Track the companies that matter to you. It's FREE! Click one of these fan favorites to get started: Apple; Google; Ford.



Microsoft Is Getting Serious About Hardware

Don't let it get away!

Keep track of the stocks that matter to you.

Help yourself with the Fool's FREE and easy new watchlist service today.

After Microsoft  (NASDAQ: MSFT  )  inked a partnership with Nokia  (NYSE: NOK  )  in February 2011 many began to speculate that Microsoft would eventually acquire Nokia. On September 2 news broke that this had essentially taken place, with Microsoft paying about $7 billion for both Nokia's devices and services business and a license to use the company's trove of patents.

This is a big development for Microsoft, which is in the middle of a transition into a devices and services company. Microsoft launched its own tablets, the Surface and Surface RT, earlier this year, and with the acquisition of Nokia's phone business Microsoft is taking a huge step forward toward its goal.

What the acquisition means for Microsoft
Windows Phone has become the number three smartphone OS in the world, recently surpassing BlackBerry, and in certain regions they growing market share fast. In the UK market share more than doubled from 4.2% in 2012 to 9.2% today. In France market share has risen even faster, from 3.6% to 11%. In Latin America Windows Phone is now the second most popular mobile platform behind Android.

In the U.S., however, market share remains low. Rising from 3% last year to 3.5% today, Windows Phone has yet to make serious penetration into the domestic market.

Nokia makes up about 80% of the Windows Phone market, with other OEMs largely focused on Android. Nokia has been growing its quarterly phone shipments at a rapid pace, and in the most recent quarter Nokia shipped over 7 million Windows Phone devices.

Source: Microsoft Investor Presentation

Since Nokia's phone unit is currently unprofitable Microsoft will absorb those losses. The company expects GAAP EPS to be reduced by $0.12 in the current fiscal year, but by fiscal 2016 growth combined with an expected $600 million in cost synergies should lead to the transaction being accretive to the EPS.

This is the sort of acquisition which is part of a long-term plan, and with the market more often focused on the short-term shares of Microsoft fell by as much as much as 6% on the day following the announcement. Microsoft's market capitalization was reduced by about twice the amount of cash Microsoft spent on Nokia, with the market apparently assigning a negative value to Nokia's phone operations.

This deal will allow Microsoft to react more quickly to the changing mobile market, with software, hardware, and marketing all under one roof. In the announcement slide show Microsoft lays out two long-term scenarios:

Source: Microsoft Investor Presentation

Compared to the size of Microsoft a few billion dollars per year in operating income means little, but compared to the price paid for Nokia it's clear that if even the low-end scenario plays out Microsoft got a real bargain. It all comes down to execution on Microsoft's part, and with a history of failed acquisitions there's certainly no guarantee of success.

One of the most compelling positives regarding the acquisition is better unit economics. Under the previous partnership Microsoft was realizing a gross profit of less than $10 per unit. With the acquisition this number is expected to rise above $40 per unit, greatly increasing profitability per unit sold. Microsoft estimates that operating income will break even with costs when units exceed about 50 million annually, and with a current annual run-rate of nearly 30 million this point could be only 1-2 years away.

Microsoft needs as many Windows devices in peoples' hands as possible, and the Nokia deal is a step forward for the company. If Microsoft can continue to grow unit volume and take market share then Windows Phone will eventually become the number two phone OS worldwide.

What the acquisition means for Nokia
Without the same resources as Microsoft, Nokia would have had trouble absorbing continued losses from the phone division. The feature phone business, also going to Microsoft, has been declining for years, and Windows Phone volume hasn't made up for the declines.

It's becoming more difficult to be an independent phone maker, with the playing field largely leveled by common operating systems. Makers of Android phones face a constantly shifting market, with Motorola, HTC, and now Samsung all enjoying periods of success. Windows differentiated Nokia from the rest, but there was no real reason to believe that Nokia had any long term advantages.

After the sale is completed Nokia can focus on its three other businesses: wireless infrastructure, a location cloud platform, and technology and patents. The company will also have plenty of cash, allowing it to invest in its businesses.

Both the wireless infrastructure business and the location platform have positive operating margins, and the removal of the phone business should lead to a profitable Nokia after years of losses.

The bottom line
I think that this deal is not a bad one for Microsoft. The company gets to use a small part of its overseas cash hoard to seriously push Windows Phones, and the short-term hit on earnings isn't very significant. If Microsoft can pull this off and make Windows Phones popular in the U.S. then $7 billion will look like a steal.

For Nokia, shedding an unprofitable division which was dragging down the company is a good idea. Prospering as an independent phone maker would have been difficult, and Nokia shareholders should be thrilled with the deal.

The tech world has been thrown into chaos as the biggest titans invade one another's turf. At stake is the future of a trillion-dollar revolution: mobile. To find out which of these giants is set to dominate the next decade, we've created a free report called "Who Will Win the War Between the 5 Biggest Tech Stocks?" Inside, you'll find out which companies are set to dominate, and we'll give in-the-know investors an edge. To grab a copy of this report, simply click here -- it's free!

Read/Post Comments (0) | Recommend This Article (0)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

Be the first one to comment on this article.

Compare Brokers

Fool Disclosure

Sponsored Links

Leaked: Apple's Next Smart Device
(Warning, it may shock you)
The secret is out... experts are predicting 458 million of these types of devices will be sold per year. 1 hyper-growth company stands to rake in maximum profit - and it's NOT Apple. Show me Apple's new smart gizmo!

DocumentId: 2621998, ~/Articles/ArticleHandler.aspx, 9/30/2016 11:49:18 AM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...

Today's Market

updated Moments ago Sponsored by:
DOW 18,329.11 185.66 1.02%
S&P 500 2,169.16 18.03 0.84%
NASD 5,313.45 44.30 0.84%

Create My Watchlist

Go to My Watchlist

You don't seem to be following any stocks yet!

Better investing starts with a watchlist. Now you can create a personalized watchlist and get immediate access to the personalized information you need to make successful investing decisions.

Data delayed up to 5 minutes

Related Tickers

9/30/2016 11:33 AM
MSFT $57.60 Up +0.20 +0.35%
Microsoft CAPS Rating: ****
NOK $5.82 Up +0.10 +1.66%
Nokia CAPS Rating: **