing power of the manufacturers of the iPhone and Google's (GOOG) Android phones, it could also allow for improved profitability per phone sold. For example, AT&T sells the iPhone 4S for $200 (no contract at $650), implying that the carrier pays $450 for the phone. With the Lumia 900, they sell the phone for $50 (no contract at $400), implying a cost of $350. That's 22% less than the iPhone for a phone which also costs the end-customer one fourth as much.
The degree of Nokia's and the Lumia's long-term success remains to be seen, but it should also be noted that Nokia doesn't have to "beat" or overtake Apple or Samsung. I do believe that the company will make substantial inroads, relative to its main competitors, but Nokia's business is scalable and fixed costs can be reduced to a point where the company could remain profitable as a smaller operator in the market. In other words, this is not a "kill or be killed" situation and I believe that there is room in the market for all three ecosystems to profitably exist.
Overall, I believe that Nokia's shares are attractive on a risk/reward basis. That said, visibility is limited, the risks are substantial, and investors in Nokia should treat these shares as a call option and be prepared to lose it all. For those reasons, Nokia's shares should represent only a small portion of anyone's portfolio (in their "highly speculative" basket). I see a successful turnaround as achievable, but the risk of failure and bankruptcy are also high.
In other words, what makes the shares attractive is the reasonable likelihood of a successful turnaround combined with the disparate magnitude of the two outcomes (success may equal a "multi-bagger" while failure equals the loss of investment), rather than a strong conviction with regard to Nokia's ultimate success.