Apple and Samsung Smartphone Profits: How They Really Compare

by Mark W. Hibben
7/28/13

Where Strategy Analytics went wrong

On Friday 7/26, Strategy Analytics (SA) issued a report with the attention grabbing headline "Samsung Becomes World's Most Profitable Handset Vendor in Q2 2013". The report estimated Samsung's operating profit from mobile phones to be $5.2 billion for Q2, whereas Apple's operating profit from iPhone sales was estimated to be $4.6 billion.

Daniel Eran Dilger quickly rose to Apple's defense in Apple Insider, denouncing the report as "simply not accurate". He was so busy excoriating SA for their shoddy analysis that he never offered an alternative to SA's profit figures for the mobile handset business. In fact, a dispassionate comparison of mobile phone profitability of the two companies is revealing and helpful in assessing their relative competitiveness. Apple and Samsung are about evenly matched in overall size and operating profit, as the table below shows.

2013 Q2 Metrics

Apple

Samsung

Revenue (billions)

$35.32

$51.71

Operating Income (billions)

$9.20

$8.58

Operating Margin (%)

26.05

16.6

Dilger spends a lot of effort trying to pick apart SA's profit estimate for Samsung's mobile phone business, but this may have been misguided. In its Q2 earnings report, issued on Friday, Samsung reported an operating profit for its Information Technology and Mobile Communications (IM) division of $5.65 billion. SA is saying that $5.2 billion of that amount came from mobile phones, smart phones and feature phones.

Dilger asserted that this couldn't possibly be true, and that the $5.2 billion must also include tablet and PC sales. I'm inclined to give SA the benefit of the doubt on this one, for the following reason. IDC just reported its mobile phone shipment figures for Q2, and Samsung shipped a total of 113.4 million mobile phones, of which 72.4 million were classified as smartphones. This comes to an operating profit of just $45.9 per phone. As we'll see, this is far less than Apple's operating profit per phone, but it doesn't say that the $5.2 billion operating profit is exaggerated. I find SA's profit number for Samsung to be at least plausible.

Apple's profit number is where SA probably screwed up, but this isn't an easy number to get right and the reader should realize that any number that anyone publishes outside of Apple is nothing more than an estimate. Unlike Samsung, Apple doesn't report operating profit for its operating segments, or for iPhones or any other product category, but only for the company as a whole.

Dilger actually shows an iPhone operating margin estimate furnished by Canaccord Genuity of 40% as of 2012 Q4. If this number is still valid, then 40% of the $18.15 billion Apple made in iPhone sales revenue in Q2 is $7.26 billion, and Apple totally dominates Samsung in mobile phone profitability. Even if we derate the Q2 iPhone operating margin by the 6 percentage point slide that has ocurred in Apple's overall operating margin (from 32% in Q4 to 26% in Q2), Apple still wins the mobile phone profit race at $6.2 billion.

Based on SA's operating profit estimate for Samsung of $5.2 billion, Samsung had an operating profit margin in mobile phones of about 17%. My derated Apple iPhone operating margin in 34%. Why do I think this is plausible? Because Apple's iPhone Average Selling Price (ASP) is about double that of Samsung, even though their smartphones cost about the same to manufacture.

Apple's iPhone ASP: $581. Samsung's mobile phone ASP: $274.

As the table below shows, I compare iHS/iSupply estimates of manufacturing costs for the iPhone 5, Galaxy S4 and S3:


Samsung Galaxy S4 (LTE version)

Samsung Galaxy S3

Apple iPhone 5

Total Bill of Materials Cost

$233.00

$205.00

$199.00

Manufacturing Cost

$8.50

$8.00

$8.00

BOM + Manufacturing

$241.50

$213.00

$207.00

Selected Component Costs

Display and Touchscreen

$75.00

$65.00

$44.00

Processor

$20.00

$17.50

$17.50

Cameras

$20.00

$19.00

$18.00

Mechanical

$22.00

$21.40

$33.00

Many analysts would have the investing community believe that Apple is fundamentally disadvantaged compared to "commodity manufacturers", but Apple's manufacturing is very lean. Can you derive a "cost of sales" per phone from the above manufacturing costs? Not quite. Based on the total manufacturing cost alone, Apple's gross margin

(selling price – total manufacturing cost)/selling price

would be about 65%. But the real iPhone gross margin is closer to 50%, I suspect, because there are additional costs including packaging, shipping, and most importantly, supply chain management. Apple maintains a small army of contract managers and engineers to oversee its suppliers. These people ensure contract compliance, work out delivery schedules, perform quality assurance, and help troubleshoot production problems.

Operating costs such as Sales and Marketing and Research and Development are subtracted from gross profit to obtain operating profit. Estimating the iPhone's share of Apple's operating costs is another gray area, since Apple only reports operating costs on a company wide basis. If iPhone operating costs were proportional to its revenue, then about half of Apple's Q2 operating costs of $3.82 billion in Q2 would be attributable to iPhone. This would bring iPhone operating profit margin down to about 40% of revenue, but Apple could be investing more heavily in iPhone, so its operating costs could be higher. Even with this higher proportion, operating margin for iPhone is unlikely to be below the worst case number I mentioned above of 34%.

Investor take away

Investor's should be extremely wary of the kind of analysis produced by SA, which seems designed at best, to garner attention. Apple has challenges, to be sure, but not quite as dire as SA's analysis would suggest.

Samsung is and will continue to be a fierce competitor for Apple. Of most concern to me is Apple's continuing slide in market share. According to IDC's Q2 data, Apple's market share declined from 16.6% a year ago to just 13.1% for 2013 Q2. Yes, Apple's iPhone shipments grew by 20% year over year, but Samsung's shipments grew faster, by almost 43.9%. In Q2, Samsung sold more than twice as many smartphones as Apple.

Apple is widely reported to be working on a low cost iPhone, and this will be an opportunity for Apple to surrender a little margin in favor of market share. Regardless of whether the low cost iPhone makes an appearance, I expect Apple's operating margin to continue to decrease, as a consequence of both lower gross margin and higher investments in R&D. I'm convinced these moves are best for Apple in the long run, but may be painful for investors in the short term.

ARM Holdings vs. Intel: the Calm Before the Storm

by Mark W. Hibben
7/26/13

The Uneasy Calm

The share price of ARM Holdings swung wildly on the morning after its 2013 Q2 earnings report, released on July 24. At market open the stock spiked to about $42.80, only to settle back by the end of the day to about $39.60, a change of almost 7.5%. It was a classic case of investors being initially excited by the report, only to have second thoughts after they digested it.

ARM had played the usual tired old game of camoflaging bad financial news behind non-IFRS (International Financial Reporting Standards) numbers, referred to in ARM's briefing charts as "normalized". In this case, the bad news was a charge of $63.4 million to settle patent litigation against ARM, which pretty much wiped out ARM's operating income for the quarter, leaving just $19.6 million.

ARM's year over year revenue growth was strong, however, at $264.3 million, up 24%. However, there are signs that ARM's revenue growth, which is closely coupled to ARM processor shipments through licensing, may be starting to slow, as the chart below shows.

After ARM's 2012 Q4 earnings report, I made a couple of observations in my article "Does Arm Still Have Momentum?", which bear repeating now that two quarters have gone by.

1) I observed that the surges in ARM's share price in Q1 2011 and Q4 2012 correlated with announcements by Microsoft of its Windows on ARM initiative at CES in January 2011 and the release of Windows RT, the version of Windows 8 that runs on ARM processors and Windows 8 Phone in October-November 2012. I inferred that investors expected Microsoft ARM devices to sell well and increase the demand for ARM processors. I also asserted, based on mostly circumstantial evidence at the time, that Microsoft's Windows on ARM initiatives would be disappointing and achieve little market share growth.

By now it's apparent that Windows RT and Windows 8 Phone have not fueled a discernable acceleration in ARM processor shipments. According to IDC, 900,000 Surface tablets were sold in Q1, and some of these were Surface Pros with Intel processors. According to Gartner Reseach, about 6 million Windows Phones were shipped in Q1. Both numbers are relatively miniscule compared to total worldwide smartphone and tablet shipments in the quarter of 210 million and 49 million respectively.

2) I also observed that ARM and Intel were on a collision course in mobile devices as well as servers. Intel was preparing low power Intel processors that would compete in the tablet and phone space, while ARM was preparing more capable 64 bit processors to be used in low power servers.

For the most part the collision hasn't happened yet. ARM's 64 bit processor designs, dubbed the Cortex A50 series, have yet to enter production and probably won't before next year. Most of the Intel processors capable of competing with ARM in tablets and phones won't be available until Q4.

In this calm before the storm, some ARM investors may find it difficult to accept Intel as a serious threat. There was some indication of this in the jump in ARM share price following its Q1 earnings report. As can be seen in the chart above, revenue grew in lock step with processor shipment growth, while operating income grew faster than revenue as operating expenses were cut. And the Intel threat was just a dark cloud on the horizon.

It wasn't until June that the Intel cloud drew suddenly closer and took tangible form that ARM investors began to take the threat seriously. By late June ARM shares had fallen from a high of about $50 on May 16 to about $35 on June 21.

The initial Intel threat took the form of the first of the 4th generation Core processors, often referred to as "Haswell". In its most power efficient form, Haswell can be used in tablets and what Intel calls 2-in-1 convertibles, tablets with detachable keyboards. But the first Haswell processors were higher power chips for desktops and laptops, and weren't suitable for tablets. The Intel threat once again seemed to abate as PC sales, and Intel's PC processor sales, continued to decline. ARMH shares have edged upward since the end of June.

The Coming Storm

ARM investors and the entire ARM ecosystem are about to witness the mobile computing equivalent of Shock and Awe when Intel unleashes their mobile processor assaults in the 3rd and 4th quarters. Intel has two main weapons in its arsenal: the ultra low power "fanless" Haswell processors, and the Bay Trail line of Atom processors. Both use Intel's 22 nm process, which shrinks the size of integrated circuits compared to the 28-32 nm process currently in use by ARM processor manufacturers. Both processor families will be more energy efficient than currently available ARM processors, as well as more computationally powerful.

The Haswell processors will go into more expensive tablets running Windows 8 Pro and will appeal to Windows users who want something more powerful in a tablet. Intel has targeted Bay Trail Atoms for mainstream consumer tablets with a price point around $200 dollars. These will be capable of running either Windows 8 or Android. At its Q2 conference call, Intel execs indicated that mobile device makers such as Acer, Samsung, etc. intended to offer the same Intel based hardware platforms in either Windows or Android configuration, and saw this as a way to lower development costs.

In my article on Intel's Q2 earnings, I allowed that Intel mobile processors might well be cost disadvantaged compared to ARM. It's difficult to tell at this point, but I suspect that Intel will price their mobile processors competitively, even if it means taking a loss on them.

Matters only get worse in 2014, when Intel brings their first processors to market using their even more advanced 14 nm process, which will start production this year in Q4, according to Intel. ARM foundries such as TSMC and IBM's Common Platform partners Global Foundries and Samsung have all announced that they're working on 14 nm processes of their own, but there's no telling when they'll be ready.

Intel's success or failure may well come down to process advantage, something ARM has very little control over. ARM is doing what it can to help Common Platform with development tools, but can't do very much for the foundries other than lend moral support. ARM's fate may be in the hands of the ARM foundries.

Apple's Relief Rally

by Mark W. Hibben
7/24/13

Expectations of a Humbled Apple

After Apple's second quarter earnings report came out on 7/23, Apple shares staged a relief rally, as in relieved that things weren't worse. Although the news was mixed, I found encouraging signs in Apple's bolstered R&D spending, as well as its continuing strong iPhone sales.

It's indicative of how much market sentiment had turned against Apple that its arch rivals in mobile, Google and Microsoft, saw moderate sell-offs after arguably stronger earnings reports. The expectations were high at the beginning of the year that Apple would collapse before the superior might of Microsoft and its Windows 8 Phones and Tablets.

I've been hearing numerous variations of this theme from Microsoft supporters and fans, and for some reason it was always Apple that would suffer, even though Google's Android users made a better target audience for Windows Phone. Most Android users disdain Apple's "toys" and pride themselves on being able to customize and control the Android OS in ways that iOS simply doesn't allow.

The threat from Microsoft has so far not really materialized, as was apparent in Microsoft's earnings report. The $900 billion write down for Surface RT and the comparatively small sales (7.4 million) of Windows 8 Phones by Microsoft's principal Windows Phone partner, Nokia, demonstrated that Microsoft still had a lot to learn about being a mobile device maker.

While Microsoft's mobile efforts have faltered, Google has an entirely different kind of problem: how to make more money from all the Android phones and devices that have been made. Google CEO Larry Page was happy to share with the world at the Google earnings call last week that Google had "activated" over 900 million Android devices as of Q2. Of course, Google never talks about how many active accounts Google Play has or how many of the "activated" devices are actually still in use.

Google had offered as of 2012 Q3 an annual "run rate" of $8 billion in revenue for mobile search, advertising and Play. Undoubtedly it's higher now, but it's unlikely to approach Apple's revenue from direct iPhone and iPad sales for the past 4 quarters: $122.2 billion.

This doesn't include revenue from mobile devices for iTunes and the iOS App store, which I'm leaving out because Apple doesn't break out mobile revenue separately in its iTunes, Software and Services category. This category has only existed for the past three quarters, but has made a total of $11.8 billion in revenue so far.

I'm not making these comparisons to argue that Apple has nothing to worry about from its rivals, but to point out that much of the disdain heaped on Apple has been overwrought. As the following table shows, Google and Microsoft posted relatively strong quarters (compared to Apple) in terms of revenue growth.

2013 Q2 Metrics

Apple

Google

Microsoft

Total Revenue ($billions)

35.32

14.11

19.9

Revenue Y/Y % Change

0.86

19

10.2

Operating Income ($billions)

9.2

3.12

6.07

Op. Income Y/Y % Change

-20.5

-3.5

-4.99 (exclusive of 2012 Q2 goodwill impairment charge)

Apple does have to worry about competition from Microsoft and Google. To assume otherwise would indeed be hubris, something Apple management has been unfairly accused of.

Positives, Negatives, and a Few Surprises

The most positive news in the report was the sale of 31 million iPhones in the quarter. According the Philip Elmer-Dewitt, the institutional consensus was for 26.57 million and the independent consensus was for 27.89. I had gone out on a limb and predicted 30 million.

Total revenue of $35.32 billion also came in ahead of the institutional consensus of $34.94. I had predicted $35.22 billion.

I was also delighted to see Research and Development (R&D) spending finally exceed 3% of revenue at 3.33% for an all-time high of $1.18 billion. I had predicted 3.41%, but I'm not too disappointed. The trajectory looks good for an additional increase in percent of revenue in Q3, based on Apple's guidance of $3.9-3.95 billion in operating costs.

Some of Apple's results I have mixed feelings about. Gross margin and operating margin were both higher than I expected or wanted at 36.9% and 26% respectively. I had expected 36% gross margin, the low end of Apple's guidance, and 24.8% operating margin (operating profit/revenue).

I realize that lower margins would have hurt Apple's stock price in the short term. Here my argument on behalf of lower margins is that Apple needs market share more than it needs profit. The cash return program and Apple's new indebtedness have barely put a dent in the cash pile, which remains at about $130 billion.

The most worrisome and surprising news in the report was the drop in iPad unit sales by 25% sequentially and 14% year over year. I definitely didn't see that one coming and had expected 18 million unit sales. At least I wasn't alone, as the institutional consensus was for 17.6 million units.

The year over year percent drop is mostly attributable to the fact that the 3rd gen iPad introduced in 2012 boosted sales in Q2. Also I think there was a disappointment factor this year that there wasn't a new iPad at what had become the accustomed time. When a 5th gen iPad didn't appear, many customers simply decided to wait.

Other not so good trends included the sequential drop of 43% in sales revenue in Greater China (China, Hong Kong and Taiwan). Tim Cook indicated that most of this was in Hong Kong, whereas there had been a sequential increase in China. This points to a crying need for a low cost iPhone in order to bring the goodness of iOS to emerging markets, but it's not clear at all if this will happen.

Clearly the worst development by far was the lack of year over year revenue growth. I can accept lower profit if Apple is growing its markets. It's lack of growth that most concerns me. Lack of revenue growth can be attributed to a number of things: lack of new products, lack of variety of new model iPhones, lack of lower cost iPhones and iPads. But if Apple doesn't have the new products yet, then it should be cutting prices to spur demand. It can afford to.

Apple has indeed promised new products for the Fall, and there is even some indication that some may emerge in the third quarter. As the Fall approaches, I'll be sifting through the rumors to see which pass the giggle test and offer my projections for Apple's new products.

Is Netflix Getting a Good Return for its Content Investment?

by Mark W. Hibben
7/23/13

No Acceleration in Membership Growth

The earnings report of Netflix exceeded Wall Street expectations, as well as demonstrating significant year over year improvement. Yet investors were disappointed and a sell-off ensued the following day.

On the basis of year over year revenue and income growth, the report should have come as good news. Total revenue grew 20% to $1.07 billion, and operating income grew by over 250% to $57.12 million.

Investor disappointment has been widely attributed to insufficient growth in paid membership, and Netflix has been growing at the same rate of about 8.6 million paid memberships/year worldwide since Q4 2011, as the chart below shows:

Since there had been expectations that Netflix's investments in new content would accelerate membership growth, the lack of any visible acceleration in Q2 accounts for most of the negative reaction.

Many Netflix investors have tended to fixate on membership growth as reflected in a recent article by fellow Motley Fool Blogger Salvatore Mattera, who writes:

"If Netflix can get the 60-90 million subscribers it thinks it can, then there’s no problem at all. A larger pool of subscribers should generate enough revenue to cover the cost of the content."

Mattera offers no analysis to back up this assertion, and in fact there's no guarantee that doubling or trippling paid membership will justify the current valuation of Netflix or assure long term profitability.

The Problem of Return on Invested Capital

The original content that Netflix has invested in has excited investors who assumed that this would spur membership growth. Even if original content had changed the membership growth trajectory, there would still be the problem of assessing the value of the programming as an investment for Netflix.

For instance, Netflix is reported to have spent $100 million to produce the first two seasons of House of Cards. How can investors assess the return on this investment? There are no ticket or disk sales tied to the show, or even Nielsen ratings for it. Netflix probably knows the viewership of every program it offers, but hasn't revealed this information to the public.

It is this lack of transparency that caused me to offer a Return on Invested Capital (ROIC) analysis of Netflix overall in my previous Netflix post. In the table below I compare ROIC for Netflix, Amazon, and Hulu's three owners, Comcast, 21st Century Fox, and Disney (from the Wall Street Journal):


Netflix

Amazon

Comcast

FOX

Disney

2012 Annual Revenue

$3.61 B> $61.09 B $62.57 B $33.7 B $42.28 B

2012 Annual Net Income

$17.15 M -$39.0 M> $6.20 B $1.18 B $5.68 B

2012 Cash and Equiv.

$748 M $11.45 B $12.42 B $9.63 B $3.39 B

Current ROIC (%)

1.03

-0.38

7.1

2.78

11.44

Generally the ROIC percent rate should be higher than the cost of capital for the company. Netflix recently borrowed $500 million at 5.375% interest, so Netflix has a way to go to get their ROIC equal to their cost of capital.

Whether Netflix can ever get to a healthy ROIC depends on being able to grow membership while holding the line on operating costs (Marketing, R&D, Administrative). Netflix did improve its operating margin (operating income/revenue) to 5.3% this quarter, compared to 3.1% in Q1, and actually reduced overall operating expenses by reducing marketing costs.

It remains to be seen whether this is sustainable. In the past, Netflix operating costs have grown proportionately with revenue, and I'm skeptical that Netflix can double membership and revenue while holding operating costs unchanged. If Netflix maintained the current operating margin of 5.3% even doubling revenue would only yield a ROIC of 4.2%.

The Problem of competition

Compounding the problem of Netflix ROIC is the problem of competition. Both Amazon and Hulu directly compete with Netflix, although Netflix is reported to have roughly a 90% share of the Internet subscription streaming market. Hulu's owners recently decided not to sell Hulu, and are now investing $750 million to enhance Hulu's content and competitiveness, according to a report in the NY Times.

Although Netflix CEO Reed Hastings justifiably criticised Amazon's online user interface as "confusing", the Hulu online interface is about as good as Netflix, so Netflix doesn't have a competitive advantage with respect to Hulu. Netflix, Amazon, and Hulu all have iOS and Android apps available for viewing their content, as well as apps for set top boxes such as Apple TV, Roku, and many Blu-ray disc players.

Generally all the apps work well and provide the convenience of watching programing whenever and wherever the user wants. Insofar as the basic technology of internet video streaming, or in their application software design, Netflix has no compelling advantage over its competitors.

Furthermore, anyone with deep enough pockets can buy or produce exclusive content for their streaming site, so this appears to be not much of a discriminator as well. Hulu's owners certainly have deep pockets, as I show in the table above, as well as ample experience producing their own content. 21st Century Fox owns Fox Television and the 20th Century Fox film studio, Comcast owns NBC Universal, and Disney owns ABC and ESPN. Hulu's three owners easily have enough unique content to overwhelm Netflix.

Netflix prospects

Netflix has been alone in its market by virtue of being a pioneer in something that the big media companies weren't convinced would be important enough for them to bother with. The decision not to sell Hulu signals a change in their thinking. The days of 90% market share for Netflix are over. In an amped-up Hulu, Netflix will face its first serious competition.

I expect that competition to be bruising for Netflix financially and for Netflix investors. Even if Netflix does not collapse in the face of its better funded rival, Netflix will have to fight hard and spend significant marketing and development funds simply to maintain their current subscriber growth rate.

I expect the effect of increased competition at the very least will be to force Netflix to increase operating expenditures on a pace with increased membership and revenue. ROIC never gets above a few percent, and Netflix never justifies its current valuation, as reflected in its P/E ratio.

 

A Cold Shower for Microsoft Investors

by Mark W. Hibben
7/22/13

Not All Bad

Microsoft's latest earnings report, released on 7/18, was a cold shower of disappointment for MS investors. Microsoft's share price plumetted 11% the following day. In retrospect, Microsoft's reorganization announcement, which many regard as an attempt to remake Microsoft in Apple's image, appears timed to deflect criticism of Microsoft's Q2 performance. MS has been trying to emulate Apple as an integrated devices/software/services company for well over a year, and has come up short when it comes to mobile.

To be sure, the financial news was not all bad, or even mostly bad. Quarterly revenue was up 10.17% year over year and operating income was down only slightly by 5% year over year, excluding the $6.2 billion goodwill impairment charge that MS took a year ago to downgrade the value of its Online Services Division (OSD).

Microsoft Business Division (home of Office) continues to perform well, with nearly 15% revenue growth year over year and operating income growth of nearly 18%. Server and Tools also did well, with 8% revenue growth year over year and over 10% operating income growth.

However, in areas where there had been high expectations, such as Windows 8, Windows RT, and Windows Phone, the news was disappointing to financial analysts and investors. The earnings presentation delivered a number of unwelcome shocks to the system:

Shock #1: Windows OEM Revenue drops 15% year over year.

In the Windows Division (WD), revenue declined sequentially by 22.6% to $4.4 billion, while operating income dropped by a whopping 68% to $1.1 billion. Year over year comparisons for WD weren't much better: a 6.4% revenue gain offset by a huge 54% operating income drop.

The OEM revenue decline confirmed my hypothesis that MS had been pushing discounted Win8 licenses onto OEMs (frontloading) in order to boost claimed sales of Win 8 (recall that MS announced that 100 million had been sold as of May).

Right now, corporate licensing of Win7 is carrying the revenue ball for Windows Division, with growth in "double digits". MS states that 3/4 of enterprise desktops use Win 7, so by the time MS pulls the plug on Win XP support next year, the other 1/4 should be converted, and this "growth" market will go away.

Shock #2: $900 million inventory write down for Surface RT.

Ever since I wrote "Microsoft's Mobile Crisis" back in November 2012, I've been skeptical about Windows on ARM and pointed to signs that Surface RT was not doing well. Since then Surface RT and Windows RT have been suffering a slow agonizing death by half measures. IDC reported that just 1.8 million Surface RT and Pro tablets were sold in Q4 2012 and Q1 2013. In the same period, Apple sold over 40 million iPads.

Windows RT devices were neither simple and intuitive enough to appeal to consumers who might otherwise buy an iPad, nor capable enough to appeal to mainstream Windows users, since WinRT couldn't run Windows 7 apps, unlike Windows 8 tablets.

Shock #3: Entertainment and Devices Division posts an operating loss.

EDD, the home of Xbox and Windows Phone 8, suffered a steep 24% sequential revenue decline as well as a 132% operating income decline. Part of this is just start up costs for the new Xbox One, but clearly Microsoft has a profitability problem with Windows Phone. Developing a smartphone OS costs bucks, and right now MS has little to show for its investment in Windows Phone 8.

Because of platform support payments required to bring and keep Nokia in the WP8 fold, Nokia gets WP8 for free. This will change if sales volume for Windows Phones ever picks up, but so far they haven't. Nokia sold 7.4 million Windows Phones in Q2. In Q4 2012 and Q1 2013, about 12 million Windows 8 Phones were sold, according to Gartner research. In the same period, Apple sold 85 million iPhones.

Microsoft and its partners such as Nokia talk a lot about building a viable third mobile ecosystem, but at the rate MS is going, it's not clear they ever get there. I've estimated that to be self-sustaining, a mobile ecosystem needs to have at least 100 million users. At its current rate, it would take a couple more years for Microsoft to achieve that viable ecosystem. Do Microsoft and its partners have two years?

Microsoft's Path Forward

Microsoft management and investors are beginning to understand that being an integrated devices company in the Apple vein is not all that easy to achieve. I tend to discount the importance organizational structure in determining the performance of organizations, since I think quality of leadership is far more important, but Microsoft's re-org probably will help. In any case, I certainly believe that Microsoft can become an effective integrated mobile devices company to rival Apple.

My current pessimism regarding Microsoft has to do with a certain doggedness I see in its pursuit of the ARM platform. The impending arrival of Intel Bay Trail processors that will outperform ARM processors in computing speed and energy efficiency will make the effort pointless. There's much added value in a Windows 8 Pro tablet packing a 64 bit Bay Trail processor that can run nearly the whole ecosystem of Windows 7 software. Such tablets will be as thin as current ARM tablets and have equivalent or better battery life.

There is a question in my mind, which I raised in my recent Intel earnings article, whether the Bay Trail family can be made as cheaply as competing ARM chips. Probably not, but this would be a secondary consideration for MS, since processors aren't the main cost drivers for tablets anyway, while the touch screens are. Microsoft badly needs a mobile device ecosystem, and the easiest way to achieve one is by bringing the current Windows ecosystem into its mobile platform. That can only be done with Intel.

Similarly Windows Phone could be hosted by an Intel processor derived from Bay Trail, which should be available by the end of the year. Going all Intel would allow MS to streamline the development process for its OS and reduce costs

Although I consider the switch to all-Intel as all but inevitable, it's not clear when it will occur (the doggedness factor). Unfortunately, MS has achieved just enough progress with Windows Phone to embolden it to continue with ARM. Microsoft could easily waste another year trying to build an ecosystem on what is for Microsoft a dead end platform.

 

Nokia's Long March to Profitability

by Mark W. Hibben
7/22/13

Smartphone Zero Sum Game

Even as Nokia's smart phone sales continued to collapse, down 32% year over year and 6% sequentially, CEO Stephen Elop claimed that Nokia had "achieved underlying profitability" at the quarterly conference call. As usual, his claim excluded restructuring charges that pushed Nokia into an operating loss of $152 million for the quarter. The sole legitimate, though limited, sign of progress was an increase in sales of Lumia Windows 8 phones from last quarter's 5.6 millin to 7.4 million.

Total revenue for the company was down 24% to $7.5 billion. Nokia's net cash and equivalents fell by more than $528 million from $5.9 billion to 5.37 billion. About the only positive in Nokia's overall financials is that it isn't as bad as a year ago, when the operating loss was $1.09 billion on revenue of $9.953 billion. Elop may call this achieving underlying profitability, but I call it hanging on by your fingernails.

Last quarter I pointed out that Nokia had effectively cannibalized its own low cost Asha line of smartphones as well as Symbian smart phones it was still selling. As the table below shows, this continued into Q2.

Quarter

Lumia Units in million

Asha Units in millions

Symbian Units in millions

Total in millions

2012 Q4

4.4

9.3

2.2

15.9

2013 Q1

5.6

5

0.5

11.1

2013 Q2

7.4

4.3

0

11.7

In order to make this less apparent, in Q1 Nokia stopped reporting Asha in the Smart Device category and lists Asha in the mobile phone category, even though Nokia's own report continues to refer to Asha as a "full-touch smartphone". This allowed Nokia to claim a 21% increase in Smart Device unit sales, from 6.2 to 7.4 million. But in fact, selling smartphones has become a zero sum game for Nokia, where it can only increase sales in one line at the expense of the other.

While steeply discounting Lumia Windows phones pumped up the unit volume, it didn't help Smart Device revenue, which was down 24% year over year and unchanged from last quarter at $1.54 billion. Both Microsoft and Nokia were "on the same page" at their conference calls, claiming to be pleased with Windows Phone "momentum".

Elop pointed out that Nokia has now sold 13 million Windows Phones, as many as it sold in all of 2012, but this really underscores the flop that was Windows Phone 7, especially since WP8 became available in 2012 Q4. At this rate, can the Microsoft keiretsu really build a sound ecosystem?

Long March, or Death March?

I've estimated that a mobile device ecosystem requires about 100 million users to become self-sustaining. This figure varies somewhat depending on the licensing structure of the OS. Currently, Microsoft still pays slightly more in platform support payments to Nokia than Nokia does in licensing fees, so in effect, the OS is free and Microsoft is being forced to create a self-sustaining mobile ecosystem in the Google vein, supported by advertising and search revenue, and sales in its content stores. In this mode, 100 million users is probably conservative, since Microsoft doesn't have anything close to the mobile device advertising revenue of Google, judging by the way Microsoft's Online Services Division (home of Bing) continues to post operating losses ($110 million in Q2).

According to Gartner Research, there were about 12 million Windows Phone sales through the end of Q1 worldwide. Assuming that Windows Phone sell about 10 million this quarter (including Nokia's 7.4 million), that means that there are about 22 million Windows Phone 8 users in the world. Just 78 million more to go, or about two more years at 10 million per quarter.

Somehow, trudging along like this adding 10 million or so users per quarter seems an implausible way to build a "viable third ecosystem". On a quarterly basis, Android is adding about 135 million users, and iOS is adding about 50 million. The goal of sustainability is not really a fixed number like 100 million users. It's a vision of mobile ecosystem vitality that is pulling away into the distance, even as Nokia and Microsoft struggle to keep up.

Clearly acceleration is needed, and that acceleration can't really come at the expense of the cash flow of Nokia or Microsoft's other Windows Phone partners. Nokia badly needs to get off the low-cost, emerging market treadmill and move up-market. The Nokia 1020 seems something of a Hail Mary pass in this regard. The 1020 offers exclusivity through a 41 Mpixel camera, a first for any smartphone. But the rest of it is generic Windows Phone. Like every other Windows 8 Phone, it uses the same tired old Qualcomm Snapdragon S4 processor.

But it's clear that Nokia doesn't expect profitability to come easily, or soon, and it is in this context that the Nokia Siemens Networks (NSN) buyout is to be understood.

Nokia had already announced that it was buying the Siemens stake in the joint venture for $2.24 billion. $1.58 billion of this will come from secured bank loans and Siemens will issue Nokia a note for the rest, due in a year.

So Nokia bolster's its cash position by gaining full access to NSN's net cash of $1.9 billion, as well as a cash cow it intends to squeeze hard in the coming year, judging by the restructuring it is undertaking at NSN. NSN had already reduced its work force by 12,900 employees compared to Q2 2012, and planned cash outflows due to restructuring are expected to be $924 million for 2013.

The NSN buyout is also consistent with the rumors of negotiations with Microsoft to sell it the Devices and Services business. In this scenario, Nokia becomes a wireless networking equipment and services company. Still a tough competitive business, but not as tough as the end-user equipment business.

Given Google's experience with buying Motorola, I'm not sure why Microsoft would want Nokia's D&S division, and I'm sure that Microsoft is better off without it for the time being. While trying to reshape itself as a devices and services business, the task of managing Nokia's devices and services business would probably be more than Microsoft could handle.