Friday, August 3, 2012

Nokia in Q2 2012: A lighter balance sheet, and a free OS

I’m not doing a full analysis of Nokia Q2 2012 results here. Very briefly, Nokia group revenues were 7.5 billion EUR with a loss of 1.53 billion EUR. A billion plus euro loss cannot be very rosy, of course, but maybe investors expected worse, as the stock price spiked up briefly after the announcements of the results on Thursday, 19 July.

Revenue & Profitability has taken a hit for the last one year, when the strategy of shifting from Symbian & Meego OS’es to Windows Phone has gone disastrously wrong for the company. A very detailed analysis of this strategy gone wrong can be found on Tomi Ahonen’s communities-dominate blog. As for this current post, the chart below tracking Nokia revenues is enough to describe the problem.

Nokia revenues - falling since 2011.

But in this post I try to delve into some of the revelations in the Q2 earnings release.

4 Billion EUR Lighter Balance Sheet

If we take a look at the balance sheet on Nokia's Q2 earnings release, there is a reduction of assets of about 4 billion EUR between Q2 2011 and 2012. About 1.4 billion EUR of this comes from impairment of Goodwill & amortization of intangible assets. This is also explained in a discussion on the operating results in the Q2 2012 interim report.

"During the second quarter 2012, based on a combination of factors, including the decline in our market capitalization, credit rating downgrades as well as our operating results, we concluded that there were sufficient indicators to require Nokia Group to perform an interim goodwill impairment analysis as of June 30, 2012. "

This explains the 1.4 billion reduction in goodwill and intangible assets. But what else did to reach this 4 billion EUR figure? 

"In the second quarter 2012, Nokia recognized EUR 800 million in valuation allowances related to its Finnish deferred tax assets in accordance with accounting standards "

Deferred tax assets is when a loss making company expects to make profits in the future, and sets aside a portion of their losses as tax credits to take advantage of, when they return to profitability. But this is allowed, in Finnish and International accounting laws, only if there is sufficient indication of the company returning to profitability. Deferred tax assets sits on the balance sheet as a current asset, and this accounts for another 800 million of the total 4 billion reduction in assets. 

The rest of the 4 billion is made of lower accounts receivable (amounts due to the company), and prepaid expenses. 

Now, I may be reading a bit too much into this, but cleaning up the balance sheet of intangibles, and deferred tax assets may be to make it more palatable to a buyer. Even though Nokia is currently valued low (it's currently valued lower than what Motorola was picked up for), most buyers would not be convinced by intangibles & goodwill on the balance sheet. Goodwill comes up when a company acquires another company, and pays more than the net asset valuation of the acquired company. The excess amount paid is not treated as a loss, but projected as an asset, which is the intangible valuation of expected synergies from the acquisition. Goodwill appears on the Nokia balance sheet because of the past acquisitions of Navteq, and others. 

Windows Phone Free Edition

Another interesting revelation in the Q2 2012 earnings report is that it's quite likely that Nokia is getting the Windows Phone 7.x OS for free from Microsoft. Here is a paragraph form the report

"Our agreement with Microsoft includes platform support payments from Microsoft to us as well as software royalty payments from us to Microsoft. In the second quarter 2012, we received a quarterly platform support payment of USD 250 million (approximately EUR 196 million). Under the terms of the agreement governing the platform support payments, the amount of each quarterly platform support payment is USD 250 million. We have a competitive software royalty structure, which includes annual minimum software royalty commitments. Minimum software royalty commitments are paid quarterly. Over the life of the agreement, both the platform support payments and the minimum software royalty commitments are expected to measure in the billions of US dollars. The total amount of the platform support payments is expected to slightly exceed the total amount of the minimum software royalty commitments. "

What this means is that - 

a. Nokia pays royalties to Microsoft for the windows phone OS

b. Microsoft pays Nokia for focusing on the OS which the Microsoft needs to succeed in smartphones

...and the latter is slightly larger than the former, meaning that net net, the OS comes for free. Of course, one can argue that it is not free, and is being paid for by intellectual property instead of cash, but the idea is that Nokia has a good deal where one of the costliest components of the smartphone BOM has been reduced to zero. In particular, Microsoft has always charged higher royalties for their OS (mobile, phone or otherwise) than competitors. It probably comes from their phenomenal success in the PC OS business that makes them believe that they can get away with a non-competitive price. As an example, I remember that when Symbian was a sperate company, and the OS was not open source'ed, they charged a royalty of approximately 7 USD per handset. Microsoft, at the same time, charged about 25 USD per handset. So if Nokia managed to get such a pricey OS for free, it bodes well for them.

This may be good news, BUT... it all depends on how Nokia has negotiated the agreement for Windows 8. If I know Microsoft, it's quite likely that the current agreement for platform support payments, extends only to Windows Phone 7.x, and a fresh one may be drafted for WP 8/Apollo. If the Windows 8 agreement also favours Nokia in the same way, then it's good news for Nokia.


So, while a lighter balance sheet makes it easier for any investor company to pick up a stake in Nokia, the revelation of a free OS is a sign of hope for Nokia. However, getting your smartphone OS for free does not mean anything if there is no demand for these phones. It will be a tough for Nokia whether or not the OS is coming for free.

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