Nokia comes in contact with reality, stock plunges

Nokia today issued a profit warning for the current quarter and the rest of year saying operations will probably be around break-even.

- Nokia now expects Devices & Services net sales to be substantially below its previously expected range of EUR 6.1 billion to EUR 6.6 billion for the second quarter 2011. This update is primarily due to lower than previously expected average selling prices and mobile device volumes.
- Nokia now expects Devices & Services non-IFRS operating margin to be substantially below its previously expected range of 6% to 9% for the second quarter 2011. This update is primarily due to lower than previously expected net sales. While visibility is very limited, Nokia’s current view is that second quarter 2011 Devices & Services non-IFRS operating margin could be around breakeven.

Translation: E7 and N8 sales are poor, IFRS net income will show a loss and we have no idea what is going to happen towards the end of the year. I am not surprised at all by the weak sales of the high end; why would anyone commit to a dying platform over buying Galaxy S II, HTC Sensation, iPhone 4 or any of the other high-end phones?

You might recall that my initial take on Nokia’s Q1 was decidedly more negative than that of the so called analysts. Then, I continued to rail against them when Elop announced his plans to reorganize the company here. What worries me is that the first thing they state as means to avert crisis is to invest more into Symbian. This is not going to end well and the drop in the share price gives good indication. It plunged on massive volume and there wasn’t even an attempt to buy the dip.

Nokia stock closed at €4.75 in Helsinki trading, down 17,53 per cent from yesterday’s closing price. Nokia is now worth around 17.8 billion euros. Equity per share is approximately 3.8 euros, so markets do not see much value in Nokia’s operations and I agree with them.

Back when Nokia was trading at 12€ the last time, I not only sold my shares at a nice profit, but also made the call that I would not buy Nokia before it was trading at 5€ or below. Perhaps I should have actually traded that call. Nonetheless, the news that have come out since have pushed my estimate of Nokia’s fair value downwards. I just don’t see value in Nokia anymore.

Symbian’s long tail

Remember the picture above. The very long tail of Symbian that will produce 150 million in sales over the next couple of years. Yeah, it’s not going to happen. You would think that at Nokia there would be someone that understands that when you announce the imminent death of an entire technology platform in a rapidly evolving industry where the platform itself has become the critical competitive factor, your sales are going to tank. Be it one way or the another, it took an actual steep sales drop to convince Nokia execs of that very fact.

Restructuring

A month ago Nokia announced its restructuring plan including outsourcing Symbian workforce to Accenture and reducing personnel by additional 4000. They also said they would decrease their Devices & Services non-IFRS operating costs by 1 billion euros by 2013 compared to 2010. The plan itself had few big problems, but given that it took less than 2 months for the shit to hit the fan for Nokia, I am now expecting additional restructuring program to be announced before the end of the year possibly in a panic atmosphere, but that really depends on what happens with the market shares of Symbian and especially WP7.

Market shares dropping

I discussed the market share development among smartphones here. Essentially, Symbian’s market share is plunging and they are about to jump on board with a platform that has 1 per cent market share and with a company that has 3.5 per cent market share. WP7 did not catch on despite the rather successful roll-out of several phones internationally with a new exiting OS that garnered positive reviews on many fronts, and this is becoming a problem for Nokia. This is what I wrote in April:

Expect the market share to continue to drop. Now, this is not a big issue for Microsoft, but to Nokia its probably crucial. If Microsoft does not deliver in the next 12-18 months it might be time for Nokia to drop smartphones and concentrate on cost leadership with some Meego initiatives on the side.

1.6 million sold devices in the first quarter and most likely less this quarter looks really bad. If this trend continues Nokia might be holding some emergency meetings in few months. To their benefit Nokia is strongly capitalized so it has time and resources to reinvent itself.

Losing contract with Microsoft

Between the time Elop came to Nokia and the announcement of the definitive agreement between the companies that Nokia would use WP platform on its smartphones, there was quite a bit speculation. I held the position that Nokia’s negotiation power was vast and they were at good position to create a partnership contract that would shift a lot of value from Microsoft to Nokia and I still hold that view. This is because WP7 would have died off completely if Nokia would have gone ahead with Android.

The details of the agreement are not public, but it is known that Nokia will pay license fees just like HTC and MS will use some of the Navteq assets in its offering. This was and still is a losing contract for Nokia. Nokia should have at least demanded the following:

  • WP platform as a crucial element in MS overall strategy
  • WP representation in company executive board
  • Guaranteed significant marketing support from MS
  • Guaranteed annual major software releases for the next 10 years
  • Short-term exclusivity to new software releases
What Nokia should do now
  • Further concentrate the R&D function geographically and on projects that are actually related to smartphones.
  • Shutdown production in Finland, there is no reason to give huge advantage to competitors on this point as no one cares were the products are made
  • Fire Esko Aho and Jorma Ollila and get rid of the idea that one should hire idiots so that one can look relatively better. Ollila already tried this by driving Alahuhta to Kone and picking Kallasvuo as CEO.
  • Spin-off Nokia-Siemens
  • Start developing something that will positively differentiate the products from other WP handsets as I don’t think the brand will do it anymore.
  • To be honest, its down to hope at this point.

The smartphone race and Microsoft’s Mango update

On 19th of May Gartner released their quarterly report on the state of the mobile phone market. Here’s the press release.

The smartphone front looks like this as of Q1:


Android has had a phenomenal success over the last year going from 9.6 per cent market share to 36 per cent currently. It is starting to seem like Android is forming into another Windows. Symbian has gone to the other direction losing 17 percentage points. In total the smartphone market has doubled over the last year, which is frankly the only thing that has kept Symbian and Nokia barely profitable. But the really interesting part of the market is Microsoft and their new Windows Phone platform, which is going to get its first major update later this year. 3.6 million devices shipped with a Microsoft OS, though only 1.6 million of these were those new WP7 devices according to Gartner. I have discussed Microsoft’s ventures here.

I personally like the Windows Phone UI and the whole concept, but as I stated before they were late to the game and made some mistakes in their execution. Plus, everyday they are giving more advantage to Android and iOS. The fact that they only shipped 1.6 million WP7 devices against Apple’s 17 million and 36 million Androids spells, if not doom for the platform, then at least serious problems for Nokia. The platform will not get any boost from latest generation hardware this quarter and future seems murky at least when compared to the already shipping latest generation Androids. I expect the platform’s market share to drop further although some Symbian shoppers may have jumped ship.

The WP7 platform’s current state seems very problematic for Nokia who is supposed to go all in next year with Microsoft. It is not going to be easy to start with a platform that is closing in on zero in terms of market share while one’s own Symbian is doing the same. Android should be benefiting from this and I expect its market share to grow steadily in the next two quarters especially as the next iPhone is rumored to ship only after summer.

Microsoft today showed of its Mango or 7.1 update for the Windows Phone platform. See here Engadget’s liveblog from the event. Overall it seems like a very solid package for .1 update and will bring the OS closer to feature parity with its closest competitors, but the key take-away from the event is that there is not going to be new hardware or software until this fall. Moreover, Nokia states that this is the version that their first WP device will use raising the expectations that they will actually ship something for the holiday quarter.

Disclosure: I am a Mac/iPad/iPhone user

Microsoft to acquire Skype, notes on acquisition pricing

Microsoft and Skype today announced that they have entered into a definite agreement under which Microsoft will pay the shareholders of Skype $8.5 billion in cash.

On the surface both the deal and the price tag make absolutely no sense. Reflections of a tech bubble; companies are paying ridiculous sums for unprofitable customers relationships.

Strategic sense

Skype has 40 per cent of the user base of Live Messenger. Microsoft already has all the infrastructure and software knowledge in place. It would make a lot more sense to built the same services in-house. Even with a sensible price tag this acquisition is questionable. Skype does have revenue model for its product, but the company is making losses and Microsoft is most certainly not interested in plowing huge chunk of its cash holdings into something that has virtually no bottom-line effect.

Skype does have a very recognizable brand name and buying up Skype removes one competitor and brings considerable weight behind Microsoft’s ambitions in the IM, VoIP and video-chatting game especially against Google Voice and Apple’s FaceTime. Microsoft points out that it has a lot of ventures and products in the real-time communications business and the acquisition of Skype plays into that creating a lot of new revenue sources. There is certainly something interesting to be made from having a well-functioning client on Windows Phone, Windows, Xbox with Kinect and other platforms with further boost coming from business side solutions, but the revenue logic is worrisome. Considering the fact that Microsoft will be concentrating its interest on Windows and Office for the sole reason that that is where its profits come from, I do not see this acquisition becoming profitable.

Valuation

Microsoft will pay 8.5 billion in cash and assume about 700 million in long-term debt. Skype made a loss of 7 million last year with operating profit at 264 million. I would sure like to see the investment banker’s figures for justifying this price. Microsoft would have to make 900+ million in free cash flow every year until infinity from this to get even close to justifying the price. Apparently they saw Skype going elsewhere as a very large negative factor.

Note on acquisition pricing

Conventional wisdom in investment banking says that pricing is rarely a deal-breaker in M&A. Who gets the corner office and how firm the golden handshake is are more important factors. But here I am talking about differences between 4.0 and 4.1 billion, not paying completely off the charts price. There are however, some additional factors that come into play. Factors that have nothing to do with the value of Skype’s business operations. In most cases buy-side transactions follow the bid high on first round adjust if something goes wrong strategy. Moreover, the price tag also tells us that Microsoft wanted to make sure that Apple and Google do not bid for Skype. And then there are various synergies that can be gained from industrial buyer led transactions. Microsoft can leverage Skype and its own products better after the completion of this acquisition.

Pretty incredible deal for Skype

Skype was founded in 2003 by Niklas Zennstrom and Janus Friis. In November 2009 Skype was valued at 2.75 billion in a divestment by eBay. And now 18 month later it is valued at 8.5 billion. The deal is incredible for Skype as there is no way it would be worth 8.5 billion as a stand alone company.

Conclusion

Skype shareholders are probably popping champagnes, Microsoft’s products will get a boost if ideas well executed, price tag makes no sense for Microsoft.

On Microsoft, who reported net earnings of $5.2 billion

Microsoft reported its earnings on 28th of April and its racked up $5.2 billion in profits on a revenue of $16.4 billion. Revenue was up 13 per cent and profits 31 per cent. Though, the stock dropped after the results came in. Microsoft is currently trading at $218 billion market cap, which seems rather low compared to its net profits and excess cash reserves. This is what Microsoft had to say:

We delivered strong financial results despite a mixed PC environment, which demonstrates the strength and breadth of our businesses. Consumers are purchasing Office 2010, Xbox and Kinect at tremendous rates, and businesses of all sizes are purchasing Microsoft platforms and applications.

We delivered strong third quarter revenue from our business customers, driven by outstanding performance from Windows Server, SQL database, SharePoint, Exchange, Lync and increasingly our cloud services. Office had another huge quarter, again exceeding everyone’s expectations, and the addition of Office 365 will make our cloud productivity solutions even more compelling. We continue to see strong adoption of our cloud-based services among the Fortune 500

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Just what on earth is Nokia doing with its R&D budget

Nokia today announced its plans to adjust its operations to match its new strategy of becoming a Microsoft OEM. Nokia will outsource all of its remaining Symbian resources including 3000 employees to Accenture and chop of further 4000 people from its payrolls. The plan is to reduce non-IFRS Devices and Services operating costs by 1 billion euros in 2013 compared to 2010. This is what the new CEO Stephen Elop had to say:

At Nokia, we have new clarity around our path forward, which is focused on our leadership across smart devices, mobile phones and future disruptions. However, with this new focus, we also will face reductions in our workforce. This is a difficult reality, and we are working closely with our employees and partners to identify long-term re-employment programs for the talented people of Nokia.

There’s nothing wrong with this, just your average corporate talk and seems all reasonable. But I cannot get over the fact that there have been 3000 employees working on Symbian software. No wonder its market share and especially mind share has tanked. The poor performance of Symbian has also been strongly reflected in Nokia’s results. Nokia now expects its 2nd and 2rd quarter non-IFRS operating margins to be as low as 6 per cent, which in IFRS language probably means pretty close to nothing.

Off-topic, isn’t it wonderful that pro-forma Ollila became non-IFRS Kallasvuo continued by non-IFRS Elop. Word of advice, Nokia would do well to concentrate more on fixing its business model than its financial statements.

The 3000 employees working on Symbian is not the only measure of bloated R&D yielding practically nothing. In fact, Nokia spent €1.5 billion on R&D during the first quarter of 2011, a few per cent increase over last year. That is almost half of its gross profit and more than 14 per cent of total revenues. In 2010 Nokia spent €5.8 billion on R&D, over 45 per cent of its gross profit and roughly 14 per cent of its revenues. Just as a point of reference, Apple spent less than $1.8 billion on R&D on its 2010 financial year, a figure that is about 2.7 per cent of its revenues and under 7 per cent of its gross profit.

I composed a little chart to illustrate R&D spending and efficiency in the IT sector for the 2010 financial year. Nokia’s figures have been translated into US dollars using 1.4 average rate. Can you spot the outliers? Nokia’s R&D really needs help, but I am not sure that is gonna happen as Elop told that they are going to spread the WP7 related development across the world. One would think that now that they don’t even have their own OS they could work from one place, but apparently not.

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