This article began as an analysis of Nokia (NOK) for the monthly value contest (I still believe that it could double over the next twelve months); however, as I progressed in my research, I decided that I could not commit myself to the idea at this price due to an overwhelming level of uncertainty. Here’s the result from my quick look at the company:
In 1865, a mining engineer by the name of Fredrik Idestam sets up his first wood pulp mill in southwest Finland. A few years later, Mr. Idestam opened a second mill along the banks of the Nokianvirta River, which he named his company after (Nokia Ab) in 1871.
Nearly 100 years later, the company made its first foray into the telecommunications industry, when it started developing radio telephones for the army and for emergency services. This eventually led to portable car telephones in 1984 and the first handheld mobile phone for NMT networks (Nordic Mobile Telephone service, the world’s first international cellular network) in 1987.
Starting in the early 1980s, the company also ventured into the world of computers (releasing the first model of the MikroMikko, which became the best-known computer brand in Finland, 48 days after IBM introduced its Personal Computer) and televisions (at one point, Nokia was the third-largest manufacturer in Europe). But as we know today, the future wasn’t in PCs or TVs; Nokia was on its way to riding the mobile revolution.
In 1987, GSM (Global System for Mobile communications) was adopted as the European standard for digital mobile technology; as a player involved in developing this new technology, Nokia was able to quickly prepare for its implementation. Four years later, Finnish PM Harri Holkeri makes the world’s first GSM call, using Nokia equipment; a year after that, the company launches its first line of digital handheld GSM phones, the Nokia 1011.
In 1994, Nokia launched the 2100 series, which was the first line to feature the Nokia Tune ringtone; from an initial target of 400,000 units, the Nokia 2100 series went on to sell 20 million phones worldwide. By 1998, Nokia attained its leadership position in the mobile phone industry; in the five years from 1996-2001, revenue increased at a blistering pace of 37% per annum.
By 2002, the company had released a phone with email capabilities, a built-in camera, video capability and 3G technology, marking the early days of the transition to smartphones. Three years later, the company announces the sale of its billionth phone, at a time when global mobile phone subscriptions were just hitting 2 billion (it is estimated to be three times that level today).
The company’s own description of what has happened since then hits the nail on the head:
“Nokia no longer has things all its own way. In the all-important smartphone market, competitors such as the iPhone and Android-based devices now pose a serious challenge. Clearly, it’s time for a rethink…”
The rethink started in September 2010, when Nokia appointed Stephen Elop, the former head of Microsoft’s (MSFT) business division, as president and CEO.
“BURNING PLATFORM” – THE MAIN CHALLENGE FOR NOKIA
Less than six months after coming on as chief executive, Mr. Elop wrote a memo to Nokia’s employees that compared the company to a burning oil rig:
“There is a pertinent story about a man who was working on an oil platform in the North Sea. He woke up one night from a loud explosion, which suddenly set his entire oil platform on fire. In mere moments, he was surrounded by flames. Through the smoke and heat, he barely made his way out of the chaos to the platform’s edge. When he looked down over the edge, all he could see were the dark, cold, foreboding Atlantic waters.
As the fire approached him, the man had mere seconds to react. He could stand on the platform, and inevitably be consumed by the burning flames. Or, he could plunge 30 meters in to the freezing waters. The man was standing upon a 'burning platform,' and he needed to make a choice.
He decided to jump. It was unexpected. In ordinary circumstances, the man would never consider plunging into icy waters. But these were not ordinary times – his platform was on fire. The man survived the fall and the waters. After he was rescued, he noted that a 'burning platform' caused a radical change in his behavior.
We too, are standing on a 'burning platform,' and we must decide how we are going to change our behavior.
Over the past few months, I’ve shared with you what I’ve heard from our shareholders, operators, developers, suppliers and from you. Today, I’m going to share what I’ve learned and what I have come to believe.
I have learned that we are standing on a burning platform.
And, we have more than one explosion – we have multiple points of scorching heat that are fueling a blazing fire around us.
For example, there is intense heat coming from our competitors, more rapidly than we ever expected. Apple disrupted the market by redefining the smartphone and attracting developers to a closed, but very powerful ecosystem.
In 2008, Apple’s (AAPL) market share in the $300+ price range was 25 percent; by 2010 it escalated to 61 percent. They are enjoying a tremendous growth trajectory with a 78 percent earnings growth year over year in Q4 2010. Apple demonstrated that if designed well, consumers would buy a high-priced phone with a great experience and developers would build applications. They changed the game, and today, Apple owns the high-end range.
And then, there is Android. In about two years, Android created a platform that attracts application developers, service providers and hardware manufacturers. Android came in at the high-end, they are now winning the mid-range, and quickly they are going downstream to phones under €100. Google (GOOG) has become a gravitational force, drawing much of the industry’s innovation to its core.
Let’s not forget about the low-end price range. In 2008, MediaTek supplied complete reference designs for phone chipsets, which enabled manufacturers in the Shenzhen region of China to produce phones at an unbelievable pace. By some accounts, this ecosystem now produces more than one third of the phones sold globally – taking share from us in emerging markets.
While competitors poured flames on our market share, what happened at Nokia? We fell behind, we missed big trends, and we lost time. At that time, we thought we were making the right decisions; but, with the benefit of hindsight, we now find ourselves years behind.
The first iPhone shipped in 2007, and we still don’t have a product that is close to their experience. Android came on the scene just over 2 years ago, and this week they took our leadership position in smartphone volumes. Unbelievable.
We have some brilliant sources of innovation inside Nokia, but we are not bringing it to market fast enough. We thought MeeGo would be a platform for winning high-end smartphones. However, at this rate, by the end of 2011, we might have only one MeeGo product in the market.
At the midrange, we have Symbian. It has proven to be non-competitive in leading markets like North America. Additionally, Symbian is proving to be an increasingly difficult environment in which to develop to meet the continuously expanding consumer requirements, leading to slowness in product development and also creating a disadvantage when we seek to take advantage of new hardware platforms. As a result, if we continue like before, we will get further and further behind, while our competitors advance further and further ahead.
At the lower-end price range, Chinese OEMs are cranking out a device much faster than, as one Nokia employee said only partially in jest, 'the time that it takes us to polish a PowerPoint presentation.' They are fast, they are cheap, and they are challenging us.
And the truly perplexing aspect is that we’re not even fighting with the right weapons. We are still too often trying to approach each price range on a device-to-device basis.
The battle of devices has now become a war of ecosystems, where ecosystems include not only the hardware and software of the device, but developers, applications, ecommerce, advertising, search, social applications, location-based services, unified communications and many other things. Our competitors aren’t taking our market share with devices; they are taking our market share with an entire ecosystem. This means we’re going to have to decide how we either build, catalyze, or join an ecosystem.
This is one of the decisions we need to make. In the meantime, we’ve lost market share, we’ve lost mind share and we’ve lost time.
On Tuesday, Standard & Poor’s informed that they will put our A long term and A-1 short term ratings on negative credit watch. This is a similar rating action to the one that Moody’s took last week. Basically it means that during the next few weeks they will make an analysis of Nokia, and decide on a possible credit rating downgrade. Why are these credit agencies contemplating these changes? Because they are concerned about our competitiveness.
Consumer preference for Nokia declined worldwide. In the UK, our brand preference has slipped to 20 percent, which is 8 percent lower than last year. That means only 1 out of 5 people in the UK prefer Nokia to other brands. It’s also down in the other markets, which are traditionally our strongholds: Russia, Germany, Indonesia, UAE, and on and on and on.
How did we get to this point? Why did we fall behind when the world around us evolved?
This is what I have been trying to understand. I believe at least some of it has been due to our attitude inside Nokia. We poured gasoline on our own burning platform. I believe we have lacked accountability and leadership to align and direct the company through these disruptive times. We had a series of misses. We haven’t been delivering innovation fast enough. We’re not collaborating internally.
Nokia, our platform is burning.
We are working on a path forward — a path to rebuild our market leadership. When we share the new strategy on February 11, it will be a huge effort to transform our company. But, I believe that together, we can face the challenges ahead of us. Together, we can choose to define our future.
The burning platform, upon which the man found himself, caused the man to shift his behavior, and take a bold and brave step into an uncertain future. He was able to tell his story. Now, we have a great opportunity to do the same.”
FEB. 11, 2011
In February, Nokia made an announcement that forever changed the direction of the company – it was joining forces with Microsoft (NASDAQ:MSFT) to strengthen its position in the smartphone market. The strategic partnership would result in Nokia smartphones adopting the new Windows 7 operating system, with one clear goal: establishing a third ecosystem to rival iOS and Android. As Mr. Elop noted at that time, “The industry has shifted from a battle of devices to a war of ecosystems.”
Catching up to today, the company has made a significant amount of progress in a just fourteen months. This past week, the company has announced two huge launches: the Lumia 900, which is supported by AT&T’s network in the U.S., and the Lumia 800C, which is supported by China Telecom’s network (one of the three major state owned carriers) in China, the world’s biggest phone market with more than 900 million accounts. Many people believe that it is too late; though Android and Apple exploded onto the scene in a similar fashion in the last half decade, they say that two ecosystems is all that can be sustained.
This article, and my thesis for Nokia, is dependent upon them being incorrect; the reason I believe that this is the case boils down to three key points: Nokia’s financial strength, their brand equity and the commitment of their partners.
FINANCIAL STRENGTH: THE BALANCE SHEET FACTOR
Looking at the 20-F filed for year-end Dec. 31, 2011, the company’s balance sheet shows roughly €10.9 billion in cash & equivalents and €3.55 billion available under committed credit facilities, compared to less than €4 billion in long term debt (half of which comes due in 2019 or beyond) and €1.35 billion in short term borrowings; for a more recent figure, the company noted during a recent call with analysts that they expect to end the first quarter with €5.9 billion in cash. At the end of the fiscal year, the company’s current ratio stood at 1.46, and the quick ratio (which excludes inventory) was at 1.33.
I point to this because I believe this is fundamentally important: Nokia can continue to invest in their business as needed (capex has averaged €600 million over the past three years and is expected to be €650 million in 2012), and does not face any near-term capital constraints; in my opinion, it’s clear that they WILL NOT be forced to do anything drastic (in the form of equity issuance, etc.) if their business continues to struggle over the next 6 to 12 months, especially after they eliminate the dividend completely (which I would expect/hope for this coming year), which could save the company €750 million per annum at the current payout of €0.20 per share.
In October 2011, Interbrand released their annual global brand rankings, which highlighted the current struggles that the company has experienced in a rapidly changing marketplace; despite this, Interbrand pegged the brand's value at more than $25 billion (14th in the world), about 60% higher than the company’s entire market cap as of April 11th, 2012.
This is a key point that many people gloss over: Admittedly, the perception of the company’s devices lagged as they failed to meet the capabilities of their competitors; now that they are closing the gap, the global equity of the Nokia brand should help mitigate some of the luster that was lost in recent product launches.
This equity is partly why the company has maintained their vast distribution network and is still able to attract the largest carriers – with the launch of the of the Lumia 800C (which I mentioned earlier) as a great example; Anna Shipley, Nokia’s communications director for China, Japan and Korea, Nokia phones are sold in roughly 200,000 retail outlets in China, including the company's own stores and through other distributors.
The company strengthened its brand recently (in my opinion) when it swiftly acknowledged a software issue with the Lumia 900 (an update to fix the issue would be available within a week), giving people who have already bought the phone and those that plan to do so by the 21st a $100 credit on their AT&T bill. This goes back to the financial strength I discussed earlier, which gives the company the ability to act as they would normally in hopes of strengthening long-term ties with customers.
PARTNERSHIPS: “A WAR OF ECOSYSTEMS”
Nokia’s partnership with Microsoft, which was formalized in April 2011, made Windows Phone the company’s primary smartphone platform; twelve months later, this partnership has released its first product on a major network (AT&T), and has received generally positive reviews (most of the negatives point to the app store, which I’ll discuss momentarily): On Amazon, of the more than 150 reviews received in the early days since launch, a full 90% are 5-stars (obviously this is a very small sample size, but it’s encouraging).
The general consensus among consumers and tech sites such as CNET, Time Techland and Slash Gear is that this is the best Windows Phone yet, and that the hardware and software are unique compared to what others bring to the table. But more important than the initial reviews on early product launches is the long-term commitment by partners to the ecosystem; and if anybody has proven that they are willing to suffer in the short-term to build up a product offering, it is Microsoft.
For years, Microsoft lost millions on the Xbox and the 360, and was willing to continue to invest in the platform in anticipation of the possibilities in gaming; fast forward to 2011, and the Kinect has revolutionized the console and its role in the family room, resulting in the Entertainment & Devices division to realize 2011 operating income of $1.32 billion, a nearly four-fold increase from the operating income reported in E&D just two years earlier.
In search, Microsoft stepped up to encroach on Google (NASDAQ:GOOG)’s territory, despite a huge advantage that the company had established in that arena (Charlie Munger called it one of the widest moats he had ever seen); Bing was launched in June 2009, and has racked up billions in losses on its way to a decent share of the market (15.3% as of March 2012). Again, this is somewhere that MSFT continues to put resources to work in anticipation of the opportunity that lies ahead, without any regard for the affect it may have on the P&L in the short term.
Even if one was to completely disagree with this strategy or to proclaim that they have only had to do this because they are late to the party (you could make those arguments), those have no bearing in this situation: Microsoft wants to be successful in this space, and has billions of dollars on hand to make sure that becomes a reality. Recently, the company has announced that they were going to finance key developers in order to make sure that their app store continues to move (over time) towards parity with the offerings of their two closest competitors.
I think Microsoft’s experience and breadth of product offerings (particularly Office) will be integral for the ecosystem as interoperability among devices becomes the order of the day; MSFT is the X-factor that gives Nokia a viable product line to compete in this market over time.
AT&T has made a similar commitment to the Lumia 900, with Jeff Bradley, senior vice president of devices, saying the week before the launch that this is “a notch above anything we’ve ever done,” specifically noting that this includes the original iPhone launch. They have a vested interest in developing a product line (outside of the iPhone) that can compete with the strength that Verizon has experienced with Droid; their actions indicate that Lumia has piqued their interest.
WHY I’M STILL NOT BUYING NOKIA
With that being said, I’m not buying Nokia at $4.23. At the end of the day, suffice it to say that I’m susceptible to an overwhelming feeling of risk aversion due to the potential risks, and more importantly, the uncertainty. I would feel much better about this investment if Nokia had exclusivity on Windows OS, because I firmly believe that its differentiation and financial backing will result in some form of success (what that means in terms of share and over what time frame, I have no idea); but with other hardware manufacturers dedicated to developing Windows phones, the success of the operating system won’t necessarily translate to huge upside for Nokia.
This is partly the beauty of investing; if Mr. Market continues to stay pessimistic on NOK and focus entirely on the numbers for the next quarter or two, there may be an opportunity in the near future to buy this company for little more than the value of their cash and the patent portfolio (from the 20-F: “We are a world leader in the development of the wireless technologies of GSM/EDGE, 3G/WCDMA, HSPA, LTE, OFDM, WiMAX and TD-SCDMA, and we have a robust patent portfolio in all of those technology areas, as well as for CDMA2000. We believe our standards-essential patent portfolio is one of the strongest in the industry”). This implies that I can even begin to estimate the value of those assets, which isn’t true today; as such, I can’t pay much more than tangible book and continue to see this as an investment due to the high level of uncertainty surrounding this company’s future.
Until then, I'll sit and twiddle my thumbs...
On Nokia’s website, the company outlines their history, which they summarize under the tile “Always Adapting” – “Over the past 150 years, Nokia has evolved from a riverside paper mill in south-western Finland to a global telecommunications leader connecting over 1.3 billion people. During that time, we’ve made rubber boots and car tires. We’ve generated electricity. We’ve even manufactured TVs. Changing with the times, disrupting the status quo – it’s what we’ve always done. And we fully intend to keep doing it.”
Many people will think that I’m way off track; based on what I’ve read, people believe that Android and iOS will dominate the market until the end of time, in defiance of what has happened in the consumer electronics segment over and over again (as Nokia itself proved). Personally, my contrarian streak is perpetual; I’m constantly questioning whether the current leader will be around tomorrow, or if today’s fallen angel could potentially rise to the top yet again.
In the case of Nokia, I think management recognizes where they went off track (Mr. Elop is spot-on in his memo from my perspective), and has taken swift and appropriate actions to get headed back in the right direction. I think the company can double from its current level over the next year (which is why I originally started this analysis for the value contest) as the perception about the market becomes less polarized, but can’t honestly tell myself that I have any way to quantify the probability or the magnitude of the possible scenarios; for me, that eliminates Nokia (at $4.20 per share) as a potential purchase at this point in time.
About the author:
As it relates to portfolio construction, my goal is to make a small number of meaningful decisions. In the words of Charlie Munger, "Patience followed by pretty aggressive conduct."
I run a concentrated portfolio, with a handful of positions accounting for the majority of my equity holdings (currently two). From the perspective of a businessman, I believe this is adequate diversification.