NOK earnings call for the period ending December 31, 2019.
Nokia Corporation (NYSE:NOK)
Q4 2019 Earnings Call
Feb 6, 2020, 8:00 a.m. ET
- Prepared Remarks
- Questions and Answers
- Call Participants
Hello, and welcome to the Nokia Fourth Quarter and Full-Year 2019 Earnings Conference Call. [Operator Instructions] 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 — Head, Investor Relations
Ladies and gentlemen, welcome to Nokia’s fourth quarter and full-year 2019 conference call. I am Matt Shimao, Head of Nokia Investor Relations. Rajeev Suri, President and CEO of Nokia; and Kristian Pullola, CFO of Nokia are here in Espoo with me today.
During this call, we will be making forward-looking statements regarding the future business and financial performance of Nokia and its industry. These statements are predictions that involve risks and uncertainties. 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 such risks in more detail on Pages 60 through 75 of our 2018 Annual Report on Form 20-F, our financial report for Q4 and full-year 2019 issued today, as well as our other filings with the US Securities and Exchange Commission.
Please note that our results release, the complete interim report with tables, and the presentation on our website include non-IFRS results information in addition to the reported results information. Our complete financial report with tables available on our website 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 Chief Executive Officer
Thanks, Matt, and thanks to all of you for joining. I would like to start my remarks today by talking about the two areas where we will have a particularly sharp focus this year, executing in Mobile Access and strengthening cash generation. I will then come back to an overview of our fourth quarter and give you some more color on our results and what we see going forward. Executing in Mobile Access and strengthening cash generation are the two most pressing issues that we face. Since we announced our third quarter results, we have listened carefully to you, our investors and many other stakeholders. We are committed to improving our performance, and based on the feedback we have received, are taking steps to provide greater transparency on progress against the commitments that we have made.
Before going into the details, however, let me make two additional upfront comments. First, despite our strong fourth quarter results, we still have plenty of work to do, particularly in Mobile Access. We expect to make meaningful progress over the course of the year, and as I said a few months ago, expect our turnaround to have firmly taken hold by the end of this year. Second, while we are very focused on addressing the areas where we need to improve, we saw robust performance in many other parts of the Company in both the fourth quarter and full-year 2019.
On a full-year basis, IP routing continued its strong momentum, gaining significant market share and improving profitability. Nokia Software delivered on its promise, with an operating margin that was up sharply from 2018. Nokia Enterprise also delivered exceedingly well, hitting its double-digit sales growth target and considerably outperforming the market. And Nokia Technologies increased its already excellent profitability. While all of this is good, we are well aware of the fact [Technical Issues] Access is not performing well, Nokia as a Company will struggle to perform well. So let me turn to that now.
To start, let me just be clear about terminology. When I talk about Mobile Access, I’m talking about the combination of our product-focused Mobile Networks business group, and our Global Services organization. This is the right grouping to look at overall mobile performance given the close linkage between the two. In our earnings release, we report net sales for Mobile Access for precisely this reason. Within Mobile Access, our focus is on four key areas: first, improving profitability through consistent product cost reductions; second, maintaining scale to be competitive; third, enhancing commercial management and deal discipline; and fourth, further strengthening operational performance and services.
Let me talk more about each of these topics, starting with improving profitability through consistent product cost reductions, which are essential to improving our Nokia level gross margins over time. We are highly competitive in 4G and are consistently rated as having the best-performing 4G networks in North America, Europe, and other parts of the world by third parties such as RootMetrics, Tutela and others. But as we discussed last quarter, we are facing challenges with high radio product costs in the early stages of 5G.
Our teams in Mobile Networks, procurement, and others are working hard to optimize those costs by addressing every possible part of product bill of materials, including semiconductors, where a transition to system-on-chip is critical. We are making the right progress, but it will take time for those results to show in our financial performance. There is typically about a six-month lag when a new cost optimized product is shipped and when it starts to impact the financials. Volumes need to increase and deployments need to take place.
To address our 5G product cost issues and meet higher performance requirements, we have started rolling out Nokia’s new system-on-chip 5G Powered by ReefShark base station portfolio. These new products made up about 10% of our 5G product shipments in Q4 2019, and we expect that number to increase progressively over the course of the year, ending at more than 35%. For full-year 2021, we would be in the range of 70% and the transition would essentially be complete in 2022.
To give you visibility to how we are performing, we will give quarterly updates this year on the percentage of 5G Powered by ReefShark base station shipped and will flag any issues that we see, both positive and negative. As of today, we are tracking against our plan and have seen some of our SoC development proceeding slightly ahead of schedule. This is complex work, however, so there is always a risk of issues or delays. That said, we are now shipping our 5G Powered by ReefShark Massive MIMO product, which launched at the end of 2019. Volumes will ramp up over the first half of the year as new variants are added, and we expect to have a full lineup of 5G Powered by ReefShark Massive MIMO by the end of the second quarter.
New 5G ReefShark-based products will continue to come and we saw the successful tape out of two new chips in January. As I’m sure many of you know, tape out is the final step of the design process before chips are sent to be manufactured into engineering samples for product integration and testing. We’re also making good progress on the next releases of 5G software with integration and verification showing improving quality and maturity compared to earlier releases. These efforts are being boosted by both added R&D headcount and better productivity. In short, we are tracking well, but there is still plenty of work to do.
The second issue I want to discuss is maintaining scale and specifically scale related to mobile radio products. We expect that when all the results are in, Nokia will have a 4G plus 5G market share in the range of 27% for 2019, excluding China. While this means we lost some share in the year in this part of our overall primary addressable market, we expect to stabilize at approximately the same level, 27% for 2020. Normal footprint fluctuations, of course, are always possible but we have and expect to continue to have the necessary scale to be competitive. One reason we have that confidence is that, our 5G win rate remains strong. This metric factors in customer size and measures how we are doing in converting our end of 2018 4G footprint, as well as adding new 5G footprint where we did not previously have a 4G installed base.
At the end of the fourth quarter 2019, our 5G win rate was over 100% excluding China, and in the mid-90% range, including China. Reflected in this overall performance, we have seen gains in Korea, Japan and the Middle East, offset by some losses, including in limited parts of Europe. In addition, we added two new communication service provider customers, where we do not currently have a 4G footprint. One of those being the publicly announced deal with Vodafone Hutchison Australia, the other is a European operator that is not public. In short, outside of China, our position remains strong with customers where we have an existing 4G base and we’ve added some new 5G customers as well. As of today, we have 66 5G deal wins and 19 live networks deployed. Pleasingly, we also added two new Enterprise 5G customers, including Deutsche Bahn. So that you can track our progress going forward, we will give quarterly updates on our win rate, as well as a qualitative view on customer developments that we are seeing. While the win rate is a good way to look at longer-term developments, near-term outcomes will be impacted by things like purchase orders, network rollout timelines, deliveries, and customer acceptances.
As additional background, three comments. First, we are focused on 4G plus 5G share figures as that is the best way to assess the question of scale and purchasing power. It is also increasingly difficult to disaggregate the two technologies’ products like Massive MIMO can be used for either one. Second, we are looking at our 4G plus 5G share, excluding China, given that pursuing share in China presents significant profitability challenges and the market has some unique dynamics. As you know, we are a long-term player in China, and it worked hard to meet requirements in the country, including support for the TD-SCDMA standard when no other Western vendors stepped up. We will continue to engage with our operator customers in China to support their 5G ambitions, but what we do with them needs to work for Nokia as well.
I want to be very clear that we are not backing away from China, but simply executing against a clear strategic goal to improve our overall business mix in the country. This means that we will be prudent in 5G, while targeting more attractive opportunities with service providers in core, routing, transport, fixed access, and our current 4G business, as well as with enterprise and web scale customers. We still expect to be a sizable player in China well into the future, and with the procurement rounds still to come, our final position in 5G will only be clear in time.
Third, I want to emphasize that if you look at our performance in 2019 against our total primary addressable market, excluding China, we were in line with market growth. The losses in mobile radio that I just mentioned were largely offset by gains in IP routing, optical, and mobile packet core.
The next focus area in Mobile Access is enhancing commercial management and deal discipline. Over the course of 2019, we have put in place strengthened commercial management processes designed to drive better performance in current contracts and improve outcomes in new ones. Deal decisions now include a sharp focus on cash and return on capital employed metrics, improved contractual terms and formal upsell commitments, as well as our standard revenue and margin requirements. We’ve also reviewed projects and customers that do not perform to our standard and have identified levers to enable better future outcomes. In some cases, there are projects where we will renegotiate terms, and in fact, there are some where we are already doing so. As expected, these new processes have already generated meaningful margin opportunities for Nokia in 2020 and we have included these into targets for sales teams and others.
Finally, further strengthening operational improvements and services, where as I’ve noted before, a turnaround is starting to take hold as we increase operational discipline and enhance our efforts to manage for margin and cash. I’m pleased that we saw progress in our Global Services operating margin in full-year 2019 compared to 2018, even if we are still below what we believe we can achieve. I also expect progress to continue in 2020 given better execution, although we will have some headwinds given a roughly similar level of network deployment services as in 2019 as new 5G builds proceed.
Improvements in 2019, particularly in the second half, were driven by a number of things, including turnaround of poorly performing projects, strict execution discipline and enforcement of standard delivery models resulting in fast and first time right network deployments, investments in digitalization and automation-driven productivity, which are starting to show results, the exit of six low-margin managed services deals, tighter control of inventories, and strengthened capabilities and new customers and higher margin growth areas. All of this work should be reflected over time in our Networks’ gross margin as the drivers and actions I just discussed take hold.
So, to conclude on Mobile Access, we will start to provide regular updates on: one, progress on improving 5G product cost through a transition to our 5G Powered by ReefShark portfolio; two, a qualitative assessment of progress against our goal to stabilize our 2020 4G plus 5G market share level, excluding China, at a similar level to 2019; and three, our 5G win rate, which is a good proxy for our longer-term 5G market share position.
Now, let me turn to our second focus area of strengthening cash generation. We saw solid cash performance in the fourth quarter, with a EUR1.4 billion increase in our net cash position, allowing us to end the year with a net cash balance of EUR1.73 billion. We expect 2020 to be free cash flow positive. As we noted in our third quarter announcement, our Board said that it expects to resume dividend distributions after Nokia’s net cash position rises to approximately EUR2 billion. Given typical cash seasonality, we would not expect to reach that level in the first three quarters of this year. Should we exceed the EUR2 billion level after that point, the Board will assess the possibility of proposing a dividend distribution for financial year 2020. In his remarks today, Kristian will give a deeper perspective on the drivers of cash this year, where we faced some particular headwinds related to Nokia Technologies and restructuring.
We have a structured program in place, including a centralized war room to drive a Companywide focus on free cash flow and release of working capital. Project asset optimization, strengthened contractual terms with customers and suppliers and reinforced controls across our supply chain and management of inventory. With the work we did in 2019, we were able to reduce inventories in the fourth quarter to the lowest level since the first quarter of 2018. Going forward, we have further increased the weight of cash targets in the incentives, not just for Nokia senior leaders, but for many on the front line with customers. We expect this change will ensure that we maintain our momentum in this critical area.
Kristian will also talk about how we will adjust our approach to earnings per share guidance, but now let me turn to the fourth quarter where we delivered strong results. While Nokia level constant currency net sales were down, we slightly increased operating margin compared to the same period last year, generated strong free cash flow, and increased our net cash balance to EUR1.73 billion, as I said. Despite the generally good performance in the quarter, our Networks’ gross margin is where we face challenges, coming in at 34.2% for Q4 2019 versus 36.3% in Q4 2018. On a full-year basis, Networks’ gross margin was 30.6% for 2019, compared to 34.7% in 2018.
On a full-year 2019 basis, Nokia level net sales were up 1% in constant currency globally, and 5% excluding China. And our non-IFRS operating margin was down about 1 percentage point versus 2018. We remain on track with cost reduction initiatives relative to our commitment to reduce 2020 cost by EUR500 million compared to 2018. In 2019, we achieved EUR200 million of recurring cost savings, as expected, even when you exclude the savings benefit from the release of employee incentives. We did this despite facing considerable currency exchange headwinds of EUR125 million.
Given that I’ve already addressed Mobile Access, let me talk briefly about the Q4 performance in our other business groups, starting with IP and Optical Networks or ION. Overall, our momentum in this business was very good. ION’s best quarter ever in terms of both absolute profits and profitability, and one of the best as far as sales go. Our FP4 product leadership in IP routing, combined with the power of the global Nokia sales channel helped deliver constant currency growth of 6% in the quarter and 12% for the full-year, excluding the video business that we’re exiting. At a time when the routing market is declining, we are clearly gaining share while also improving profitability. Optical Networks had a good year and fourth quarter. Constant currency Q4 sales rose 16% year-on-year, and profitability increased meaningfully for the full year. Even if there is plenty of work still to do, including continuously reducing product costs, we can now say with confidence that we are one of the scale players in Optical. Pleasingly, our leading PSE-3 chipset is shipping in volume and has already been deployed in the first direct optical connection between the USA and Africa with Angola Cables.
Next, Nokia Software, where our underlying performance has also been strong. Profitability, as I said, was very good with full-year operating profit, that was up sharply by 31% compared to 2018. Software sales were down in the fourth quarter and slightly for the full-year on a constant currency basis, but I want to make two points to put those results in context. First, we had a tough compare in the fourth quarter, given that the same period in 2018 was Nokia Software’s strongest top line quarter on record. Second, on a full-year basis, software grew in every region except China and India. As you know, we report India as part of the Asia-Pacific region. Overall, I remain confident that the trajectory is in the right direction for our Software business.
Then Nokia Enterprise. I talked on previous calls about a goal of double-digit growth for full-year 2019, and the team delivered that. Constant currency year-on-year net sales growth was 33% in Q4 and 18% for the full-year versus 2018. Q4 and full-year 2019 absolute profits and profitability both improved year-on-year. For 2020, we are aiming for double-digit sales growth again. Importantly, for a business in growth mode, we added nearly 40 new customers in Q4, including Microsoft to close with 122 new logos for the year, excellent growth.
Two important things for you to consider when assessing our Enterprise business. First, we have moved quickly to grow the business from less than 5% of our total revenue to about 7% in 2019. If we maintain our trajectory, I see no reason why we cannot get to 10% and even beyond. Second, while we have been very successful in leveraging our routing and optical portfolios in the Enterprise, we are now seeing rapid uptake of our wireless capabilities. We more than doubled the number of private wireless customers in 2019 to around 130 in total and see continued robust demand in the market.
Next, Fixed Networks, which continues to face challenges in the market transition from copper to fiber, as I have noted before. We saw some initial signs of progress in Q4, including a lower decline rate in constant currency year-on-year sales and strongly improved profitability compared to the first three quarters of the year. On a full-year basis, however, the results from Fixed were disappointing. We continue to have a sharp focus on costs and have targeted selective expansion in new areas, particularly Fixed Wireless Access, where the pipeline is robust.
Finally, even though Nokia Technologies sales were down in both Q4 and full-year 2019, profitability remained robust with a 320 basis point increase in operating margin for the full-year compared to 2018. Excluding 2018, revenue from our divested Digital Health business, licensing revenues in 2019 were roughly stable. Our existing license agreements provide us with some near-term stability in this business, and as renewal deals come up, we will be adding our strong portfolio of 5G patents into the current licensing package of earlier generations of mobile technology. We believe these new patents have meaningful value for us to tap in the future.
With that, let me turn to giving a regional perspective and to first say that we expect that when all the results are in, we will have gained share in our primary addressable market in every region with the exception of China and Asia-Pacific. Asia-Pacific, while very strong in many countries, was impacted by India, more on that in just a moment, where we had a slight decline in share, but we will not be sure of how much until we see all of the operators report their 2019 capex. On a constant currency, full-year 2019 basis, we saw sales increase in Asia-Pacific, Europe, Latin America and North America. Sales were down for the same period in Middle East and Africa by 2%, but that was still a good performance in the context of challenging market dynamics. It is also pleasing to see that we have now been chosen by early adopter operators in the leading 5G markets from Sprint and Verizon in the US, to SoftBank in Japan, to Korea Telecom in South Korea, among others. In addition to being selected by Orange, France, and O2 in the UK.
I’ve already talked in detail about China and would now like to share some more color on North America and India. With 5G deployments progressing in 2019, North America saw 1% constant currency sales growth for the full-year, despite a 5% constant currency decline in the fourth quarter. Uncertainty related to the announced operator merger where we have a large footprint has continued to present challenges. And as I said last quarter, we cannot predict when this situation will be resolved. We ended the year having launched 5G networks in many US markets and expect that progress to continue in 2020.
Next, India, which we report as part of the Asia- Pacific region and which is a country where we have a long history and robust share. As I’m sure you know, India’s telecom sector is in the midst of some serious turbulence. A general market slowdown after multiple years of heavy 3G and 4G investments by operators was exacerbated when the Indian Supreme Court recently ruled that operators need to pay large accumulated financial liabilities dating back several years. Like other companies in this market, Nokia is now trying to fully understand the full potential impact of these developments and their impact on customer demand and overall market risk. It is too early to say how the situation will play out, but it is certainly an area that we are watching closely.
With that, let me turn the call over to Kristian.
Kristian Pullola — Chief Financial Officer
Thank you, Rajeev. I will take a different approach today than in previous quarters. I will start with cash, as this is what we do internally nowadays in all our meetings to remind the organization of the focus needed. I will then continue with a brief summary of our financial results for Nokia Technologies and Group Common and Other, then take a look at Group level results in Q4 and full-year ’19; and finally, I will quickly provide an update on our cost savings program and close with some remarks on our guidance.
Okay. Let’s start with our cash performance in Q4. On a sequential basis, Nokia’s net cash increased approximately EUR1.4 billion to a quarter-end balance of approximately EUR1.7 billion. The higher-than-expected cash balance was partly driven by lower-than-expected restructuring cash outflows, where approximately EUR100 million moved from ’19 to ’20. Free cash flow was positive EUR1.4 billion in Q4, primarily driven by operating cash flow, which benefited from a solid adjusted net profit, net cash inflows from net working capital, and a one-time benefit as a result of settling certain interest rate derivatives. This one-time benefit totaled EUR190 million, of which EUR160 million positively impacted free cash flow and EUR30 million positively impacted cash from financing activities. These inflows were partly offset by outflows related to capex, restructuring, cash taxes, and a convertible loan to one of our partners.
To give a bit deeper — to dive a bit deeper into net working capital. Excluding restructuring cash outflows, we generated EUR320 million from net working capital, primarily driven by a EUR680 million decrease in inventories, as expected. There were two key parts to achieving this. First, our solid Q4 net sales enabled us to reduce our previously existing inventories in accordance with our plans. Secondly, our efforts to optimize our incoming inventories has kicked in strongly. The team has quickly resumed disciplined execution and we are pleased to see the improvement in our numbers. Offsetting this, receivables increased EUR360 million, mostly driven by seasonality, partly offset by improved collections, including higher sales of receivables. In Q4, we were also able to collect a portion of the overdue receivable from a state-owned operator and we expect to collect the remainder in the upcoming quarters.
Liabilities were approximately flat, as we did not see typical seasonal increases in accounts payable. This was due to a combination of two things. First, already having high inventory levels earlier in the year. And second, our successful efforts in improving our inventory management.
The strong free cash flow performance in Q4 led to a full-year free cash flow that was somewhat negative, as expected. While we are showing signs of progress, there is clearly still more work to be done here. We have plans for this and we are making needed changes, and we’ll track the execution very closely throughout 2020. As I have explained in the past quarters, the whole Nokia organization has put extensive focus on free cash flow.
One area I would like to provide a bit more clarity around is our cash conversion, meaning converting our non-IFRS profits into free cash flow. We are focused on improving our cash conversion over time. We do, however, have two large headwinds in 2020. First, our free cash flow continues to be negatively impacted by restructuring. These outflows amounted to EUR450 million in ’19 and are expected to be EUR550 million in ’20. Second, while Nokia Technologies business generates a strong operating profit, the annual free cash flow performance can differ significantly from our P&L performance, both up and down. This has to do with the structure of some of the agreements, where we receive large prepayments in cash. We put this on our balance sheet and recognize this as net sales over the lifetime of the agreement. Due to these factors, we expect a substantial gap between P&L performance and free cash flow performance in 2020. Of course, over the life of each agreement, the free cash flow performance matches the P&L performance.
On the other hand, we expect four tailwinds for our cash conversion in 2020. First, the fact that our capex is lower than our depreciation and amortization, mainly due to the adoption of IFRS 16. Second, our pensions-related cash outflows are less than our P&L expenses as we can utilize our pension surpluses to offset cash requirements. Third, financial interest where our cash outflows are less than our non-IFRS P&L expenses, mainly due to some non-cash expenses related to the interest component of certain customer contract booked in financial interest. And fourth, taxes where our cash taxes are lower than our non-IFRS P&L taxes, due to the utilization of deferred tax assets. The four tailwinds are relatively small in size, and as a result, we face significant overall headwinds when it comes to converting our non-IFRS profits into free cash flow in 2020.
Therefore, our positive recurring free cash flow guidance in 2020 is driven by our assumptions of an improvement in net working capital performance, as well as improved operational results. This will be partly offset by a larger expected difference in 2020 between profits and free cash flow in Nokia Technologies. Over time, we expect the gap between our non-IFRS net profit and free cash flow to narrow, particularly as our restructuring cash flows decline. Of course, if we signed any new license agreements that include large cash prepayments, our free cash flow performance could be better than our non-IFRS net profit in one quarter or a year, and then the gap between our non-IFRS net profit and free cash flow could reexpand.
Two final points here. First, a purely accounting topic, and this relates to the implementation of IFRS 16, which involves leasing payments. This was implemented at the start of ’19, which means that our ’18 and ’19 cash flow statements are not fully comparable. Approximately EUR220 million of cash outflows that were shown in cash outflows from operating activities in ’18 are now shown as cash outflows from financing activities. This has a positive impact on our net cash from operating activities and a negative impact on our cash — net cash from financing activities. Also, this had a positive impact on our recurring free cash flow calculation in ’19. However, no impact on net cash. Second, FX moves can have a large impact on net cash.
Then over to Nokia Technologies, where the team finished ’19 with a — with good results. While Q4 net sales declined 11% year-on-year, this was primarily related to higher one-time sales in the year ago quarter. Excluding these, net sales would have declined slightly year-on-year. Our annualized licensing run rate continues to be EUR1.4 billion. From a profitability perspective, Q4 operating margin improved 310 basis points. This was primarily due to lower patent portfolio costs and lower licensing-related litigation costs.
Moving on to Group Common and Other. Net sales declined 11% year-on-year on a constant currency basis as declines in Radio Frequency Systems or RFS were partly offset by growth in Alcatel Submarine Networks or ASN. In RFS, net sales were negatively impacted by temporary capex constraints in North America related to ongoing merger activity, as well as the absence of a large customer rollout which benefited the year ago quarter. In ASN, growth was driven by the ramp-up of new projects, which are also expected to benefit 2020. ASN closed the year with a very strong order book.