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Why Nokia's (NOK) Phone Division Is At Risk

|Includes: Nokia Corporation (NOK)

Why Nokia's (NYSE:NOK) phone division is at risk

Nokia has been recently the focus of attention for many investors. First, because it released a competitive product, the Lumia 920, in the smartphone business, vs. Android/iOS devices. Second because the share price, after riding to the bottom until end of July, has found a second life since, increasing 100% since its lowest point in July. Third because the first shipments of his new flagship, Lumia 920, have sold out in many countries, and the Asha Full Touch line has been warmly welcomed in developing economies (6.5m volume in Q3).

Some analysts have upgraded their recommendation and targets for the share, mostly Scandinavian ones: Nordea (strong buy, 19.10), Danske (buy, 23.11), Pohjola Market (buy, 15.10). However, we can notice that their target remains in the range EUR 2.9-3.1, which is a modest 14-20% premium vs. current price. Is NOK long-term value so close to the current trading price?

Part of the answer lies in the risks inherent to NOK's phone business. Nokia is at risk. Here are the main reasons why.

1. The cost-structure of the company in the smartphone business is not sustainable and cannot generate positive cash flow.

 

Q1 - 2011

Q2 - 2011

Q3 - 2011

Q4 - 2011

Q1 - 2012

Q2 - 2012

Q3 - 2012

Sales (EUR m)

3528

2351

2194

2747

1704

1541

976

Volume shipped (million)

24.2

16.7

16.8

19.6

11.9

10.2

6.3

COGS/Sales

-71%

-77%

-79%

-80%

-84%

-98%

-104%

OpEx/Sales

-24%

-32%

-30%

-27%

-33%

-35%

-45%

Operating margin/Sales

5%

-9%

-9%

-7%

-17%

-33%

-49%

Lay-offs D&S (*)

1540

1000

1300

5500

2600

3500

5000

Source: NOK quarterly reports
(*) D&S = Devices & Services, all phone division (smart+feature phones)

NOK's volume faced a continuous drop since Q1 2011 (last quarter when the smartphone division was profitable). Nokia is a big ship, a phone-maker that used to make 25-30m smartphones per quarter in 2010, and suffered a drop by 50% of its volume within 1 year (Q1 2011/Q1 2012), and by 66% within 3 quarters (Q4 2011/Q3 2012). It is impossible to adjust quickly the production capacity to such a drop, because we are talking of an initial output of 25 million smartphones (Q1 2011).

As you can notice in the table above, NOK tried to anticipate in Q4 2011 to re-calibrate the workforce, to decrease OpEx, and COGS. But the landing point was overestimated, resulting in more and more lay-offs in 2012.

If we assume COGS/Sales is assumed to be ideally a constant ratio, NOK is far from that, and is not really taking actions to decrease this, as you can see in 2012 (84%->98%->104%).

As for OpEx, which are marketing and R&D expenses, Nokia is doing a better job here, but the level is not sustainable in the long-run. Which company can be profitable with spending 33-35% of the price in R&D and marketing, when it already "eat" 80-90% of the price in making the product?

2. The feature phone market is rapidly decreasing and will soon not contribute anymore to the operating margin.

Feature phone market turned according to Gartner from 325m shipped units in Q3 2011 to 259m in Q3 2012.

All in all, this is a drop of 20% year-to-year that can be expected in 2012 vs. 2011.

At the same time, NOK's operating profit for featured phones dropped from an average of EUR 350m in 2011 to EUR 100m in 2012. How sustainable is that?

3. More lay-offs might be coming, implying more expenses.

NOK announced 10,000 layoffs in D&S in June 2012. NOK already laid off 5,000 employees in Q3 2012 in D&S, which is half of the target, and clearly - the situation has not improved (operating margin at -49%). There are still 38,000 employees in the D&S business, resulting in sales of EUR 3.3bn in Q3, while AAPL generates $30bn with 30,000 employees (not only smartphones, though, but it gives some kind of a comparison in the industry).

NOK is likely to lay off more people in early 2013, resulting in more cash burn.

Conclusion

NOK's phone business is clearly at risk, because the company is still moving from an established maker of quarterly 25-30m smartphones to a challenger, ramping volume up from 1m Lumias in Q4 2011. The faster-than-expected decline of Symbian models plays an important role in this, as quoted in Q4 2011 report by NOK's management: "Following the announcement of our strategic partnership with Microsoft in February 2011, our strategy included the expectation to sell approximately 150 million more Symbian devices in the years to come. However, changing market conditions are putting increased pressure on Symbian (…) We now believe that we will sell fewer Symbian devices than we previously anticipated".

These factors are internal, not external, since it is about adapting your production capacity to the demand. To cope with these challenges, NOK would need to take significant measures to "clean" the company, by shutting down factories to decrease costs.

In this situation, NOK's phone division cannot even be a target for a buyer, who wants to inherit such a cost structure?