Nokia Corporation’s (NOK) CEO Rajeev Suri on Q3 2014 Results – Earnings Call Transcript

Actual results may therefore differ materially from the results we currently expect. Factors that could cause such differences can be both external, such as general economic and industry conditions, as well as internal operating factors. We have identified these in more detail in the risk factors section of our 20-F for 2013 and in our Interim Report issued today.

Please note that our results release, the complete interim report with tables and the presentation on our Web site include non-IFRS results information in addition to the reported results information. Our complete interim report with tables available on our Web site includes a detailed explanation of the content of the non-IFRS information and a reconciliation between the non-IFRS and the reported information.

With that Rajeev, over to you.

Rajeev Suri – President and CEO

Thank you Matt and thanks to all of you for joining. It is a please to speak to you today after a quarter where Nokia delivered both growth and strong profitability. As you know, in our guidance earlier this year we pointed to networks growth in the second half. In fact all three of our businesses grew on a year-on-year basis in the third quarter and networks delivered a particularly strong overall performance with 13% year-on-year net sales growth and near record profitability.

HERE followed closely behind with 12% growth and technologies with 9%. This robust performance is a result of the right strategic choices, strong execution across our three businesses, particularly in Nokia Networks and some interesting tailwinds in the quarter that I will discuss in a bit more depth later.

Last quarter I gave you an update on the progress of my 100 day plan and while I won’t go through each of the five priorities that I set, I would like to give a brief comment in two areas. The first is the effort to move rapidly from high level strategy and vision to bold and detailed execution plans. I believe that we have made good progress in that area and I’m looking forward to sharing more with you and getting your feedback at our Capital Markets Day in London on November 14th. We have looked hard at where we are today, where we see opportunities in the future and how we define our long-term strategy and vision.

The second is on the topic of culture and values. One quarter ago on the same day as our earnings announcement, we started sharing our refreshed values with company leaders, followed by an all employee cascade. The response from employees have been remarkable with about 95% awareness of our new values and close to 90% favorability. Given that the launch was done in the midst of summer holidays, we are extremely pleased with this outcome and in fact my team tells me that the short time it took to reach such levels is among the best they have ever seen. So good momentum in this area that provides a sound foundation as we now move further align our culture around some common things.

Let’s now turn to the quarter. At the group level we delivered net sales of €3.3 billion, a 44.5% non-IFRS gross margin and non-IFRS operating profit of €457 million or 13.7% of sales. In terms of our businesses let me start with HERE, where we just announced the appointment of Sean Fernback as President. Sean is a well-recognized technology expert with 25 years of experience in the location, automotive, consumer and telecommunication businesses. He joined HERE earlier this year from TomTom, where he oversaw the overall product design, hardware and software engineering and manufacturing of all of their consumer products and accessories. I’m extremely pleased to have Sean take on this challenge and join the Nokia Group leadership team.

In addition to Sean’s appointment, the primary topic I would like to discuss about HERE is an adjustment to our strategy. We will increase our focus on our excellent automotives and small but fast growing enterprise businesses. We will also continue to extend our reach to consumers to work with mobile device vendors such as Samsung and internet players such as Yahoo!. This is a business for us that leverages our location cloud capabilities and it will help us remain fully tapped into the innovation of the consumer eco system.

While we increase focus in these areas, we will de-prioritize efforts to build direct-to-consumer businesses. We simply see better opportunities in other parts of the HERE business and we want to target our resources to those areas. As I mentioned on our last call, we will also work to strengthen operational effectiveness at HERE in order to ensure that we’re getting maximum output from our significant R&D investment and to improve longer term profitability.

Despite these actions, I want to be very clear that the vast majority of HERE will not change and much of it will even be strengthened through greater focus. We know we have customers who depend on us today and we remain absolutely committed to meeting their needs in the future. With this adjustment to our strategy, we will require to conduct impairment testing, which as you will have seen as resulted in a significant impairment of goodwill and change in the asset carrying value of HERE. Timo will share additional details about this topic in his remarks.

Turning back to the quarter, HERE had net sales of €236 million, up 12% year-on-year and the first year-on-year growth since the second quarter of 2012. Strong automotive and enterprise sales and the positive impact of our expanded license agreement with Microsoft more than offset the loss of revenue from the former devices and services business.

From a profitability perspective HERE had another breakeven quarter, reflecting the investments we are making in the business. An example of this is the commitment we are making to our location platform, which enables faster time to market for our customers and helps them provide a broad range of services such as real-time traffic and parking to end users. HERE’s customers are starting to move from being content only customers to platform customers.

Highlights in the quarter for HERE include the completion of the acquisition of Medio, a pioneer in the area of real-time analytics, the demonstration of new technology to support the development of the connect car and enable smart cities and an agreement with Samsung to bring HERE maps and location platform services to Tizen-powered smart devices combined with the development of a companion application for Android based Samsung Galaxy products.

HERE’s leadership was recognized by Frost & Sullivan, who noted that HERE stands apart for its knowledge and industry experience, impressive data collection ability, high level of personalization, revolutionary products and wide ranging partnerships with nearly every OEM and system vendor. As we bring more focus to HERE’s strategy and that we start to benefit from some of our significant R&D investments, we see opportunities to improve HERE’s financial performance as I already noted.

Next on to Nokia Networks which had a strong quarter. Net sales were up 13% year-on-year at €2.9 billion and up 15% versus the second quarter. At constant currency Nokia Networks net sales would have increased 15% year-on-year and 12% sequentially. It was particularly pleasing that this growth did not come at the cost of profitability. Non-IFRS gross margin reached 39.1% and non-IFRS operating margin was 13.5%, both clearly very strong.

We now have delivered six consecutive quarters with non-IFRS gross margin over 36% and our non-IFRS operating margin was the second best in the history of the business. We agreed to some exciting new deals in the quarter including a renewed and expanded managed services contract in Nigeria with Etisalat, radio access and services for Telefónica Spain and a five country win for IMS and voice over LTE with a major European operator just to name a few.

We also work with a number of customers to ensure readiness for the iPhone 6 launch, including support for voice over LTE. Our relentless focus on quality delivered good results with a quality assessment by China Mobile of its commercial TD LTE network showing a clear advantage for Nokia Networks in terms of both network performance and implementation speed. From a technology perspective we continued to show leadership in 4G radio technology with a number of product launches, including the world’s first 3.5 gigahertz carrier aggregation capable radio and a solution to smoothly migrate WiMAX networks to TD LTE advanced.

Telco cloud and virtualization remain a clear priority for us and we became the first vendor to supply a commercial telco cloud solution compliant with ETSI Architecture for end to end voice over LTE services. In previous calls I told you that we will be placing a higher priority on partnering and our new partnering business unit went live in the quarter. We see considerable potential in this area and have already announced partnerships with Flash Networks and Red Hat. While we feel good about our performance in the third quarter, it is also important to recognize that we had some unique developments, business mix, regional mix and some catch up sales from earlier quarters.

Let me briefly talk about each of these issues, while also providing some more detail about the quarter. First, our business mix was weighted heavily to mobile broadband versus global services, 57% to 43%. We have not seen a proportion like that for many years and do not expect it to continue at that level as the services team will now accelerate activity to deploy equipment delivered to our customers in the third quarter.

Mobile broadband delivered excellent growth and profitability in the quarter. While global services delivered its 6th consecutive quarter of double digit non-IFRS operating profit, their year-on-year sales declined by 5%. Overall good performance from both segments, but particularly MBB with a combination of strong higher margin LTE network deployments and co-network sales.

Our R&D spend remained roughly flat year-on-year but we continue to generate significant productivity gains and are actually increasing headcount as we reduce subcontractor spend. As a result we’re able to continue to add R&D capacity to areas like LTE, small-cells and liquid core.

Additionally, within the mobile broadband mix we saw strong hardware sales where our cost reductions continue to deliver significant benefits. We remain focused on getting global services back to growth. The rate of year-on-year sales decline has slowed and given that services sales typically lag product sales in our industry by two to three quarters, we see positive signs for the future.

Second the region mix was quite favorable from a profitability perspective. In particular North America was up 53% year-on-year and 50% sequentially. Quite pleasingly we saw a recovery in Europe which grew 9% year-on-year and 15% sequentially and showed robust deal momentum.

Greater China also had a strong quarter with excellent sales growth, as well as the absence of cost incurred in anticipation of a technology shift to TD LTE related to major projects, something we have referenced in earlier calls. Middle East and Africa was also up year-on-year, despite ongoing challenges related to the political and security environment in several countries. We saw a slight dip in Asia-Pacific with lower network deployments in Japan, mostly offset by higher network deployments in Korea and India.

In Latin America, which I called our most challenging region on our last call, we saw a net sales decrease by 4% year-on-year, primarily due to lower network deployments in Brazil and Mexico. While this is a slower rate of decline than we have seen in earlier quarters and we believe that the new management we have put in place is gaining traction, we are still not pleased with our performance in this region and the work we need to do to turn it around is not yet done.

Third, as you are aware we faced some component shortages in the first half of the year. We saw those come to an end for most products in the third quarter and as a result we were able to largely meet the demand that we had not been able to capture earlier in the year. These catch up sales gave us a positive sales bump in the third quarter. Thus while we’re optimistic about the future, we are cautiously so, given increasing concerns about risks to the macro-economic environment.

We believe we are better positioned than others to face potential headwinds, given our lean cost structure and operating discipline. Overall I’m quite pleased with the performance of networks and indeed proud of the team for delivering such a strong quarter.

Moving to Nokia Technologies. It was a quarter that from a numbers perspective was largely business as usual. Sales at EUR152 million were up on both a sequential and annual basis. Profitability was also good, with a 17% year-on-year increase in non-IFRS operating profit.

The technologies team contributed multi-year research and development of speech codec reference software to the enhanced voice service, EVS codes that was selected by 3GPP in the quarter. Additionally we made continued progress on building the strong business infrastructure necessary to support our longer-term ambitions.

Over time, we clearly expect more from this business as we seek to expand patent, technology and brand licensing as well as other opportunities. But as I said on the last call, we will approach new opportunities within technologies in a methodical way, possibly testing some ideas in the market and using a strict gating investment model. Ramzi Haidamus is now fully onboard to lead the team and he will be joining us at the upcoming Capital Markets Day to give some more perspective on technologies and future focus areas.

Before handing over to Timo, I want to close by saying that while Q3 was good, we will not be lulled into complacency. There is still plenty of work to do to keep networks performing well and to tap the full potential of technologies and HERE. With that Timo, over to you.

Timo Ihamuotila – EVP and Group CFO

Thank you, Rajeev. I would like to start by spending the next few minutes taking you through our cash performance during Q3 as there were a number of significant non-operational drivers that impacted our cash flow and quarter ending cash balance. On a sequential basis, Nokia’s gross cash decreased by approximately €1.4 billion with a quarter ending balance of approximately €7.6 billion. Net cash and other liquid assets decreased by approximately €1.5 billion sequentially, with a quarter ending balance of €5 billion.

Compared to Q2 the primary drivers of the decrease in our net cash balance related to the payment of the ordinary and special dividends, which totaled approximately €1.4 billion or €0.37 per share as well as share repurchases which totaled €220 million in Q3.

From an investing perspective, we have cash outflows in Q3 of approximately €160 million related to the acquisitions of SAC Wireless and Medio as well as cash outflows of approximately €60 million related to capital expenditures. Looking at the operating cash performance of Nokia’s continuing operations in Q3, cash inflows of approximately €400 million were primarily driven by strong performance at Nokia Networks.

Finally on cash and the Microsoft transaction, last quarter I commented that we expected to receive the balance of the net proceeds from the sale of devices business during the second half of this year. While we did not receive any material payments related to this in Q3, we have subsequently received a majority of the expected proceeds in early Q4 with the remainder expected to be received in early 2015.

Then a few words on OpEx. In Q3 continuing operations, non-IFRS OpEx increased by 5% year-on-year and 7% sequentially. The year-on-year increase was primarily due to higher operating expenses at HERE and to lesser extent at Nokia Networks. As we have commented in recent quarters, we are continuing to invest in targeted growth areas for HERE, for example in Connected Car and enterprise segments. We believe these investments are well aligned with industry trends and needs of HERE’s customers.

For example, HERE recently received the highly coveted supplier innovation of word from BMW Group for its work in the area of connected driving. Also of the 62 new car models presented at the recent Paris Motor show, HERE was present in more than 50. At the same time, as Rajeev mentioned, we are focusing on improving HERE’s overall OpEx efficiency to drive growth and strengthen its financial performance.

Sequentially, the increase in continuing operations non-IFRS OpEx was primarily due to higher R&D expenses in Nokia Networks, where we continue to invest in focus areas. I said earlier, while we are increasing our R&D headcount, we are simultaneously benefiting from efficiency measures that have been implemented over the past couple of years.

In addition, we have more recently started newer initiatives, including broader deployment or lean and [indiscernible] methodologies across networks and are increasing automation. These are all efforts aimed at efficiently expanding our overall R&D capacity.

When combined with our strong focus on quality and innovation, we believe we have created a strong operating model to support our strategy. Turning to OpEx trends in Nokia Technologies, where we are investing to support the strategy and opportunities for this business, consistent with these technologies, non-IFRS R&D increased 9% sequentially.

Completing the OpEx picture, Group common functions, non-IFRS OpEx was €32 million in Q3. As I mentioned last quarter the SG&A in Group common functions is generally stable but the other income and expense can fluctuate. Then a few words on HERE and the impairment charge. As a result of an adjustment to its strategy and the related new long range plan, we conducted an impairment assessment of the goodwill related to our HERE business in Q3.

Subsequently we recorded a charge of approximately €1.2 billion to Nokia’s operating profit for the impairment of goodwill based on our assessment that the recoverable amount of HERE is now €2 billion. The impairment charge is the result of an evaluation of the projected financial performance of our HERE business. This takes into consideration the clearly slower ramp up of net sales related to direct to consumer monetization than earlier expected and our plans to curtail our investment in shares and higher risk and longer term growth opportunities.

It also reflects that the current assessment or risks related to the growth opportunities that we plan to continue pursuing, as well as related terminal value growth assumptions. After consideration of all relevant factors, we reduced the net sales projections for HERE particularly in the later years of the forecast period which in turn reduced projected profitability and cash flows. Additionally changes in foreign exchange rates increased the carrying amount of good will in euro terms, which in term increased the amount of the impairment. Somewhat related to the impairment charge as well as HERE’s cumulative loss position over the past three years, we also recognized a €325 million valuation allowance related to HERE’s Dutch deferred tax assets during Q3.

Staying with tax, in Q3 Nokia recognized €2.1 billion of deferred tax assets from the reassessment of recoverability of deferred tax assets related to Finland and to a lesser extent to Germany, of which €2 billion was recorded as a non-cash tax benefit in Q3 2014 reported tax expenses.

If you recall, as a result of the transactions with Siemens and Microsoft last year, we performed an assessment of the potential and recoverability of Finnish deferred tax assets. At the end of Q3 2013 we disclosed that Nokia Group had total approximately €2.7 million of net deferred tax assets, which had not been recognized in our financial statements.

We have since been utilizing some of these assets in recent quarters against our taxable profits in Finland, including part of the gain on the sale of the devices business to Microsoft. At the end of last quarter, we disclosed that Nokia had approximately €2 billion of unrecognized Finnish deferred tax assets.

Based on recent profitability and latest forecasts, Nokia has been able to re-establish a pattern of sufficient tax profitability in Finland and Germany to utilize to cumulative losses, foreign exchange, foreign tax credits and other temporary differences, which consequently allowed us to recognize or write back the EUR2.1 billion, of which EUR2 billion came through P&L.

A significant portion of Nokia’s Finnish and German deferred tax assets are indefinite in nature and available against future Finnish and German tax liabilities. On a non-IFRS basis, after having recognized these deferred tax assets we now expect to record tax expenses at our long-term effective tax rate of approximately 10% and 25%.

However Nokia’s annual cash tax obligations are expected to continue to be approximately €250 million until Nokia’s deferred tax assets have been fully utilized. Cash taxes may vary depending on profit levels in different jurisdictions and license in companies potentially subject to withholding tax in certain jurisdictions.

Applying the estimate, the 25% long-term effective tax rate to Nokia’s continuing operations Q3 non-IFRS pretax profit of €432 million would have resulted in a tax expense of approximately €30 million higher than the one we recorded in Q3. And this would have reduced our non-IFRS EPS by approximately €0.01. So please remember to use the approximately 25% tax rate in your EPS model going forward but note our ability to utilize the deferred tax assets to partially mitigate future potential cash tax obligations.

And now a few words on capital deployment. During Q3 we commenced repurchasing shares as part of our two year, €1.25 billion share buyback program. In total we repurchased approximately 36 million shares in the quarter, equaling €220 million. We plan to recommence the buyback program during the current quarter.

Finally I’d like to spend a few moments on our guidance for the rest of the year. While I’m pleased with the strong year-on-year revenue growth and excellent profitability in Nokia Networks this quarter, it is worth noting that the benchmark for growth in Q3 was quite low.

In addition as Rajeev highlighted, networks Q3 top line also benefited to some degree from our ability to address the component shortages that negatively impacted our top line progression earlier in the year. Something we also don’t expect to benefit from to the same extent in Q4.

In closing, we have made good progress in Q3 and we are highly focused on capitalizing on the value creation opportunities we see ahead of us across all three of our businesses. We look forward to discussing this in more detail at our upcoming Capital Markets Day in London next month.

And with that I’ll hand over to Matt for Q&A.

 

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