22 October 2010

NOK: Income Statement Analysis for the September 2010 Quarter

Nokia Corp. (NYSE: NOK and HEL:NOK1V) earned 0.14 per diluted share on an IFRS basis in 2010's third quarter, up from a loss of €0.15 per share in the same quarter of 2009.  Both quarters ended on 30 September of their respective years.

The loss in the year-earlier quarter was primarily the result of Nokia writing off €900 million of intangible assets.

On a non-IFRS basis, which excludes special items, third-quarter earnings fell from €0.17 to €0.14 per share.

This post examines Nokia's Income Statement for the most recent quarter and compares the entries on each line to our "look-ahead" estimates.  For a variety of reasons discussed below, reported earnings doubled the €0.07 per share we had forecast for earnings per share.

In a second article, we will report Nokia's scores as measured by the GCFR financial gauges.  The follow-up post will also provide the latest figures for the various financial metrics we use to analyze Cash Management, Growth, Profitability and Value.

Before getting into the details, we will take one step back to introduce the subject of today's analysis.

A Finnish company with a rich history, Nokia Corporation has been the leading global producer of mobile phones since 1998.  The company also sells the network infrastructure that supports these phones. 

The overall profit attributable to Nokia shareholders fell to €891 million in 2009, from €4.0 billion in 2008 and €7.2 billion in 2007.  Net Sales dropped from €50.7 billion in 2008 to €41.0 billion in 2009.  Global economic weakness certainly had a negative effect.  However, Nokia's most visible problem has been its inability to stem the success of Apple's (NASDAQ: AAPL) iPhone, which was first introduced in 2007.  The Blackberry product line sold by Research in Motion (NASDAQ: RIMM) and, more recently, smartphones based on the Android architecture promoted by Google (NASDAQ: GOOG) have also become popular at Nokia's expense. 

In the latest and most dramatic attempt to regain its competitive position, Nokia announced on 10 September 2010 that it would replace its Chief Executive Officer with Mr. Steven Elop, formerly of Microsoft (NASDAQ: MSFT). 

Among other things, the company hopes Mr. Elop, a Canadian citizen, will be able to resolve its long-standing difficulties in North America.  Only 3 percent of the mobile devices Nokia sold in 2009 and only 5 percent of Nokia's net sales in 2009 were in North America.

The price of Nokia ADRs is down about 70 percent from a $41 peak in late 2007.  The company's market value is now roughly $40 billion.

Additional background information about Nokia and the business environment in which it is currently operating can be found in the look-ahead.

Please click here to see a normalized depiction of the actual and projected results for the just-concluded quarter, as well as the quarterly Income Statements for the last couple of years. Please note that our organization of revenues, expenses, gains, and losses, which we use for all analyses, can and often does differ in material respects from company-used formats. The standardization facilitates cross-company comparisons.

In the September quarter, Nokia's Revenue rose 4.7 percent, from €9.81 billion last year to €10.3 billion in the last three months.   Revenue was 1.7 percent more than our €10.1 billion target for the quarter.

Excluding the impact of changes in Euro exchange rates, Nokia's third-quarter Revenue declined 2 percent from 2009 to 2010.

Revenue increased 28 percent North America and 27 percent in Latin America, which are the two regions where Nokia has the least sales.  In Europe, Nokia's largest market, Revenue decreased 5.2 percent.

The Devices and Services business segment had Revenue of €7.17 billion, which was at the upper end of the company's guidance to expect sales between €6.7 billion to €7.2 billion.  D&S revenue increased 3.7 percent when compared to sales of €6.9 billion in the September 2009 quarter.

On a constant-currency basis, D&S revenue declined 5 percent.

Nokia shipped 110.4 million mobile devices in the quarter, 1.8 percent more than last year.  The volume increase was led by a 20-percent rise in the number of devices sold in Latin America. 

Nokia's market share fell because the total number of mobile devices sold across the industry grew at a robust 14 percent.  The company's preliminary estimate is that its market share declined from 34 percent in the third quarter of 2009 to 30 percent in the third quarter of 2010.

Nokia noted that "industry-wide shortages of certain components, particularly in the low end of the market where Nokia’s position is strong, during the third quarter 2010" had a negative effect on the number of devices it was able to sell.

It would be interesting to learn how much the market share would rise if North America, where Nokia sold only 3.2 million devices in the September quarter, were to be excluded.

Reversing a trend, the average selling price of these devices rose from €64 to €65.   The ASP rise was the result of higher-priced smartphones comprising a greater percentage of the sales mix.  Changes in currency exchange rates also lifted the Euro-denominated ASP.

Revenue from Nokia Siemens Networks was €2.94 billion, up 6.6 percent from €2.76 billion in last year's third quarter.  NSN's reported revenue was near the midpoint of the €2.7 billion to €3.1 billion range in the company’s guidance. The revenue increase was primarily due to "increased sales of 3G network infrastructure as well as network planning and optimization services and network operations activities."  The company was also able to complete some sales in India, which had been delayed by an "industry-wide issue related to security clearances."

Sales at the smaller NAVTEQ increased an impressive 52 percent to €252 million.  Nokia attributed the rise to "improved sales of map licenses to mobile device customers as well as improved demand and higher navigation uptake rates in the automotive industry."

The Cost of Goods Sold in the quarter was €7.33 billion, or 71.4 percent of Revenue. This ratio translates into a Gross Margin of 28.6 percent, a substantial 260 basis points less profitable than the 31.2-percent Gross Margin in last year's third quarter.

Nokia's Gross Margin also fell 210 basis points short of the 30.7-percent target we established for the third quarter.

Nokia's spending on Research and Development added up to €1.41 billion, essentially flat relative to the same period of 2009.  The R&D expense was 7.4 percent less than our €1.52 billion estimate. As a percentage of Revenue, the R&D expense was reduced from 14.1 percent in September 2009 to 13.7 percent in the latest quarter.

The Sales, General, and Administrative expense of €1.18 billion was also about the same as last year, but this amount decreased from 12.1 percent of Revenue to 11.5 percent.  The amount spent on SG&A was 8.8 percent less than our €1.3 billion estimate.

Other operating items (€131 million in income, €82 million in expense) resulted in income of €49 million, an unusually strong result.

Subtracting the various operating expenses from Revenue yields Operating Income of €403 million, which was €111 million more than our €292 million estimate.  The difference between the actual results and our estimate is mostly explained by lower-than-anticipated R&D and SG&A spending, plus unanticipated other operating income. 

In last year's third quarter, a €914 million special charge resulted in an Operating loss of €426 million.

Non-operating items, mostly financial income and expenses, resulted in a net expense of €82 million. We had expected €75 million.

Nokia’s effective income tax rate has tended to fluctuate widely from quarter to quarter, and this experience was repeated with the third quarter's near-zero tax rate.  Nokia reported that the third quarter quarter tax rate benefited from a "dividend withholding tax legislation changes in certain jurisdictions."  This one-time benefit more than offset negative tax issues associated with Nokia Siemens Networks deferred tax items.

We expected a 20 percent tax rate.

The exclusion of a hefty €207 million after-tax loss attributable to non-controlling interests (Siemens?) leaves €529 million (€0.14 per share) as the bottom-line Net Income "attributable to equity holders of the parent."

Our estimate for the latest quarter was €274 million (€0.07 per share).

In summary, Nokia reported much stronger-than-expected earnings in the third quarter of 2010.  In some ways, factors outside of the company's control made the results appear more favorable than they might have otherwise.  For example, the company would have reported a two-percent sales decline, instead of a nearly five-percent gain, had the Euro remained constant relative to other currencies. 

Since some expenses were probably also lifted by the currency changes, it is not obvious how the the currency changes affected net income.  The source of $131 million (€0.035 per share) in "Other Income," which boosted the operating results, also wasn't immediately clear.

It is known that earnings per share were boosted by approximately €0.02 because one-time factors allowed the company to avoid a provision for income taxes.

It is also apparent that Nokia's Gross Margin fell below 30 percent of the first time in several years, and the company's share of the market for mobile devices fell.

Full disclosure: Long NOK at time of writing.

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