Market participants have the nasty habit of getting so caught up in the present that they fail to accurately understand the future. A stock is not a claim on the past but rather a right to share in future earnings. The market's evaluation of Nokia (NOK) is a case study in a constrained mode of thinking. Most articles on the company begin with a thorough look at its decline - a market leader with nearly half of the global mobile market in 2007 to a laggard with a slipping 20% today. Its stock price has followed, collapsing by 93% from its 2007 highs to $2.69 today - its market valuation is below book value. Complacency is a common fault of successful companies, and it was Nokia's, which stayed on the sidelines of the smartphone revolution that Apple (AAPL) and Google (GOOG) led. The story of a company's precipitous fall from grace into the depths of irrelevance has its allure, but it is a story that does not suit Nokia. It does not suit Nokia because the company has experienced a sort of creative destruction in which it has cast off its own Symbian platform in favor of the outside Windows Phone system, taken enormous strides in a painful restructuring process, and created products that have closed the gap competitors once had.
The Enormous Cost of Re-Orientation
Nokia abruptly brought its Symbian platform to the guillotine over the past year. CEO Stephen Elop called it a "burning platform," product development and marketing were axed to just one device, and the majority of its employees were shown the door. Nokia's management expected a soft landing and sales of 150 million Symbian phones during the two-year transition to the Windows platform, yet its actions led Symbian sales to bleed like a stuck pig from 30 million units in Q4 of 2010 to 3.4 million in Q3 of 2012 and to some immaterially low number in the future. Analysts have hastily dished out withering criticism on Nokia's failed handling of the Symbian transition. But all of that is in the past. Looking into the future, today's non-existence of Symbian is akin to a tree that has just been pruned. Symbian's disappearance paves a way for Nokia's Windows Lumia offerings free of the expenditures associated with maintaining a system on life support.
With the house cleared, the second part of the turnaround depends on the success of Nokia Windows Phone offerings, chief among them the Lumia smartphone line. The first demonstration of the potential of the Nokia-Microsoft partnership came in the April 2012 release of the Lumia 900, which sported a 4.3 inch display, 4G/LTE support, and the Windows 7 system. The product was not a product that a company that is about to die releases. The phone was bold without the drag of desperation. Tech critics reviewed the phone favorably; co-founder of Apple, Steve Wozniak, said it was better than the iPhone 4S and Android offerings on the market; and Nielsen found that 96% of buyers were satisfied with the Lumia, 95% would recommend it to a friend, and 91% said it was better than its competitors. Sales doubled QoQ to 4 million units in Q2 - Lumia's sales in its launch period outpaced Apple's iPhone release in 2007 and Samsung's Android roll out in 2009 (with a caveat: the smartphone market has grown considerably since then). With the release of Windows Phone 8, and no upgrade path to the new operating system for current Lumia owners, Lumia sales fell to 2.7 million units in Q3, supported by rebates and subsidies. However, analysts have made much ado about something that has little consequence in the future. The first generation of Lumia phones merely served as a litmus test for the new release and the Windows Phone 8 platform. And in that sense, they passed with flying colors. Whatever Nokia's missteps were in the reorientation, the company demonstrated that it once again values future success above its past.
A New Nokia
The company will release its second generation of Lumia products in November. The flagship Lumia 920 received glowing reviews from CNET, PC Advisor, Benzinga, and Verge. More importantly, it will provide value to customers.
A ground-breaking product: CNET writes, "The Apple iPhone 5, Samsung Galaxy S3, and Nokia Lumia 920 are all titans in their space, and competition is fierce." Nokia must have something on its hands to elicit such comparison. The Lumia 920 has a clearer, sharper display than its rivals, an 8.7 mega-pixel camera with bleeding edge image stabilization technology, the best mapping technology, and a design "whose yellow, red, white, black or gray polycarbonate body and rounded edges produce a punch of pop sensibility in an otherwise staid design world." All of this means nothing without positive customer reception. For the first time in a long time, Nokia is generating excitement and generating traction. Pre-orders have led the Lumia 920 to be sold out at Best Buy and Italian online retailer Nstore (twice), while it tops the most popular lists at PhoneHouse in France, and Digital Phone in the U.K. Although these early indicators cannot be put into quantifiable terms, they are promising in regard to customer interest for Nokia's new products.
Carrier Support: Cellular carriers are being taken to pasture by the Apple / Google smartphone duopoly. Apple has done to carriers what Wal-Mart (WMT) did to its suppliers - it "controls the customer billing experience" and leverages its iPhone sales to demand subsidies that eat into carrier margins and destroy their ability to differentiate themselves. The Windows Phone ecosystem offers the first chance to break the market's stranglehold. The carriers, which are the ultimate sellers of any phone, will aid Windows Phone 8 products through heavy promotion and marketing spend. Finally, the new Lumia family will be available through a wider distribution channel than the first generation was.
Completing the Windows 8 Ecosystem: Microsoft (MSFT) has bet the house on Windows 8, calling it the most important product the company has released since Windows 95. The Verge sees Windows 8 as a revolutionary moment for Microsoft, an operating system upon which the company can build an ecosystem. It is on this new elegant and personal platform that the Windows Phone ecosystem will gain critical mass. For consumers who are or become absorbed in the Windows universe, the Lumia line will be the strongest offering to complete missing link. The Windows 8 platform will differentiate the Lumia line from the iPhone and Android products. Plus, the ecosystem provides a choice to consumers who feel stuck between iOS and Android. All this will occur as Microsoft provides a marketing tailwind of over $1.5 billion for Windows 8.
These catalysts have been brewing for some time, but they will come to a boil when Windows 8 is released in late October and the Lumia 920 becomes a reality on November 2nd. The first Lumia release has generated sales of around 10 million smartphones in the first three quarters of 2012. The new Lumia line will be free from the first generation's limitations, chief among them being a mediocre operating system and an abrupt, short-lived cycle. With the above thoughts in mind, Lumia sales in 2013 could total 25-35 million units, in line with Deutsche Bank's forecast of 25 million for 2013. And unlike Nokia's 2012 Symbian offerings, the Lumia line will actually be profitable. Research firm iSuppli calculated a gross margin for the Lumia 900 of 52% by breaking it apart. This bodes well for Nokia's smartphone Q3 gross margin of -3.5%, which was caused by hits to inventory allowance, price erosion, and lower sales volume relative to fixed costs. The re-emergence of Nokia in the smartphone industry will propel revenue and earnings in the short and mid-term.
A Faster-Than-Expected Restructuring
Nokia has taken a number of steps to adequately buy itself time to transform. It has slowed the bleeding of its cash position, ending Q3 with net cash of EUR 3.6 billion. Netting out one-time restructuring cash outflows of EUR 380 million from the EUR -429 million in operating losses, operating cash flows were EUR -49 million. Nokia expects EUR 650 million in restructuring outflows for Q4, and EUR 800 million in 2013. The company possesses enough net cash to safely complete its restructuring. And, its issuance of EUR 750 million in convertible debt due in 2017 this week will help it manage its looming debt maturity in 2014 without having to expend cash.
The restructuring has led to a strong decrease in YoY operating expenses across the board: -19% in Devices and Services, -13% in Location and Commerce, and -14% in the Nokia-Siemens Network. These reductions will continue into 2013. Combined with lower operating expenses, the remaining core parts of Nokia's business have rebounded. Feature phone sales increased QoQ by 3% on the back of the Asha line, and the Nokia-Siemens Network posted top-line growth and an impressive non-IFRS margin of 9.2%, up from 0.2% in Q2. There is an important caveat that may bring these numbers back to reality - the weakening EUR has aided Nokia's global businesses considerably. Whether this trend continues is yet to be seen. Regardless of the future of Nokia's feature phones and the Nokia-Siemens Network, their newly-reached stability is a favorable backdrop to Nokia's smartphone revival.
But It's the Future, Man
What if Nokia's turnaround doesn't pan out? What if its new Lumia line doesn't gain traction and sales are paltry? What if Apple and Samsung squeeze Nokia out of the market entirely? What if Windows Phone competitors like HTC eat Nokia's lunch? In these worst cases, Nokia possesses a valuable amount of risk mitigation for investors in the form of its patent portfolio and net cash position. Analysts have valued Nokia's portfolio at around USD 6 billion. This conservative estimate is based on Nokia's ability to generate income through litigation and licensing, which the company estimates at EUR 500 million annually. Revenue will continue in the foreseeable future, because its portfolio has an average life expectancy of more than 10 years. The potential market price of the portfolio determined by comparable transactions, such as Google's purchase of Motorola Mobility, is higher than a revenue-based valuation. Regardless, Nokia's intellectual property assets represent a buffer to the risk that equity holders face. If things don't turn up, the company's high break-up value represents a threshold for the downside at around $1.60 per share.
Make no mistake - Nokia will continue its struggle in Q4, and management predicts an operating margin for Devices and Services of -6%. This will probably mean adjusted operating income that walks the line in much the same way that Q3 did. But the company has suffered through the most painful part of its reorientation, and so has its stock. It has absorbed a majority of its restructuring costs with enough capital to comfortably complete the process, turned around its businesses to operating profitability, and produced smartphone offerings that will take advantage of enormously positive catalysts. Looking into the future, Nokia's creative destruction marks this year as a bottom in Nokia's ensuing re-emergence.
Disclosure: I am long NOK.