Nokia Avoiding Death Spiral

 Nokia (NOK) delivered better-than-expected growth in Lumia smartphone units and successfully preserved cash, signaling that the company is avoiding a death spiral. Nonetheless, weak operating results serve as a reminder that the transition to Nokia's new smartphones will be a slow and expensive journey that will test investor patience. We remain convinced that Nokia will survive the transition--something we cannot say about rival  Research in Motion (RIMM)--but Nokia's position as one of many Windows phone manufacturers will leave the firm in a fundamentally weaker position than it has enjoyed for much of the last decade.

Nokia reported second-quarter revenue of EUR 7.5 billion, down 19% year over year as shipments of smartphones based on Nokia's legacy Symbian platform collapsed to 6 million units from 17 million units from the second quarter of 2011. The Symbian platform is dead, however, so shipments of Nokia's Lumia products are much more important for the future prospects of the firm. This quarter, Nokia delivered Lumia sales of 4 million units, doubling the first-quarter total. The success with Lumia phones was driven by strong traction in China and Latin America.

Volumes stabilized in Nokia's lower-cost feature phone segment, with unit shipments up 2.4% year over year, though prices continue to fall, with Nokia delivering a second-quarter average selling price of EUR 31 per device. This business will continue to decline, but as long as declines are moderate, it provides cash and brand awareness that will help Nokia navigate through its transition on the smartphone side of the business.

Gross margin for Nokia's smartphones plummeted to just 2%, but this reflects EUR 220 million in charges for allowances for component inventory, purchase commitments, and inventory revaluation. Although there could be additional allowances during the transition period, removing these charges would take Nokia's smartphone gross margin back to 16%. The critical first step during this transition is to gain critical mass in unit shipments and market penetration, so we understand that aggressive pricing is helping to drive volumes. However, to have a sustainable model, we believe Nokia needs to drive this gross margin back toward 30%. Although we believe that switching costs will tie users to the Windows platform, it is not yet clear to us how Nokia will be able to differentiate its devices from other manufacturers that plan to support the Windows platform.

Finally, Nokia took steps to more effectively manage its balance sheet this quarter. The firm's net cash position fell EUR 675 million to EUR 4.2 billion, but this includes a EUR 742 million annual dividend payment. Also muddying the waters around Nokia's cash position was a EUR 400 million benefit from the prepayment of royalty income and a EUR 360 million use of cash in working capital as a result of restructuring initiatives. Nokia cannot run operating losses in its devices and services group forever, and the current quarter was a notable improvement after the alarming cash-burn rate investors saw during the first quarter.

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