2023-09-05 17:13:02 ET
Nokia Oyj (NOK)
Goldman Sachs Communacopia + Technology Conference
September 5, 2023, 01:50 PM ET
Company Participants
Pekka Lundmark - President & Chief Executive Officer
Conference Call Participants
Alex Duval - Goldman Sachs
Presentation
Alex Duval
Hi, everyone. I'm Alex Duval. I head up the Europe Tech Hardware team for Research, Goldman in London. Delighted to be here with Pekka Lundmark, CEO of Nokia. Thank you also all for joining and look forward at the end of this Q&A to be doing some audience questions as well. Just like to state, the conversation is not intended for the media and is off the record. So once again, Pekka, thank you so much for joining.
Question-and-Answer Session
Q - Alex Duval
Maybe we can just kick off with some high-level questions. Firstly, we could talk about the 2023 outlook for the wireless market. I think you pointed recently to the broader industry trend of inventory digestion, and lower CapEx at some players in North America. So, what's your latest view on scope for recovery in the second half of this year? And to what degree is there some [services and baked] (ph) into your guidance that second half mobile networks and network infrastructure revenue is going to be roughly flat?
Pekka Lundmark
The big picture in the operator investments is really that because of the supply chain crisis that they experienced -- the industry experienced in ’21 and ‘22, in ’22 they bought more than they built. And in ‘23, they are buying less than they built. And, the big picture is that in ‘24, we expect this kind of to normalize. Then another question is then that how much do they build then? And there we are also seeing some cyclical downturn in terms of their network build-outs be it, and this is something that I believe they are still themselves figuring out that how will then this look like in ’24, ‘25. Of course, the macroeconomic development is playing into this inflation and high interest rates is affecting their spend. And as we all know, that industry is in a way cyclical. But the good thing is that, for us is that, we are gaining share in a market that is structurally a little bit weak at the moment, but we are strengthening our relative position there. And ultimately, it is a question of timing that when they will have to start spending again, because the data traffic keeps on growing 20% to 30% per year. And if they want to stay competitive, eventually, they will have to start investing again.
Alex Duval
Makes total sense. And you talked about hopefully getting to an equilibrium level by next year. What are your thoughts on the sort of growth level for the wireless market as you go into 2024? Some investors ask whether there could be a risk that some of the sort of weakness in '23 as it were spilled into '24? So how much confidence do you have on growth next year?
Pekka Lundmark
It all depends on their network build-out speed. I believe the inventory digestion question will be more or less behind us in '24. That's a very difficult question to answer. If we look at -- for example, what Dell'Oro is saying about North American wireless infrastructure market. This year is down significantly 35%. And I think the latest they are saying is, was it plus 14% for next year? So this is kind of consistent with what I said earlier that, that '22 was, in a way, a peak here, then more than normal, then ’23 was below normal, and then ‘24 hopefully would be somewhere in between.
Alex Duval
Got it. Makes sense. And if you were to think on a sort of two, three-year view, how are you thinking about the market? What are your thoughts on the drivers and growth level?
Pekka Lundmark
Well, there are big differences, of course, in terms of those drivers between the CSP market and the -- then the enterprise and web scale market. The CSP market as a whole will not be a fast growth market, low single-digit kind of trajectory through the cycle at best. So if you want to grow in the CSP business, you have to take share, and that's exactly what we've been doing. We've been investing a lot in technology, and we have been improving our relative position there. So it is possible to grow in the CSP space as well. But then, of course, the real growth driver will be enterprise. And there are two, three big things there, of course, on the web scale side and data centers.
AI is driving significant investments there. And then the other part is then the enterprise digitalization where so far, the investments have been driven by IT needs when you put ERP workloads on cloud. But then the thing that is now happening is that operational technology gets connected, gets networked, all these machines are getting connected, and that increases the requirements on network. So the enterprise networks are also presenting much more than before kind of mission-critical CSP type of network requirements, and that is an extremely important thing for us.
Alex Duval
Makes sense. I'd like to now zoom in a bit on North America. We've kind of talked holistically. But if we think about North America, how realistic is growth next year? I think one of your peers is talking about sort of positive rebound in growth rates despite the fact Dell'Oro has just fairly meaningfully revised down growth this year for even chunkier declines. So what gets the market kind of growing next year in North America, given that, that was one of the earliest markets that started adopting various flavors of 5G?
Pekka Lundmark
Well, again, I'm referring to what Dell'Oro -- if you ask specifically about 5G infrastructure market in North America, what Dell'Oro is saying, minus 35% this year and plus 14% next year. So they are expecting a rebound. But ultimately, this goes back to operators' decisions as to their rollout speed. But the reality is that in North America, only about half -- slightly over half of the base stations in 5G have been upgraded to mid-band. So if operators want to stay competitive, they will have to continue to invest.
Alex Duval
Got it. Let's perhaps pivot to India because that's been a big story this year. We've seen it emerge as a strong growth driver for the wireless industry. Can you talk about how much sort of further opportunity for growth there is? Is this the peak? Because, obviously, things rolled out perhaps a bit faster than people thought? Or is there still an opportunity for future growth there, either driven by the market itself or perhaps your strong market share position getting even better in the region?
Pekka Lundmark
Of course, the big needle mover for us in India is the fact that we broke into the 5G network of Reliance Jio, which was 100% Samsung Network in 4G. And now we are a significant supplier in 5G. And why is this important? Jio network is the largest mobile network in the world outside of China. They have about 300,000 base stations in their network. The US carriers, I think they are around, what, 80,000 to 90,000 each to put things into perspective. So this is a significant needle mover for us.
And remember, our Indian revenue in 2022 for the whole group was EUR1.3 billion. Now we have over 300% growth in the first half of the year. Of course, that type of growth will not continue, and we are expecting some normalization in the second half of this year and then into '24 as well. But the big picture in India is that if '22 was here, EUR1.3 billion, then -- the '22 was EUR1.3 billion, '23 will be exceptionally high, then the new run rate, new normal will be somewhere in between, but significantly higher than the EUR1.3 billion that we had in '22.
Alex Duval
Makes total sense. And could you just help us think a bit about the kind of performance requirements you've seen in India? Is there anything you particularly call out? And how does that play into the strength of as it was a new Nokia where you have higher quality silicon and better performance?
Pekka Lundmark
I think it's a little bit of a myth that customers in countries like India would have much kind of lower requirements and so on. There is some difference. And if I generalize a lot, I would say that in some of these countries, in some cases, kind of off-the-shelf products are okay. But at the same time, also Indian customers are extremely demanding in terms of their requirements. But the difference is perhaps that some of the Western largest operators, they have a traditionally significant R&D departments of their own that have really kind of taken the network specifications to the perfection that they have always had a lot of customer-specific requirements that we are not seeing quite to the same degree in countries like India.
Alex Duval
Makes sense. And how should we think about profitability? Because that was also a topic of conversation, I think, before these rollouts started. Can you help us sort of think about that a little bit?
Pekka Lundmark
Well, there are obviously margin differences between regions, and it's no secret that North American margins have been higher than in most other parts of the world. India has been a little bit lower, but still they are not horrible margins in any way. India for us is gross margin dilutive. But it is still operating margin increasing accretive because of the high volume. Of course, we have to remember that this -- the key characteristics of this business is high fixed cost because of R&D, EUR4.3 billion last year and to be able to cover that investment you need high market share, you need high volumes.
Alex Duval
Brilliant. Now, I'd like to shift on to network infrastructure in a minute, but perhaps my last couple of questions on wireless and particularly on the sort of market share situation. As I alluded to before, you've done a ton of work to improve your product. It feels like you're clearly moving ahead quite well. And it'd be great to get your assessment on sort of where you are now? And to what degree you see further opportunity for share gain, either as a function of that particular investment or continued opportunities from some of these Chinese vendors? Where do you see the opportunity for share? Because it feels like the last few quarters or even years, you've actually improved your market share position in wireless in quite a number of markets.
Pekka Lundmark
So in network infrastructure, just in case there are people in the audience who have not noticed, but network infrastructure business in 2020 delivered an operating profit of slightly more than EUR400 million in 2020. In 2022, the operating profit was EUR1.1 billion. So in two years, from EUR400 million plus to EUR1.1 billion in operating profit. And that is a combination of two factors. It's a significant increase in technology competitiveness in pretty much all the segments. And that combined with a higher market share, and you will have seen the growth -- top-line growth in segments like fixed networks, for example. There is now some normalization in operator spending also in the network infrastructure side, but also here, the fundamentals are extremely good because the data traffic, as discussed, will continue to grow and, for example, fixed broadband penetration in most parts of the world is still extremely low. And once the fiber is in the ground, it will provide you an internal upgrade opportunities for new capacities and so on. So we are extremely bullish on the overall kind of outlook of this business.
There are market share gain opportunities also here, including from Chinese competitors. Of course, there are in some countries political considerations where people do not want to have vendors from certain countries. We are positioning ourselves as a trusted vendor that you can rely on in all situations. And of course, we come from a trusted country, and we are a trusted company. That is an important thing in many customer decisions. But then there is, of course, a technology race also. We are now moving to 5-nanometer technology and then in the coming years to 3-nanometers. And then all of the competitors will not be able to follow that development.
And then one final point kind of on where the demand for all of this will be going. When you look at the -- where the world of technology is going, there are -- there's one hugely important thing, obviously, as we all know, is cloud compute. The world is becoming a massive decentralized computer. The other big thing is AI that is crunching all this data. These are the two anchors. But the third thing that you do need is the network that connects all those nodes. So the three big things you need is cloud compute, AI and the network. And that network, obviously wireless is a big driver there. But in relative terms, an even bigger driver for AI will be data center interconnect and all the routing and optical connections that will be needed to connect all the users to the data centers. And that will be the fundamental driver of NI demand for many, many years to come.
Alex Duval
It's brilliant. I think that segues very well into my next question, which is just to ask you to give a sort of high-level view of the latest dynamics you're seeing in each kind of main segments within network infrastructure. For example, if we look at the fixed access portion of your business, there should be some opportunities in terms of fiber investment, governmental investments and things like that. But be great to get a bit of a picture across that and IP networks, optical and so on.
Pekka Lundmark
Yes. As you know, we have four businesses inside the network infrastructure business group and kind of to simplify this a lot. We have had two businesses that have, for the past two, three years, performed really, really well, and they are IP networks that has been on high profitability for several years already, kind of high teams in terms of operating margins. There, we have been gaining share, especially in the edge routing. We are now penetrating the core routing and very importantly, penetrating into web scale switching. We had a switching deal with Microsoft, for example, last year, which is really a breakthrough into a new growth segment. And the non-CSP share of the IP network business is about 20% at the moment. And that's clearly where the growth will come from. So profitability has been good. Now we need more growth.
Then the fixed access is something that has had extremely strong growth in -- both in '21 and '22. Now we are seeing some normalization of that growth because the comparables comps are getting much tougher. But also there, the fundamentals are extremely good because, as I said, the penetration rates of homes passed and homes connected in most parts of the world are still very low, and we are clearly the technology leader in passive optical networks. We have over 40% market share in in OLTs, which is the central office side of the broadband connection in the whole world. And again, as I said earlier, once the fiber is in the ground, you first upgrade to 1 gigabit capacity then you upgrade to 10 gigabits and then 25 gigabits and so on. The US government has said that their goal is to have a 1 gigabit service for every citizen in the country. And that's why they are, for example, investing in this BEAD program, which is connected to the Buy America initiatives, and we are now the first vendor to meet the requirements of Buy America for broadband, which means that we are the first one to qualify for the BEAD funding, which has now been allocated to the states.
It's all together EUR43 billion, I think, is the fund and about 10% of that will turn into addressable market to Nokia. And we have currently about 60% market share in the US for this type of application. So we believe that we will be a key beneficiary of these government spend programs for broadband. And of course, the BEAD program in the US is only one example programs that we are seeing different -- in different parts of the world. So that's the fixed broadband business.
Then optical networks is a really interesting case because that is unlike the two others, that has been subscale in terms of size and market share and also consequently, profitability in the recent years, but there is strong improvement there now. We have invested a little bit in the same way as in 5G -- we have invested a lot in technology development recently. And now we have our two latest generations, PSE-5 and PSE-6, which will start ramping at the end of this year, which is our 5-nanometer technology solution, which gives, for example, superior ranges for 800 gigabit Ethernet services that will help operators to optimize their network architectures, it's getting a lot of traction. We have a good growth in optical now in the first half of the year. And gradually, that is turning into profitability as well. This is a business that despite the overall good profitability of NI, but optical has clearly been behind. It has been in low single digits, and our goal is high single digits in that business.
And then the final business, which is subsea networks. Obviously, there is a lot of demand in this business driven by web-scale investors who are building their own subsea networks. There is a lot of political interest in this business also because obviously, most of the traffic in the world is touching or going through a subsea cable at some point, and there are quite significant geopolitical and also defense and military connections to the security of this network. So this is also highly relevant in today's world. The nature of this business is different from our other businesses. It's in a way offshore project business where you are laying and maintaining cables -- undersea cables. Demand is good. Profitability has so far been on the low side. But in the new deals that we have made, we have gradually been pumping up the margins and profitability. So that is also going to the right direction. So good dynamics actually in all businesses in NI at the moment.
Alex Duval
Very helpful. And I guess just to go back to this point about sort of inventory clear out, I think you sort of helped us understand that on wireless. To what degree is there sort of different timing or time line for that if you think about network infrastructure? Is it broadly similar? How should we be thinking about it?
Pekka Lundmark
It is -- I would say it's broadly similar. And the operators stockpiled especially customer premises equipment in '22 when they were afraid that they would not be getting enough. So in a way, compared to the rollout, they overinvested in or overpurchased in '22. Now they are under purchasing this year compared to the rollout, and then we expect that to normalize in '24.
Alex Duval
Got it. And it sounds like your sort of characterizing dynamics is pretty good in network infrastructure. Obviously, we've seen some players like Juniper guiding a bit more conservatively than people had expected and some of that probably reflected orders to my understanding. So how should we sort of conceptualize your positive view in that context? Is it more just that as well as market dynamics you need to overlay the kind of share gain opportunities and the product cycles which you're undergoing?
Pekka Lundmark
Of course, we have cases where we are gaining market share. But still, I would say that talking about this inventory digestion dynamics and network rollout speed, I would actually say that our view is pretty similar to what we have seen from some of the competitors and clearly seeing some of the dynamics that are slowing down the orders, especially this year because, again, operators did overspend a little bit in '22 and now they are maybe underspending in '23.
Alex Duval
Great. Really keen to leave some time for questions at the end of the fire side. But maybe we can discuss two group level topics. Firstly, margin, secondly, cost control. So I think you recently reiterated your long-term EBIT margin target and talked about sort of 14%, if I remember rightly. What are the key levers and drivers that kind of underpin that? And then at the same time, despite recently adjusting your 2023 top-line guidance, you actually only narrowed your EBIT margin target. So can you help us understand a bit the moving parts?
Pekka Lundmark
We have taken a lot of proactive actions on the cost side because we were kind of expecting that this slowdown in inbound would be coming as you -- some of you may remember, we announced already in '21, a EUR600 million cost reduction program where we said that the pace of that program or the speed execution period will depend on the overall market demand which was really strong in '22, which -- as a result of which we did not move that quickly in '22, but we are clearly accelerating that now, and we are still keeping the targets that we published when it comes to the cost position at the end of '23.
And as you have seen, despite the weak demand and actually extremely weak demand in our most profitable market, which is North America, which was minus 40% in the second quarter, a catastrophic number, I would say. Despite that, we delivered 11% operating margin in Q2, which shows that we are -- have been able to increase our cost resilience quite a lot. And my message has been very clear that should it be so that this weakness in overall demand from operators would persist longer than expected, we are ready to take more action on the cost side if needed. This is not time to announce anything like that, but we are following this very carefully, and there is more to come if needed.
Alex Duval
Great. Well, I think we have 10 minutes left on the panel. I see someone with a microphone over there. So if anyone would like to raise their hand, yes, perhaps the gentleman at the back.
Unidentified Analyst
Can you comment a little bit about your strategy for private networks -- enterprise private networks?
Pekka Lundmark
Sorry, what's the question about -- private enterprise networks?
Alex Duval
Enterprise private network.
Pekka Lundmark
Yeah. Absolutely. Thank you. That's a great question. We had -- as I said, first of all, in terms of the market demand, since CSP market will not be a growth market, and the only way there to grow is to take share, it's a completely different situation in enterprise markets and non-CSP markets, where the first driver, obviously, is web scalers, data centers and AI where we are making big moves. But then the other thing is really then the kind of enterprise networks for different verticals, where the big driver is that when in the past, this -- for example, routing investments were driven by IT needs, where you put your ERP and other workloads on cloud and you need to invest in routers.
Now the big thing that is going on in industrial campuses is the digitalization and build and making the operational machines connected, and that puts a totally different set of requirements on the networks. The enterprise networks are actually becoming mission-critical networks in a completely way -- completely different way than before. They start to resemble some of the requirements of the CSP networks. And that's fully understandable when you all of a sudden, if you start connecting cranes in a container terminal or moving machines in a mine or robots or in the future industrial drones and so on. It's totally different requirements on bandwidth, on quality, on latency, on end-to-end security of the network and everything and that it really the sweet spot for us in enterprise, because we know how the CSP networks work, and we want to bring all that expertise to the mission critical networks of enterprise.
This is still a fairly small business for us. It was EUR2 billion last year, less than 10% of our top line. We had 27% growth in the second quarter, even higher than that in the first quarter. And as I have said, we want to make non-CSP revenues to be as quickly as possible, 10% of our sales. And then after that, it needs to go to 20% and then to 30%.
Alex Duval
Time for another question. Gentlemen over there.
Unidentified Analyst
Thank you. In wireless, you see the rebound in customer orders coming in '24, more driven by macro sites or small cells. Where do you expect the rollout of 5G to come?
Pekka Lundmark
There is still there is still a lot of macro site deployment that needs to take place. I do not want to name any carrier specifically. But even in the US, which is one of the most advanced 5G markets, there is still a lot to do on the macro side. And all you need to do is to just look at this number that how many percent of the 5G base stations have been upgraded to mid-band. Surprisingly, large part of the 5G services or what operators call 5G services are FDD bands and dynamic spectrum sharing, then you get the 5G logo on the phone, but the user experience is not that much better than 4G. And if carriers really want to push their ARPU up so that they can monetize 5G big time, they will need mid-band capacities, and they will need standalone core, that will really then enable true 5G services. And I'm arguing that we have only scratched the surface of this opportunity so far.
Alex Duval
Time for another question?
Unidentified Analyst
Hi. How much more expensive is building products in America for Buy American. What does that do to your margins? Thank you.
Pekka Lundmark
It is more expensive, but obviously, we have calculated our business case very carefully, and we believe that this is a good investment. Remember, we are not building our own factory. We are relying on contract manufacturers. But of course, this has been incorporated into our margin plans and the subsidies, the government subsidies, they are not coming to us, they are going to -- whoever builds the network. But of course, our goal is that we would not take a hit in terms of margins despite the slightly higher cost. But then how many percent higher exactly, that is a trade secret.
Alex Duval
I can squeeze in one more question. Anyone? Maybe I'll just finish with one question. You made a lot of progress on your semis engineering. You're obviously really focused on a complete different way of doing that in the last few years. Can you just sort of give us an update of where you are there and perhaps how far you think, if at all, you're behind other competitors? Or have you fully caught up at this point?
Pekka Lundmark
We have pretty much caught up and then there are examples where I believe that we are taking a lead as well. If I take one step back and explain why we are doing all this. I mean there was a belief some years ago that general purpose compute and CPUs would, in a way, rule the world for everything. That is not happening. If anything, it's going to the opposite direction at the moment. When you look at data centers, it is purpose-built compute that is ruling. When you look at AI, the same thing, I mean look at NVIDIA. The same thing is true to things like 5G networks where we absolutely believe that purpose-built compute for the most demanding parts of the network like in L1 processing and beamforming algorithms in the radio gives the best power consumption, the lowest cost and the best performance.
This is why we are investing in our own silicon. We are building significant IP blocks of our own. Then we are working with partners like Marvell and Broadcom. Sometimes they bring some of their IP blocks and then they package the whole thing together. But our very clear conclusion is that for certain parts of the network, you need purpose-built compute and a significant part of our competitiveness needs to come from a strategy where we process significant own IP in those blocks.
Alex Duval
And maybe just as a follow-up, one of the ideas of using sort of Open RAN and virtual RAN was that you could actually use the sort of general purpose compute. Would it be fair to say that the progress of those new technologies has perhaps been a bit slower than expected, and maybe that was one of the reasons the ability to get the energy efficiency and performance and so on?
Pekka Lundmark
Well, these two are necessarily not mutually exclusive. I mean as you know, we support Open RAN and Cloud RAN 100%, but the reality is that it is coming more slowly than most people thought still some years ago. I think the latest Dell'Oro forecast is that 15% of the radio market would be Open RAN in 2026, 1-5. The way it will most likely go is that when you take the CU and DU of the base station, which are the parts that you could put on cloud compute, you will need hardware acceleration there, which is then purpose-built compute. Otherwise, power consumption will be quite too high and performance will not be enough. Again, we are ready to deliver all alternatives that customers want. This is not a religious question for us at all. But these are some of the technical realities that O-RAN and Cloud RAN are facing at the moment.
Alex Duval
Great. We'll pack on that note. Thank you so much for joining us. Thanks, everyone, in the audience.
Pekka Lundmark
Thank you.
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Nokia Oyj (NOK) CEO Pekka Lundmark presents at Goldman Sachs Communacopia + Technology Conference (Transcript)