Nokia Corporation interim report for Q3 and January-September 2020

PEKKA LUNDMARK, PRESIDENT AND CEO, ON Q3 2020 RESULTS

“In my first quarter as CEO of Nokia, I have seen both opportunities and challenges. As our solid Q3 results demonstrate, we are making good progress in many parts of our business. Profitability was up on a year-on-year basis, we had the fifth consecutive quarter of solid free cash flow, Nokia Enterprise maintained its double-digit growth, and we continued to strengthen the competitiveness and cost position of our mobile radio products.

When I look ahead, however, the good progress we have made is not enough. Our financial performance in 2021 is expected to be challenging, and more change is needed. We have lost share at one large North American customer, see some margin pressure in that market, and believe we need to further increase R&D investments to ensure leadership in 5G. In fact, we have decided that we will invest whatever it takes to win in 5G. Our customers are counting on us and we will be there for them.

We announced separately today some important changes to our operating model. The goal of this new model is to better align with the needs of our customers, and through that improve our performance and create shareholder value. The changes announced today mark a shift from end-to-end as a strategic principle to a more focused approach with each business group having a distinct role in our overall strategy.

Each of the four new business groups will have P&L responsibility and ownership of creating a path to becoming one of the market leaders in their respective sector. The changes optimize our operating model for better accountability and transparency, increased simplicity and cost-efficiency.

We plan to share more details about our strategy in December and at a Capital Markets Day in March. A more rigorous approach to capital allocation will be key to our strategic direction. As a technology company we will invest to win in those segments where we choose to compete.

Equally important is our view of the future, where we see an opportunity to lead in “network-as-a-service” business models for telecom operators and enterprise customers. This change offers a broad opportunity for Nokia to provide a trusted, software-led and cloud-based network capability that can be rapidly integrated, deployed, and self-managed as a complete service, allowing us to move up the value chain and provide additional “network plus” value-adding services. This vision will take time to become a reality, but Nokia is well positioned to win given our deep experience in delivering carrier-grade network performance and extensive work with webscale companies and enterprises.

I have no doubt that the potential of Nokia is substantial, even if delivering on that promise will take time. We expect to stabilize our financial performance in 2021 and deliver progressive improvement towards our long-term goal after that. We intend to provide an update on long-term outlook at the latest on Capital Markets Day. I am confident that with the right strategy, focus, and operating model we will be successful. Today, we embark on that journey.

NOKIA FINANCIAL RESULTS

The financial information in this report is unaudited. Non-IFRS results exclude costs related to the acquisition of Alcatel-Lucent and related integration, goodwill impairment charges, intangible asset amortization and other purchase price fair value adjustments, restructuring and associated charges and certain other items that may not be indicative of Nokia’s underlying business performance. For details, please refer to note 2, “Non-IFRS to reported reconciliation”, in the notes to the Financial statement information included in Nokia Corporation Interim Report for Q3 and January-September 2020. Change in net sales at constant currency excludes the effect of changes in exchange rates in comparison to euro, our reporting currency. For more information on currency exposures, please refer to note 1, “Basis of Preparation”, in the “Financial statement information” section included in Nokia Corporation Interim Report for Q3 and January-September 2020.

• Both non-IFRS and reported net sales in Q3 2020 were EUR 5.3bn, compared to EUR 5.7bn in Q3 2019. On a constant currency basis, both non-IFRS and reported net sales decreased 3%, primarily due to services within Mobile Access. The services-related declines in Q3 2020 were primarily driven by lower levels of network deployment services, consistent with our expectation, as disclosed in our Outlook section of the Report for Q2 and Half Year 2020. In Nokia Enterprise, we continued to make great progress and delivered 15% year-on-year growth in net sales.
• The impact of COVID-19 on Nokia’s financial performance and financial position was primarily related to factory closures, resulting in a net sales impact of approximately EUR 200 million in the first nine months of 2020, with the majority of these net sales expected to be shifted to future periods, rather than being lost. At the end of Q3 2020, we were no longer experiencing factory closures related to COVID-19. In addition, COVID-19 has affected our operational costs, and we now expect a temporary benefit of approximately EUR 250 million due to lower travel and personnel expenses related to COVID-19 in full year 2020.
• In Q3 2020, non-IFRS gross margin was 37.4% (reported 37.3%) and non-IFRS operating margin was 9.2% (reported 6.6%). During the period, Nokia continued to deliver improvements in gross margin and operating margin.
• In Networks, gross profit and operating profit increased, driven primarily by improved performance in Mobile Access and Optical Networks. In Mobile Access, we continued to drive improvements in our portfolio by strengthening our roadmaps, reducing product costs and improving our product performance. In Optical Networks, our significantly improved year-on-year results were due to a particularly strong Q3 2020, which benefitted from pent-up demand, following the easing of temporary supply chain constraints related to COVID-19.
• Non-IFRS diluted EPS in Q3 2020 was EUR 0.05, compared to EUR 0.05 in Q3 2019, primarily driven by continued progress related to our cost savings program and a net positive fluctuation in financial income and expenses, partially offset by a net negative fluctuation in other operating income and expense, higher investments in 5G R&D to accelerate our product roadmaps and cost competitiveness in Mobile Access and lower gross profit.
• Reported diluted EPS in the first nine months of 2020 was EUR 0.03, compared to negative EUR 0.10 in the first nine months of 2019. The change was primarily driven by lower amortization of acquired intangible assets, continued progress related to our cost savings program, a net positive fluctuation in financial income and expenses and lower costs related to network equipment swaps, partially offset by higher investments in 5G R&D to accelerate our product roadmaps and cost competitiveness in Mobile Access and a net negative fluctuation in other operating income and expense.
• Q3 2020 was the fifth quarter in a row of solid free cash flow. We established a program in Q1 2019 to focus on free cash flow. Since establishing this program, reduced working capital has been a significant source of cash, principally because of lower net sales and, to a lesser extent, improved execution. During Q3 2020, net cash increased by approximately EUR 0.3 billion, resulting in an end-of-quarter net cash balance of approximately EUR 1.9 billion. During Q3 2020, total cash increased by approximately EUR 0.1 billion, resulting in an end-of-quarter total cash balance of approximately EUR 7.6 billion.

COVID-19

The COVID-19 pandemic has made vividly clear the critical importance of connectivity to keep society functioning. We believe we have a resilient customer base, and we feel a sense of duty to our customers and the communities they serve.

We believe the impact of COVID-19 on Nokia’s financial performance and financial position has so far been primarily related to factory closures. Due to significant uncertainties and risks in estimating the impact of customer-related delivery and implementation challenges, we are now focusing our COVID-19 disclosure on the impact of factory closures, which have had a net sales impact of approximately EUR 200 million in the first nine months of 2020, with the majority of these net sales expected to be shifted to future periods, rather than being lost. At the end of Q3 2020, we were no longer experiencing factory closures related to COVID-19. The EUR 200 million of negative impact in the first nine months of 2020 relates primarily to Alcatel Submarine Networks within Group Common and Other, which experienced temporary factory closures that impacted Q1 2020 and Q2 2020.

COVID-19 also affected our operational costs (for example, temporary lower travel), capital expenditures (temporary delays), cash outflows related to taxes (tax relief), and net working capital (for example, lower inventories due to temporary disruptions). In full year 2020, we now expect a temporary benefit of approximately EUR 250 million due to lower travel and personnel expenses related to COVID-19, of which approximately EUR 150 million is expected to benefit operating expenses and approximately EUR 100 million is expected to benefit cost of sales.

Potential risks and uncertainties continue to exist related to the scope and duration of the COVID-19 impact and the pace and shape of the economic recovery following the pandemic.

During the COVID-19 pandemic, we have continued to advance our 5G roadmap and product evolution, as planned, and we believe that our COVID-19 mitigation actions in R&D have been successful. We believe we remain on track with our plans to drive progressive improvement over the course of 2020.

Health and safety

Naturally, Nokia’s first focus during the COVID-19 pandemic is to our employees. We have in place strict protocols for Nokia facilities and provided clear advice to our employees about how they can mitigate the risks of COVID-19 in situations where they have to go about critical work.

We have taken a range of steps, including banning international travel for Nokia employees, except for strictly-defined ‘critical’ reasons; closing all our facilities to all visitors, with the exception of people engaged in essential maintenance and services, and asking our staff to work from home wherever possible. We started implementing these measures in some regions already in January and have updated guidance as the situation has developed.

As the overwhelming majority of Nokia employees continue working remotely, we are providing guidance on how staff can maintain a healthy work-life balance and look after their physical and mental well-being.

Supporting the essential services our customers provide

The products and services that we provide have never been more critical in enabling the world to continue to function in an orderly way. We continue to work closely with all our customers, to ensure that the changing needs and requirements at this time are well understood and that we respond appropriately to them.

In Q3 2020, connectivity continued to bring together people isolated from each other by the COVID-19 pandemic. Remote working and schooling, robust delivery of basic services and smart deliveries are just some examples that have been enabled by our connectivity solutions. Our shared value project with UNICEF in Kenya continued in Q3 2020 with the first schools connected in September using our Fixed Wireless Access solution, FastMile. The work started in early 2018. The current COVID-19 pandemic has underlined the importance of connectivity to enable digital learning and inclusion.

Nokia has a global manufacturing footprint designed for optimized global supply, and to mitigate against risks such as local disruptive events, transportation capacity problems, and political risks. Our supply network consists of 25 factories around the globe and six hubs for customer fulfillment. As a result, at the Nokia level, we are not dependent on one location or entity. We have also established a global command center to manage the supply chain challenges arising from the outbreak; and we are ready to activate relevant business continuity plans should the situation in any part of our organization require this.

Impact on asset valuations

COVID-19 has affected the valuations of certain assets, including investments in non-publicly quoted assets through Nokia’s venture fund investments and pension plans, the valuation of which is inherently challenging in fast-moving market conditions. In Q3 2020, the valuation uncertainty has decreased compared to Q2 2020 but still remains elevated (for details, please refer to note 5 “Pensions and other post-employment benefits” and note 8 “Fair value of financial instruments”) in the “Financial statement information” section included in Nokia Corporation interim report for Q3 and January-September 2020).

In relation to its financial statements as of September 30, 2020, Nokia has also considered the indicators of impairment of goodwill and other intangible assets, recoverability of deferred tax assets, valuation of inventories, and collectability of trade receivables and contract assets. Based on these assessments, COVID-19 is currently not expected to have long-term effects on Nokia’s financial performance that would require adjustments to the carrying amounts of goodwill and other intangible assets or deferred tax assets. Also, Nokia has not identified any material increase in the amount of bad debt or need to adjust the valuation of inventories.

Doing our part to fight the pandemic

We also feel another sense of duty – to the societies where Nokia operates. As a global company, we have a duty to be part of the global fight against this pandemic. In Q3 2020, we also continued our support for the mHealth program with UNICEF in Indonesia where their real-time big data and artificial intelligence platform is allowing policymakers and citizens to understand the levels of physical distancing, movement and mobility at the village level. As a result of the insights from the platform, UNICEF Indonesia has been able to materially assist in the formation of evidence-based policy to fight COVID-19, ensuring a lower disease burden and a brighter future in Indonesia.

These actions demonstrate our strong commitment to supporting global efforts to end the pandemic and overcoming the disruption and challenges we currently face.

OUTLOOK

¹    Free cash flow = net cash from/(used in) operating activities – capital expenditures + proceeds from sale of property, plant and equipment and intangible assets – purchase of non-current financial investments + proceeds from sale of non-current financial investments.

Networks and Nokia Software are expected to be influenced by factors including:

• Our expectation that we will underperform our primary addressable market, which is expected to decline on a constant currency basis in full year 2020, excluding China (This is in comparison to our earlier commentary to slightly underperform our primary addressable market, which is expected to be flattish on a constant currency basis, excluding China). We lowered our expectations regarding network deployment services within Mobile Access, and we lowered our expectations for our primary addressable market, excluding China, due to the impact of COVID-19;
• Our expectation for operating profit seasonality in 2020 to be similar to 2019, with the majority of operating profit to be generated in the fourth quarter. Due to our strong free cash flow performance in the first nine months of 2020, we no longer expect our free cash flow seasonality in 2020 to be similar to 2019;
• Potential risks and uncertainties related to the scope and duration of the COVID-19 impact and the pace and shape of the economic recovery following the pandemic;
• Competitive intensity, which is particularly impacting Mobile Access and is expected to continue at a high level in full year 2020, as some competitors seek to take share in the early stage of 5G;
• Our expectation that we will accelerate our product roadmaps and cost competitiveness through additional 5G investments in 2020, thereby enabling us to drive product cost reductions and maintain the necessary scale to be competitive;
• Our expectation that we will drive improvements in automation and productivity through additional digitalization investments in 2020;
• Customer demand could weaken and risk could increase further in India, after the country’s Supreme Court upheld a ruling that telecoms companies must pay retroactive license and spectrum fees;
• Opportunities and risks in North America following the completion of a merger, and, more broadly, the potential for temporary capital expenditure constraints due to potential mergers or acquisitions by our customers;
• The timing of completions and acceptances of certain projects;
• Some customers are reassessing their vendors in light of security concerns, creating near-term pressure to invest in order to secure long-term benefits;
• Our expectation that we will improve our R&D productivity and reduce support function costs through the successful execution of our cost savings program, which is explained in more detail in the Cost savings program section of Nokia Corporation interim report for Q3 and January-September;
• Our product and regional mix, including the impact of the high cost level associated with our first generation 5G products; and
• Macroeconomic, industry and competitive dynamics.

Nokia Technologies is expected to be influenced by factors including:

• The timing and value of new and existing patent licensing agreements with smartphone vendors, automotive companies and consumer electronics companies;
• Results in brand and technology licensing;
• Costs to protect and enforce our intellectual property rights; and
• The regulatory landscape.

Additionally, our outlook is based on the following assumptions:

• Nokia’s outlook for recurring free cash flow in 2020 is expected to be supported by an improvement in net working capital performance and improved operational results, partially offset by a more substantial difference in 2020 between profit and free cash flow in Nokia Technologies;
• In 2020 and 2021, Nokia expects the free cash flow performance of Nokia Technologies to be approximately EUR 600 million lower than its operating profit, primarily due to certain major prepayments we received from certain licensees in 2014 and 2017 (new);
• Non-IFRS financial income and expenses are expected to be an expense of approximately EUR 250 million in full year 2020 and EUR 300 million over the longer-term. (This is in comparison to earlier commentary for an expense of EUR 300 million in full year 2020 and per annum over the longer-term). Our updated commentary is primarily due to our expectation for lower costs related to the sale of receivables and improved FX results driven by lower expected hedging costs;
• Non-IFRS income taxes are expected at a rate of approximately 26% in full year 2020 and approximately 25% over the longer-term, subject to the absolute level of profits, regional profit mix and changes to our operating model;
• Cash outflows related to income taxes are expected to be approximately EUR 350 million in full year 2020 and approximately EUR 400 million per annum over the longer term until our US or Finnish deferred tax assets are fully utilized (This is in comparison to earlier commentary for EUR 400 million in full year 2020 and EUR 450 million per annum over the longer term.) Our updated commentary is primarily due to our expectation for lower cash taxes in 2020, driven by COVID-19-related tax reliefs and delayed timing of certain tax outflows; and uncertainty related to timing of certain expected cash tax outflows over the longer term; and
• Capital expenditures are expected to be approximately EUR 500 million in full year 2020. (This is in comparison to earlier commentary for EUR 550 million in full year 2020 and EUR 600 million over the longer-term.) We are not currently providing longer-term assumptions for capital expenditures, and our updated full year 2020 commentary is primarily due to temporary delays related to COVID-19.”

 CT Bureau