Q3 2019 Earnings Call Transcript

Published: 24 Oct 2019

[Operator:]

Hello and welcome to the Nokia Third Quarter 2019 Earnings Conference Call. All participants will be in listen-only mode. After today’s presentation, there will be an opportunity to ask questions. Please note, this event is being recorded. I would now like to turn the conference over to Mr. Matt Shimao, Head of Investor Relations. Sir, you may begin.

[Matt Shimao:]

[Rajeev Suri:]

Thanks, Matt. And thanks to all of you for joining today. Nokia’s third quarter was solid. We had guided to a quarter that would be soft and believe that the end result was better than that. Free cash flow was positive; sales were up, including in four of our six regions; operating margin was solid; our strategic focus areas of Nokia Enterprise and Nokia Software performed well; IP Routing sales grew a fourth consecutive quarter; our cost discipline was good; and we continue to win new 5G deals and launch new 5G networks. As you will have seen in our release today, we also expect a strong fourth quarter with robust operating margins and a €1.2 billion improvement in net cash, allowing us to end the year deal with a €1.5 billion net cash balance. Despite this progress, some of the risks that we flagged previously are materializing, and we believe these will create some challenges going forward. Several of these risks are related to the market and others are specific to Nokia. I will talk about these risks in greater detail. You will have seen however that they caused us to revise our guidance for this year and the next as well as defined a longer term operating margin target.

[Kristian Pullola:]

Thank you, Rajeev. Today, I will take you through the financial performance of Nokia Technologies and Group Common and Other as well as Group level results. I will be quicker than normal in this section in order to focus my prepared remarks on four key topics

[Matt Shimao:]

Thank you, Kristian. For the Q&A session, please limit yourself to one question only as a courtesy to everyone else in the queue. Nicole, please go ahead.

[Operator:]

Thank you. We will now begin the question-and-answer session. Our first question comes from Andrew Gardiner of Barclays. Please go ahead.

[Andrew Gardiner:]

Good afternoon, guys. Thanks for taking the question. If I could ask a bit about the increased sort of 5G investment that you’ve been talking about. You spent a lot of time on the call just now talking about the semiconductor side of things, the SoC strategy in particular. Can you just give us a bit more detail of around what’s happening with ReefShark in terms of the internal development versus external development? You mentioned, Rajeev, diversifying the supplier base. Are you having to now sort of invest, spend your own money in order to get outside suppliers in, and restart that -- the chipset strategy around 5G, and so we’re going to see both, your own internally developed ASICs with an outside SoC provider, and just sort of how long it’s going to take to fix that, and then get to the lower product costs that you you’ve highlighted?

[Rajeev Suri:]

Thank you, Andrew. So, number one, this is not a new strategy. We started working on the System on Chip strategy already in 2018. Right? And so, when Tommi joined, we started accelerating that. So, we’re already on a path here, specifically last year we started to diversify our suppliers. Those decisions have been made sort of over the last several months. So, what’s happening right now is when he moved to 5G, we chose FPGA-based products. They give you flexibility, they give you time to market advantage, but then they’re expensive. And so, what we’re doing is, we’re moving to equity SoC-based products, which we’ll progressively start shipping during 2020. So, it’s not like it’ll all come at one go at the end of 2020 or something. It’s going to progressively start shipping, and hence we think will progressively mitigate. Now, why are we spending even more? Because we want to be continuing to be aggressive and accelerate what we have already started. And yes, we do our own sort of SoC design, but now we’re working with multiple suppliers.

[Operator:]

Our next question comes from Sandeep Deshpande of JP Morgan. Please go ahead.

[Sandeep Deshpande:]

My question is, I mean, when we look at your third quarter results in terms of your performance on the margin front, on your cash generation front and in terms of what you’re guiding to cash generation into the fourth quarter, what I’m trying to understand is, why are you signaling this dividend deferment or cut to the market, when you are indicating that by the end of this year, your cash position will be at the higher €1.5 billion? I mean, a cut in dividend would have been fair given the more difficult environment, but why this complete lack of dividend? Is this a signal that you expect this business to remain very difficult through ‘21 or ‘22? Because the kind of dividend cut you’ve instituted seems to suggest a much more difficult environment.

[Rajeev Suri:]

Thanks, Sandeep. So, I think, I’d call it pause, is the right word. So, what has the Board decided to be resolved to not distribute the third and fourth quarterly installment for the dividend for the financial year 2018, right? Number one. Now, why is that the case? One, we want to guarantee our ability to increase 5G investments; two, we want to continue investing in the growth areas that are accretive to Nokia, whether you look at margins, you look at cash position, so, those are Enterprise and Software; and three, to strengthen Nokia’s overall cash position. So, what we’ve said is that the Board expects to resume dividend distribution after the net cash position of Nokia improves to approximately €2 billion. So, that’s when we’ll be able to resume. Now, the mechanics of that are that the Board will seek a dividend authorization from next Annual General Meeting and will continue to review distributions on a quarterly basis from then. So, I think, the key word from is pause.

[Operator:]

Our next question comes from Richard Kramer of Arete Research. Please go ahead.

[Richard Kramer:]

Rajeev, I just want to get your take on what’s been missing in the execution and leadership in Mobile Access, because that seems to be your principal area where you’re having difficulty? You’ve had three leaders in four years. I know, you’ve had very difficult integration. You’ve staked out some time ago that your desire to lead in 5G. I mean, what is it specifically over the last few years that has been so difficult in the execution in that area? And, how confident can you be now that that’s going to change into 2020 and beyond, given how difficult the environment is for many of your large operator customers? Thanks.

[Rajeev Suri:]

Fair question. So, I changed leadership in Mobile Access, first, we’ve broken to two, and I sort of brought in Sanjay Goel for leading services side. And we’re already seeing results and proof points of that business turning, right? So, it will be less and less on the watch list, if I can call it like that, by next year, I expect the substantial turnaround there. Okay? So, we’re seeing automation of services, we’re seeing digital workflow systems, we’re seeing new growth potential services like cognitive AI-driven services, enterprise services, IoT services, which have higher margins. We’re seeing better management of prices and hence protection of margins and care and technical support services, we’re reducing deploy rollout, which is traditionally lower margin. We’re seeing more remote delivery and global delivery. So, I think that will start to be out of the woods in the next few months, although it will be very critically on my watch list. So, that’s number one. Sanjay brought in that sort of change. And then, Tommi. Tommi has taken the list of 10 major steps that he’s taking to drive performance improvements, and we’re already seeing proof points of that, not least evidenced by the fact that we have got these 48 deals, and we are launching 15 commercial networks as well. So, if you go back a couple years, what really happened was that first Nokia was dealing with the migration of the portfolio that nobody else in the industry had to deal with regard to this Alcatel-Lucent phase-out. And you recall, we had some delays in 2017 as well with our migration projects. But, we got out of that in a way that we are now the best performing 4G networks vendors, whether you look at RootMetrics, it’s an excellent study, it’s not a Nokia study, or if you look Ookla, these folks have said in 125 metro markets in the U.S. both in 2018 and the first half of 2019, pointing to AirScale product that we’ve helped our customers get number one position in network performance. That gives me confidence that we’re going to be able to do the same in 5G. Now, the reason we chose FPGA was that when we were dealing with sort of the footprint migration from Alcatel-Lucent, we wanted to ensure that we get time to market catch-up as soon as possible. Now that is not the most efficient from a cost point of view. That is why we diversified our supplier base, as well as -- and admittedly, one supplier let us down as well. And so, we diversified our supply base, and started ramping up the SoC thing. It is not starting now, it’s already been in progress. It’s a shipment that will start to begin in our portfolio that will make the difference. So, I expect that will be in a much better position at the end of 2020, beginning ‘21, but it will progressively mitigate over the course of the year. And so, I’m watching this very closely with Tommi, with Sanjay and the teams, and I have confidence. The last thing I will say, Richard, is that 5G NR is based on NSA non-standalone. So, what really matters is your 4G installed based. And that is our strongest competitive advantage, because we have the best performing 4G networks, and there is no 5G network that performs well without an underlying strong 4G layer. This is why our customers will stick with us through this situation.

[Operator:]

Our next question comes from Aleksander Peterc of Societe Generale. Please go ahead.

[Aleksander Peterc:]

I’d just like to understand, given the sizable cut to your 2020 margin outlook, would you be able to give us more color on whether that is more of a scale or top-line issue, a gross margin issue, maybe related to pricing pressures, or an OpEx issue? And it’s a combo of those, but which is the most important here? Thanks.

[Rajeev Suri:]

Thanks. We’ve said, Alex, that next year, that we could expect to grow in line with the market as opposed to outgrow the market and it’s also driven by our prioritizing cash and profit over growth. But, has changed, four things. Like we said, high cost associated with the early generation 5G products, the first generation products; profitability challenges in China, which we think will continue, given the nature of aggressive price making expected there in 5G; some pricing pressure in early 5G deals, and I’ll say selective; and fourth, uncertainty related to the announced operator merger in North America where we have a particularly large footprint. So, we saw that impact in Q3, would likely want to see it in Q4, and we can’t predict when that will close. So, it could also likely be for the first half of next year. So, I think, in that order, it’s a gross margin because of this product cost issue, which will progressively mitigate over 2020.

[Kristian Pullola:]

And then, of course, on top of that, we do have the negative impact that comes from the additional investments that we are now making in 5G, as well as in IP and digitalization, which is also kind of impacting then operating margins.

[Rajeev Suri:]

And to be clear, that’s OpEx, and it’s not cogs.

[Operator:]

Our next question comes from David Mulholland of UBS. Please go ahead.

[David Mulholland:]

There’s been discussions and questions around the competitiveness of your portfolio, or whether we call it price competitiveness or performance for quite a while. And I think, it was about two years ago, now that we saw Ericsson saying they were facing issues in reinvesting. And since we now are largely executing in that from a gross margin perspective, why is it taking so long to come to this realization of the need to reinvest, if you look into next year?

[Rajeev Suri:]

So, this isn’t -- so, 5G only started meaningfully rolling out this year. This for us is not a 4G product cost issue, it’s a 5G product cost issue. And so, that’s started from beginning of this year. Like I said earlier, I mean, the System on Chip strategy has been put into motion already a while ago, diversified our supplier base. We are increasing the investments purely because we want to increase even more the SoC penetration in our products and continue that. And of course, we know how to do System on Chip. Yes, we started with FPGA with 5G because it’s gave us that time to market catch-up advantage, but we do that in much of our portfolio with FP4 and PSE-3. So, we’re just replicating that in mobile.

[Operator:]

Our next question comes from Achal Sultania of Credit Suisse. Please go ahead.

[Achal Sultania:]

I’m just trying to understand, like, how you’re positioning with your product on the 4G side of the market. I think, when we look at your revenues in the number of regions, for example, China, U.S., Korea, I think, we’ve seen that there is a big divergence between your performance and your key competition’s performance year-to-date. U.S. and Korea, I can understand predominantly because there was a first mover advantage with 5G. China, still 5G hasn’t actually started in full flow, yet there is a big divergence and still we haven’t seen any gross margin impact on your competition. So, just trying to understand, are you losing share on 4G, because of these issues that you are facing on 5G? And, how does that position you going into next year, and your ability to actually grow in line with the market next year? Thank you.

[Rajeev Suri:]

Thanks, Achal. I’ll just try to step back and sort of look at that question. So, I think, the issue we’ve seen in Q3, what we pointed to also in Q4 is the impact of this one operative situation with regard to the merger activity where we have a sort of large, particularly large footprint, that impacts us more than the other players. And so, that reduces -- or negatively impacts the business mix. So, that’s what I would say to that answer. Then, when it comes to China, I know 5G has not started, but the reality is that even in the underlying business, there are sort of profitability challenges, hence our priority on profit and cash in that market.

[Operator:]

Our next question comes from Robert Sanders of Deutsche Bank. Please go ahead.

[Robert Sanders:]

Yes. Just a question on your 5G SoC strategy. I was just interested in understanding what your view is on ASIC versus ASSP. I mean, you had this issue with ReefShark with Intel’s 10-nanometer process. It seems like you’re over-engineered for what the customers want. But, given you’ve got these challenges now, wouldn’t it make sense just to switch to an ASSP vendor, like a Marvell to just get your time to market right, rather than pursuing this ASIC strategy at low costs, given that they are typically more expensive and take longer to get to market? Thanks.

[Rajeev Suri:]

Thanks, Robert. So, nothing much to add, apart from what I’ve already said. So, it’s not a case of over-engineering the product. That’s not what we see. It is the case of shipping more SoC relative to FPGA. That’s as simple as that. So, when we get more SoC being shipped in our products, which will progressively happen in 2020, we’ll start to see the gross margin benefit.

[Operator:]

Our next question comes from Stefan Slowinski of Exane BNP Paribas. Please go ahead.

[Stefan Slowinski:]

I just had a question regarding the comments you made about country exits, potentially exiting countries as you focus on profitability and margins and cash flow. And you specifically called out China multiple times as being challenged from a profitability standpoint. So, are you suggesting that potentially China could be a country that is a candidate for exiting altogether, at least for part of your business? And how would that impact your ability to have enough share globally to continue to invest in order to maintain the products? Thank you.

[Rajeev Suri:]

No. I think, we’ll be a significant player in China for a long time to come. Look, I mean, let’s just talk about China for a minute. The China volume of base stations in the world are approximately 60%. Right? The revenue share of that volume is approximately half that. The profit share of that volume in the medium term is negligible. So, that to me explains the China. So, in China, we are going to change our business mix, more private networks with state-owned enterprises. It will take some time. More core networks, higher margin, more routing and transport and backhaul, higher margin, with service providers, obviously 4G radio, and we’ll see what happens with 5G radio, and then, more routing and transfer and optical, web scale players. We’re not starting this now, we already have that underway. So, the business mix might change. The cash flow will get better. And the contribution margin, sort of as a quality, improves, yet, the revenue might come down. And if that’s the case in some other markets, we’ll do the same. But again, there might be some projects we have to do it, but no wholesale country exits per se.

[Operator:]

Our next question comes from Pierre Ferragu of New Street Research. Please go ahead.

[Rolf Bulk:]

Hi. This is Rolf standing in for Pierre, who is in a noisy environment on a mute. Thanks for taking our question. You mentioned your hardware issues in your radio portfolio and how you plan to address them. And we were wondering what about software issues. You mentioned early this year some difficulties, which led to revenue recognition -- delayed revenue recognition in radio software? And there’s been report that you’re meeting challenges on that front as well. Could you talk about the situation there and how you plan to address potential issues?

[Rajeev Suri:]

Thank you for the question. So, first of all, it’s not in mobile radio, all of it is just in 5G -- I mean, only in 5G is what I mean, not in 4G, not in Single RAN, not in 3G. So, it’s in 5G. It is primarily product cost issue as we’ve just discussed. But tied to that, SoC shipment or ReefShark family of chipset shipping, AirScale base station are also some features that that would be brought forward. So, but we have the feature for launch. Even if some features might be delayed because of SoC, the reality is that there are workaround solutions all the time that we work with our customers on. We launched 15 networks, we’re winning 48 customers, we’re converting 100% of our 4G customer base to 5G. So, it is the 5G product cost issue, that’s the primary thing.

[Operator:]

Our next question comes from Sebastien Sztabowicz of Kepler Cheuvreux. Please go ahead.

[Sebastien Sztabowicz:]

I know, it’s a little bit early, but could you please help us understand what kind of growth do you see for your key markets for 2020? Should we expect a better market environment in 2020 versus 2019, and where do you see I would say basically growth or top-line pressures in the coming quarters? Thank you.

[Rajeev Suri:]

We see growth continue in 2020. Within that, there will be a mix dimension, depends on where the growth comes from. In general, we can expect Transport to be strong. We can expect Software, our success to continue that. We can expect Enterprise growth to continue. Of course, 5G will drive growth as well. But overall, we’d say growth for the market will continue, and we’d likely be in line with the market.

[Operator:]

Our next question comes from Simon Leopold of Raymond James.

[Simon Leopold:]

You’ve given us, I think, a lot of the breadcrumbs around the cash flow and general trending, but I want to make sure I’m interpreting your expectations as to when you think you can resume paying dividend. Roughly speaking, it sounds like you expect to be at that -- the targeted levels of net cash by the end of 2020, perhaps early ‘21. I just want to make sure I’m interpreting your commentary accurately, or if there are other variables I need to consider?

[Kristian Pullola:]

So, let’s just -- if I kind of repeat the facts that Rajeev talked about, we’ve taken a pause on the dividend. The Board has said that it will resume payments as we get to €2 billion or so of net cash. We’ve also said that we will seek an authorization from the next AGM to be able to track the situation on a quarterly basis. That’s all we have. Yes. We’ve also said that from a cash expectation point of view, we expect to end the year at a €1.5 billion, and that we expect to generate positive cash flow in 2020. Clearly, our object is to try to get to a dividend payment situation as quickly as possible. Thank you.

[Matt Shimao:]

Thank you, Simon. Nicole, I think, we have time for one more question today.

[Operator:]

Our next question comes from Stuart Jeffrey of Agency Partners. Please go ahead.

[Stuart Jeffrey:]

I’ve just got a question again on the China angle, linking into economies of scale questions. I appreciate that you don’t want to chase unprofitable business. But, China 5G could be a huge proportion of 5G spend late next year and in 2021. And if you don’t play a role in that for margin issues, then, doesn’t that impact your ability to drive manufacturing economies of scale, R&D coverage, all those things that have historically led people to -- other companies to struggle for scale and then struggle to be competitive in the long-term. So, I just am trying to better understand, can you really pull out of some of these big contracts opportunities without damaging your long-term competitiveness, globally, not just in China?

[Rajeev Suri:]

Thanks, Stuart. So, first of all, I’m not giving any particular guidance on where we’ll end up in share, in 5G in China. But, I will say that -- I’ll just repeat first, yes, China 5G, just like China 4G, will be about 60% of the global volume of base stations and half of that will be the revenue market share of that. But, in the next, let’s say medium term -- and for me, medium term, let’s say is about three years. The profit share of that will be negligible. Then, the question on volume, do you need the strong China volumes, even if unprofitable, to help your overall situation, we’ve done the math on that. It is not decisive. No, we don’t have to have them. Just because we are always going to be in a scale position, the way we see it. And for me, scale position is the market share that we are aspiring to globally. So, I think we’ll be able to cover it. Remember also that we have recently increased our market share in Japan quite a bit with a couple of customers, et cetera. So, on the whole, we will always be in a strong scale position, and additional volumes of China do not necessarily give us component purchasing, economies of scale, the manufacturing economies of scale.

[Matt Shimao:]

Thank you, Stuart. And thank you everyone for your questions today. I’d now like to turn the call back to Rajeev.

[Rajeev Suri:]

Thank you, Matt and Kristian, and thanks to all of you for your questions. If you take a step back and look at what we have said over the course of the call, I hope two things are clear. First, while our performance today is not where we wanted to be, we have the right actions underway to drive meaningful improvement over the course of 2020 and a full turnaround in 2021. Second, we see a clear set of drivers for creating future value. Some of these are near-term, some are mid-term, and some have a longer horizon, but all are important, all will get our focus and all can create value. With that, Matt, back over to you.

[Matt Shimao:]

Ladies and gentlemen, this concludes our conference call. I would like to remind you that during the conference call today, we have made a number of forward-looking statements that involve risk and uncertainties. Actual results may therefore differ materially from the results currently expected. Factors that could cost such differences can be both external such as general economics and industry conditions, as well as internal operating factors. We have identified these in more detail on pages 60 through 75 of our 2018 Annual Report on Form 20-F, our financial report for Q3 issued today, as well as our other filings with the U.S. Securities and Exchange Commission. Thank you.

[Operator:]

The conference has now concluded. Thank you for attending today’s presentation. You may now disconnect.