Nokia's Long March to Profitability

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Even as Nokia's (NYSE: NOK) smartphone sales continued to collapse, down 32% year over year and 6% sequentially, CEO Stephen Elop claimed that Nokia had "achieved underlying profitability" at the quarterly conference call.  As usual, his claim excluded restructuring charges that pushed Nokia into an operating loss of  $152 million for the quarter. The sole legitimate, though limited, sign of progress was an increase in sales of Lumia Windows 8 phones from last quarter's 5.6 million to 7.4 million.

Total revenue for the company was down 24% to $7.5 billion.  Nokia's net cash and equivalents fell by more than $528 million from $5.9 billion to 5.37 billion. About the only positive in Nokia's overall financials is that it isn't as bad as a year ago, when the operating loss was $1.09 billion on revenue of $9.953 billion. Elop may call this achieving underlying profitability, but I call it hanging on by your fingernails.

Smartphone Zero Sum Game

Last quarter I pointed out that Nokia had effectively cannibalized its own low cost Asha line of smartphones as well as Symbian smartphones it was still selling. As the table below shows, this continued into Q2.

<table> <tbody> <tr> <td> <p><span>Quarter</span></p> </td> <td> <p><span>Lumia Units in million</span></p> </td> <td> <p><span>Asha Units in millions </span></p> </td> <td> <p><span>Symbian Units in millions </span></p> </td> <td> <p><span>Total in millions</span></p> </td> </tr> <tr> <td> <p><span>2012 Q4</span></p> </td> <td> <p><span>4.4</span></p> </td> <td> <p><span>9.3</span></p> </td> <td> <p><span>2.2</span></p> </td> <td> <p><span>15.9</span></p> </td> </tr> <tr> <td> <p><span>2013 Q1</span></p> </td> <td> <p><span>5.6</span></p> </td> <td> <p><span>5</span></p> </td> <td> <p><span>0.5</span></p> </td> <td> <p><span>11.1</span></p> </td> </tr> <tr> <td> <p><span>2013 Q2</span></p> </td> <td> <p><span>7.4</span></p> </td> <td> <p><span>4.3</span></p> </td> <td> <p><span>0</span></p> </td> <td> <p><span>11.7</span></p> </td> </tr> </tbody> </table>

In order to make this less apparent, in Q1 Nokia stopped reporting Asha in the Smart Device category and lists Asha in the mobile phone category, even though Nokia's own report continues to refer to Asha as a "full-touch smarphone." This allowed Nokia to claim a 21% increase in Smart Device unit sales, from 6.2 to 7.4 million.  But in fact, selling smartphones has become a zero sum game for Nokia, where it can only increase sales in one line at the expense of the other. 

While steeply discounting Lumia Windows phones pumped up the unit volume, it didn't help Smart Device revenue, which was down 24% year over year and unchanged from last quarter at $1.54 billion.  Both Microsoft (NASDAQ: MSFT) and Nokia were "on the same page" at their conference calls, claiming to be pleased with Windows Phone "momentum."  

Elop pointed out that Nokia has now sold 13 million Windows Phones, as many as it sold in all of 2012, but this really underscores the flop that was Windows Phone 7, especially since WP8 became available in 2012 Q4.  At this rate, can the Microsoft keiretsu really build a sound ecosystem?

Long March, or Death March? 

I've estimated that a mobile device ecosystem requires about 100 million users to become self-sustaining. This figure varies somewhat depending on the licensing structure of the OS. Currently, Microsoft still pays slightly more in platform support payments to Nokia than Nokia does in licensing fees, so in effect, the OS is free and Microsoft is being forced to create a self-sustaining mobile ecosystem in the Google vein, supported by advertising and search revenue, and sales in its content stores.  In this mode, 100 million users is probably conservative, since Microsoft doesn't have anything close to the mobile device advertising revenue of Google, judging by the way Microsoft's Online Services Division (home of Bing) continues to post operating losses ($110 million in Q2). 

According to Gartner Research, there were about 12 million Windows Phone sales through the end of Q1 worldwide.  Assuming that Windows 8 Phones sell about 10 million this quarter (including Nokia's 7.4 million), that means that there are about 22 million Windows Phone 8 users in the world.  Just 78 million more to go, or about two more years at 10 million per quarter.

Somehow, trudging along like this adding 10 million or so users per quarter seems an implausible way to build a "viable third ecosystem." On a quarterly basis, Android is adding about 135 million users, and iOS is adding about 50 million.  The goal of sustainability is not really a fixed number like 100 million users.  It's a vision of mobile ecosystem vitality that is pulling away into the distance, even as Nokia and Microsoft struggle to keep up.

Clearly acceleration is needed, and that acceleration can't really come at the expense of the cash flow of Nokia or Microsoft's other Windows Phone partners.  Nokia badly needs to get off the low-cost, emerging market treadmill and move up-market.  The Nokia 1020 seems something of a Hail Mary pass in this regard.  The 1020 offers exclusivity through a 41 Mpixel camera, a first for any smartphone.  But the rest of it is generic Windows Phone.  Like every other Windows 8 Phone, it uses the same tired old Qualcomm Snapdragon S4 processor. 

But it's clear that that Nokia doesn't expect profitability to come easily, or soon, and it is in this context that the Nokia Siemens Networks (NSN) buyout is to be understood. 

Nokia had already announced that it was buying the Siemens stake in the joint venture for $2.24 billion.  $1.58 billion of this will come from secured bank loans and Siemens will issue Nokia a note for the rest, due in a year. 

So Nokia bolsters its cash position by gaining full access to NSN's net cash of $1.9 billion, as well as a cash cow it intends to squeeze hard in the coming year, judging by the restructuring it is undertaking at NSN.  NSN had already reduced its work force by 12,900 employees compared to Q2 2012, and planned cash outflows due to restructuring are expected to be $924 million for 2013. 

The NSN buyout is also consistent with the rumors of negotiations with Microsoft to sell it the Devices and Services business.  In this scenario, Nokia becomes a wireless networking equipment and services company.  Still a tough competitive business, but not as tough as the end-user equipment business.

Given Google's experience with buying Motorola, I'm not sure why Microsoft would want Nokia's Devices and Services division, and I'm sure that Microsoft is better off without it for the time being.  While trying to reshape itself as a devices and services business, the task of managing Nokia's devices and services business would probably be more than Microsoft could handle.

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Mark Hibben has no position in any stocks mentioned. The Motley Fool owns shares of Microsoft. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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