Deconstructing Nokia's Third Quarter

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By BRational
October 19, 2004

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Like other Nokia investors, I have waited for the Q3 03 earnings release to get a sense of whether the negative momentum that had been evident in the first two quarters would be continuing, or whether the company's fortunes would show some signs of reversal. While the analyst community is quick to jump to conclusions on a company's prospects on the basis of one or two quarters, I did not think that this one quarter would necessarily give us sufficient indication of how the company might fare in the remainder of the year and beyond. Nokia had apparently suffered from serious market positioning errors, and the vast array of new models announced this past quarter would undoubtedly take a few months before making a visible impact on the bottom line. With that in mind, I examined the quarter's numbers (already reported and discussed by Eric on this board), which can be found on the company's web site.

In this election season, those of us in the US are being treated to heavy daily doses of spin�every word uttered by either party candidate is spun over and over by professional spinmeisters, who convey completely opposite implications from the same set of statements, pronouncements and even facts. My initial reaction to Nokia's 3Q numbers was one of mild disappointment and deep concern, tempered by some good news on the infrastructure side and to a lesser extent on handset market share�lesser extent because the unit growth is evidently driven by discounted pricing, meaning flat earnings and considerably lower margins�but more on that later. My initial reaction though was strongly contradicted by the near immediate onslaught of positive spin on these same numbers. Surely I must have missed a few important nuggets that some of the colleagues that I respect and admire on this board must have caught on to, and that widely followed names in the analyst community found quite satisfactory. With the benefit of a little more time, I went over the numbers in the earnings release, and now I find that my mild disappointment has turned to apprehension, coupled with bewilderment at what it is that analysts have found so pleasing about the company's performance this quarter.

Are the numbers stellar? By no means�by almost any measure, this year's numbers are dismal relative to the same quarter last year, and the cumulative numbers for the year deserve a failing grade compared to last year's totals. Are there positive signs that point to a safe and bright future? Possibly, as the quarter-over-quarter numbers have several potentially positive developments, though the strength and fiability of these indications are hazy at best for the time being.

Before delving into the numbers, I find the current grouping of the company's businesses to be a real nuisance. Specifically, with handsets no longer the exclusive domain of "mobile phones", but also within the purview of the so-called "multimedia" and "enterprise solutions", proper appreciation of Nokia's results in mobile handsets (aka "subscriber units") have gotten cloudier, greatly diminishing the transparency of the company's performance to investors. In a previous post, Eric consolidated the results of "multimedia" and "enterprise solutions" with those of the mobile phones division, as these constitute "mobile units". However, this is not entirely clean. Mobile Phones include some, but not all, camera phones; multimedia includes game players such as N-Gage, which in my view should not be considered a mobile phone. I also understood that all UMTS/WCDMA handsets are attributed to multimedia. And while "enterprise solutions" includes the smart communicator, it also includes various security devices, as well as software development that may not be directly related to the development of handsets. These distinctions are important, because without the major gains in multimedia the overall mobile units picture looks sorry indeed (44% decrease in profits this quarter relative to the same quarter last year).

I have pasted below a portion of a table in the report linked earlier, summarizing the Nokia Q3 and January - September 2004 Results. This table first shows profits for Q3 2004 and 2003 side by side, and similarly the year-to-date profits for Jan � Sept for 2004 and 2003. Here is what I see:

� Operating profit decreased 20% overall for the quarter, compared to the same quarter last year; for the year to date results, the decrease in 2004 is 11% so far.

� For the mobile phones division, this decrease is an eye-popping 44% for the quarter, and 36% for the year to date. While some of this decrease is offset by the impressive gains in the multimedia division, the contribution to the bottom line is tiny in both absolute and relative terms, and is entirely negated by the growing operating loss in enterprise solutions (decrease of 94% relative to Q3 03, and 90% for the year).

� Networks (infrastructure division) has saved the day, contributing nearly 20% of the quarter's and the year's profit (from almost nothing in the past year's quarters, and a net loss the previous year and in the years before).

EUR million             Q3/04    Q3/03 Change  Jan-Sept Jan-Sept Change
                                       (%)      2004     2003    (%)

Operating profit      928      1 154  -20      2 973    3 342   -11
  Mobile Phones         822      1 473  -44      2 708    4 230   -36
  Multimedia             87      -177            15      -293     
  Networks              181         4            618      -260     
  Enterprise Solutions  -66      -34    -94     -156      -82     -90

Operating margin (%)    13.4      16.8            14.7      16.2     
  Mobile Phones    (%)  18.6      28.8            21.1      28.4     
  Multimedia (%)      9.5     -37.6            0.6      -18.9     
  Networks (%)          12.3      0.3            13.9      -6.6     
  Enterprise Soltns(%) -38.4     -30.1          -28.4     -20.3     

While networks are an important ingredient to the wireless company's portfolio of product and service offerings, and a critical link in building close relationships with carriers, it is probably fair to say that many investors have predicated their investment on the company's prowess in mobile handsets, its trend-setting image in mobiles, and its market dominance in many segments of that market. And the story in that portion of the business remains murky at best. There appears to be a positive market share story (reported to be back at about 33%-- though it is not clear if that would also include those units produced by multimedia and enterprise solutions). But when the company indicates that its "pricing strategies have achieved the objectives", what this means is that market share was regained through price reductions�not just "marginal" reductions, but apparently substantial reductions�with operating margins for mobile phones decreasing from 28.8% to 18.6% year over year for the mobile phones division. Mind you, in this cut-throat business, 18.6% operating margin in handsets is nothing to sneeze at. But if there was any doubt that commoditization is rampant at the lower and middle end, the magnitude of the slide and its consistency reveal not just a one-off aberration, but confirmation of a seemingly firm trend.

To counteract the above trend, the wireless industry in general has been promoting higher end models, which carry premium pricing, and hence higher margins. In this case, one must assume that the higher end models are those accounted for under the multimedia division. From that standpoint, Nokia's turnaround in that division looks much less impressive, as the operating margin there is a mediocre 9.5% for the quarter (and 0.6% for the year). Against the past year's negative returns from that division, 9.5% is great. However, as the much hoped-for source of lift in handset profitability, the evidence is mixed at best. Just how fast will higher end multimedia phones have to grow before they return the company to the profile of a growth company is not clear, nor would it be realistic to expect that segment to take on the explosive growth characteristics that 2G provided Nokia. To date, it does not appear that Nokia's position in UMTS/3G matches its dominant role in the 2G GSM world. This may change, as that segment moves firmly beyond its timid first steps, but the initial evidence points at a different market share situation in 3G than we've had in 2G.

Where does all this leave us? Different investors will draw different conclusions. Some may point to the full pipeline of new models in all segments; or the legendary efficiency of the Nokia logistics machine; or the company's leadership with the Symbian platform; or the improving market share picture that demonstrates yet again that Nokia still knows how to pull strings and deliver in this market. These are all undoubtedly good indications. The company still has a vast reserve of talent, across the spectrum of wireless technologies and consumer product design. However, when it comes to the bottom line, there is unfortunately little of substance for the faithful investor to cheer about. This is not just quarter-to-quarter� we have had three declining quarters year on year, with a cumulative deficit in operating profit of 11% year to date. Where the potential is probably most realistic is for some of the medium to higher end models to reach the kind of production levels at which Nokia's well-demonstrated scale economies would kick in. Even there, segmentation of the market into ever-smaller slices means that there are limits to how much operating efficiency could be squeezed through Nokia's vertically integrated operations. As the slices become smaller, greater sourcing from specialist component makers becomes more attractive. The company suggested as much by indicating that they would consider working with an original device manufacturer so they can produce handsets for the CDMA EV DO market (which was quickly interpreted by the Qualcomm faithful as Nokia buying chipsets from Qualcomm). Nokia may have learned to change to meet the challenges of a market that is no longer following the script it had written for it.

Additional thoughts, insight and differing interpretations would be appreciated.


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