Nokia Rethinks R&D Spending

CEO Stephen Elop is slashing the research budget and using Microsoft's Operating Systems for Phones

(Bloomberg) — Last November, Nokia Oyj researchers north of Helsinki chain-sawed a one-ton block of ice into 50-centimeter slabs and mounted them with infrared cameras to trace heat trails left by hands. Their goal: to study touch screens.

The "whimsical experiment," inspired by Finland's tradition of ice sculptures, was conducted by the Nokia Research Center's Tampere branch, its website says. Together with projects such as building an electronic nose, stretchable electronic skin and sending anthropologists to Indian villages to observe rural mobile-phone use, it gave Nokia what analysts say is a bloated devices research and development budget.

At $4 billion a year, it is more than twice Apple Inc.'s entire $1.78 billion R&D budget. At least a third of it goes to Symbian and MeeGo platforms that Chief Executive Officer Stephen Elop said last week Nokia is retreating from in favor of Microsoft Corp.'s Windows Phone 7. Elop plans "substantial" R&D spending cuts as he struggles to claw back ground lost to Apple's iPhone and Google Inc.'s Android-based devices.

"There's a lot of fat in that research and development budget," said Adnaan Ahmad, a London-based analyst at Berenberg Bank. "They've plowed a hell of a lot of R&D money into competing with the iPhone and Google, but they've plowed it into a technology like Symbian that's from the 1990s."

With Nokia using Microsoft's operating system, software is one of the ripest fields for the Espoo, Finland-based company to cut costs and improve productivity. About four-fifths of Nokia's 18,000 to 19,000 R&D employees are in software, according to Credit Suisse estimates.

Painful Transition

On Feb. 11, within hours of Elop announcing the switch to Windows, hundreds of employees walked out in Tampere, where about half the 3,000 workers are Symbian developers.

"There's a long and painful transition period ahead," said Sami Sarkamies, a Helsinki-based analyst with Nordea Bank. "Development resources for Symbian and MeeGo will be clearly reduced and Nokia will be quickly building competencies related to Windows Phone 7 products." Based on Nokia's presentation, it may be planning to cut R&D costs by about a third, he said.

Symbian-related research costs for Nokia reached about $1.4 billion last year, with more than a third of its 17,200 R&D workforce assigned to the operating system, according to Sanford C. Bernstein & Co. Apple spent $772 million on the iPhone in 2010, when it introduced the iPhone 4, according to the broker. Apple's R&D was 2.7 percent of sales for the year ended September, while Nokia's 2010 devices R&D was 10 percent of the division's sales.

'Visibly Disappointing'

Nokia's R&D budget for handsets is a third higher than Samsung Electronics Co.'s, almost double BlackBerry-maker Research In Motion Ltd.'s and more than twice Motorola Mobility Holdings Inc.'s, Sanford Bernstein estimates. With Nokia Siemens Networks, Nokia's total R&D budget was $7.8 billion in 2010, more than Google's or International Business Machines Corp's.

Nokia's output for that R&D spending is "visibly disappointing," Sanford Bernstein analysts Robin Bienenstock and Pierre Ferragu wrote in a report this month.

Investors punished Nokia after Elop unveiled his new plan, with shares dropping 14 percent on Feb. 11, the most in almost 19 months. They fell as much as 4.4 percent today. Since Apple unveiled the iPhone in June 2007, they have tumbled more than 67 percent. Cutting R&D spending "is seen as a major area of potential upside for the company," the analysts wrote.

Nokia will get "billions" in benefits from its partnership with Microsoft, Elop said in Barcelona yesterday.

"The value transferred to Nokia is measured in the B's, not the M's," he said, without elaborating.

Not an Experience

Nokia's R&D budget may have been justified if it were gaining ground and commanding higher prices. On both fronts it's failing. It cut prices, pulling down margins. Fourth-quarter profit fell 21 percent to 745 million euros ($1 billion).

Since Elop became the first non-Finn to head Nokia on Sept. 21, Google's Android software has become the biggest smartphone operating system by shipments, passing Nokia's Symbian, according to researcher IDC. Nokia's share of the fast-growing smartphone market plummeted to 27.1 percent from 50.8 percent when Apple shipped its iPhone in 2007, according to Gartner Inc.

Nokia's R&D was always about a checklist of features, not an experience the way Apple's is, says a former Nokia Research Center developer who didn't want to be identified because he still works in the mobile-phone industry. Nokia, which worked with touch screens and accelerometers years ahead of the iPhone, couldn't get them into products, he said.

Nokia's research labs working on leading-edge technology in far-flung countries were fragmented and not tied to any particular product group, leaving developers working on prototypes they knew weren't going anywhere, he said.

'Boring' Nokia

Nokia's haphazard efforts resulted in clunky products that drove customers to easier-to-use devices. Phones running on Symbian require users to input more keystrokes to perform tasks such as updating a contact than iPhone and Android phones.

"It's not a question of the amount of money, it's how much you can productize," says Howard Anderson, who founded Boston technology consultants The Yankee Group and now teaches at MIT's Sloan School of Management. "It ought to be called development and research, because these days it's more short-term tactical stuff rather than long term."

Take India's Micromax Informatics Ltd, which is challenging Nokia's leadership in the world's second-largest mobile-phone market. Employing 12 people in R&D and using off-the-shelf technology from Taiwan and China, it makes cheap phones with features sought by Indians including slots to insert multiple SIM cards to carry multiple phone number. One such customer, 28-year old software engineer Pradip Bakshi, checked out Nokia phones in New Delhi last week, called them "boring" before taking off with a $130 Micromax device.

'Ahead of the Duck'

Nokia will have to come up with better innovations to fulfil Elop's strategy of standing out in the Windows Phone 7 market against Samsung and LG Electronics Inc., the world's second-and third-largest handset makers. Longer term, he wants to leapfrog Apple and Android, although can't say how.

"We have significant investments in the next disruption, the next wave of mobile innovation," he said in an interview. "It's impossible to say what that disruption will be but we want to shoot ahead of the duck, to use the Finnish phrase."

Elop plans to ship one product this year based on MeeGo, a platform it's developing with Intel Corp., as "an opportunity to learn" before redeploying MeeGo team members and product elements to Windows Phone 7 and future platforms. He says the company needs to explore the frontiers of engineering—"future materials, future chemicals, all sorts of things that are way in the future"—if it is to leapfrog competitors.

Keep Control

"Something like an ice touch screen quickly turns into an examination of some of the most advanced mechanisms for sensor detection," he said. "Sometimes it may seem a bit playful but in the end it has a direct impact on our long-term plans."

At the investor meeting in London, he enthused about adding better cameras and imaging, "advanced sensors, GPS accelerometer, gyroscopes" and other hardware to Nokia's Windows phones to differentiate them from others.

Some investors say Nokia should stay with a few such projects and not throw the baby away with the bathwater.

"The danger for Nokia will be if they let Microsoft take complete control," said Mario Bellusci, a Milan-based technology fund manager for Eurizon Capital, which holds Nokia shares. "If Nokia goes down the Hewlett-Packard route and starts to drastically cut R&D for short-term profitability, in the long term they will suffer a lot."

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