Microsoft Needs More Than Nokia for Windows Phone to Succeed

Truly monumental changes are in the works at tech giants Microsoft (NASDAQ: MSFT  ) and Nokia (NYSE: NOK  ) . Or at least that's what we're led to believe. With Microsoft's massive $7.2 billion purchase of Nokia's handset business set to close in the coming months, Microsoft and Nokia are both supposed to be looking toward newer and brighter futures.

Both Microsoft and Nokia reported earnings this week. Sadly for this turnaround narrative, the results, especially from Nokia, paint a far bleaker picture than perhaps many realize. I know, I know -- I'm as surprised as you that Microsoft would throw good money after a bad acquisition. I guess there's a first time for everything, right?

Source: Microsoft.

However, the current struggles at Nokia highlight some very ugly truths for Microsoft going forward, as it vies to become relevant in the mobile market that's essentially passed Microsoft by.

Nokia's nightmarish numbers
Nokia's fourth-quarter earnings were truly dreadful. Perhaps most importantly, as far as Microsoft is concerned, is that things at Nokia's handset business appear to be going from bad to worse.

For starters, it's worth noting that Nokia began reporting its handset business as a discontinued operation now outside its core business. For the quarter, revenue from discontinued operations fell 29% from Q4 2012, and 4.5% from the third quarter of this year. Equally alarming, Nokia's handset shipments also came in well short of what had been expected, declining to 8.2 million shipments during the quarter versus 8.8 million in the third quarter.

For the quarter, Nokia's handset division saw its non-International Financial Reporting Standards operating margin decline 6 percentage points from the year before to -7.3%. Its handset business is bleeding money.

Put in proper context, it seems Nokia is getting a pretty sweet deal here, swapping what's by far its most challenged business for more than $7 billion of Microsoft's cash, while Microsoft is about to acquire a total mess of a business. That would be fine normally, as the tens of billions of dollars of cash Microsoft generates each quarter make botched acquisitions like this easy to weather.

However, Nokia's importance to Microsoft was arguably more strategic than financial. Microsoft had planned to use Nokia as the partner that helps drive what will be its glorious resurgence in the mobile space. But as we saw with Nokia's recent report, Microsoft's grand ambitions are likely crashing and burning in front of its very eyes.

Garbage in, garbage out
Since virtually all models involve a fair deal of assumptions, even the most sophisticated model can generate an outrageous outcome if it's based on unrealistic expectations. And in comparing Microsoft's ambitions for Nokia versus the current business realities at the Finnish smartphone maker, Microsoft's comeback plans are looking more and more like a pipe dream.

In the short term, the deal is almost assuredly going to be a money-loser for Microsoft. In its acquisition presentation, Microsoft estimated it would need to sell roughly 50 million Nokia smartphones to hit its operating income breakeven point. But in the full year Nokia reported on Thursday, it managed to sell only 30 million handsets. And especially with handset sales actually losing momentum in the fourth quarter -- traditionally the strongest quarter for smartphone sales -- it's hard to imagine how Microsoft will hit its breakeven point anytime in the near future. 

Source: Microsoft.

However, it gets worse when looking at the long term.

By 2018, Microsoft is targeting a 15% share of the global smartphone market, which, at that point, will have growth to 1.7 billion units. This means Microsoft believes it will be able to grow its smartphone sales to roughly 255 million units, or about Apple's market share, even as Nokia's handset sales are declining in the present.

Source: Microsoft.

In arriving at a final value for the deal, Microsoft estimates the Nokia handset deal will result in a net present value of between $15 billion and $30 billion. But again, this is predicated on Microsoft's achieving operating margins of 5% at the low end, and 10% at the high end. But again, remember, Nokia's handset business saw its operating margin decline meaningfully to 7.6% in its most recent quarter.

We're seeing a common thread emerge here -- that there's a gaping chasm between the current state of affairs at Nokia and what Microsoft believes it will be able to achieve with Nokia going forward.

A tall order indeed
Now, I'm all about being an optimistic, so forgive me for saying that this seems largely unachievable for Microsoft from where I'm sitting.

But it does.

Microsoft needed to make a bold move to demonstrate that it's serious about growing its presence in mobile. But from the look of things today, Microsoft will need to move far beyond just Nokia to achieve its desired 255 million shipments in five years' time.

In fact, it's been widely rumored that Microsoft has been in active discussions with other smartphone OEMs, such as Sony, Samsung, and many others, about possibly expanding their own portfolios of Windows-based smartphones in the year ahead.

However, as Microsoft prepares to bring Nokia's handset business under its corporate umbrella, it's looking more and more like a botched deal from the start. And that's something that should have Microsoft investors up in arms at the prospect of yet another botched billion-dollar buyout.

Apparently, history does repeat itself with Microsoft.

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  • Report this Comment On January 25, 2014, at 8:58 PM, hmmm wrote:

    You seem confused....

    Nokias sales by and large were determined by

    MS. (exclusive deal remember?)

    issues....

    Apps in the app store

    hardware support for better phones

    Nokia had HD screens and quad core processors the second it was available.

    MS and its new D&S will only be held back by its OS and app offerings.

    These are both getting better but to imply that Nokia somehow dropped the ball is incorrect.

    YoY results for nokia?

    as an investor 2012 would make me worry

    2013 was a definite positive.

  • Report this Comment On January 25, 2014, at 9:51 PM, CharlesClarke3rd wrote:

    Rockstar is shutting down Android and possibly Google. They spent a year developing an open and shut case on Google and all Android vendors. Android is done. So Windows Phone has no shortage of Windows Phone vendors in 2014. Rockstar is allowing hybrid phones for now, but only as a transition measure. As I've said before Android marketshare is Microsoft marketshare and not Google. This is the future. Deal.

  • Report this Comment On January 25, 2014, at 9:55 PM, jkirchhoff wrote:

    Why doesn't Motley Fool simply rename itself "The Apple Co. Marketing Arm"? Every article your company posts is about the demise of MSFT, its incompetence, and the inferiority of their products. Yet, they seem to be getting stronger every year! Repeated performance ( and outperformance) over many quarters doesn't lie!!

    Windows 8 IS a success because it has spawned an integrated platform on which to build a devices culture (which includes Xbox) that operates on a single OS. Its (minor!) bugs will be fixed with future versions as all software is improved.

    NOK did not market or make the effort in this latest quarter for Windows Phones. That is the reason for the soft numbers. MSFT's marketing and distribution strength will broaden the reach of the D&S products and I believe resume the increase in market share that it was establishing prior to the most recent quarter.

    Please, try to bring a little objectivity to your articles and state that MSFT's business increased across ALL divisions, a testament that they must be doing somehting right with Windows 8, Surface, and the remainder of its young D&S business.

  • Report this Comment On January 25, 2014, at 10:43 PM, NoWindows8LockIn wrote:

    Microsoft's strategy is embarrassingly transparent. They wanted Nokia so that they could create vendor lock-in on the mobile device market. They wanted Dell so that they could create vendor lock-in on the desktop. Windows 8, with the metro-sexual interface, was supposed to get us all accustomed to the idea that we do not own our device anymore...really...Microsoft will keep everything for us in the cloud, and make self-extraction near impossible.

    What Microsoft failed to understand is that, unlike Apple, many of the users of Microsoft are not sheep and some of them, especially the tech heads, do not take kindly to being manipulated with anti-competitive tactics.

    This is a very dangerous game that Microsoft is playing, trying to create a closed ecosystem that has been open for 30 years, potentially destroying the goodwill that allowed the the monopoly to create it in the first place.

    If Microsoft underestimate how infuriating their monkeying around with Windows 8 and Windows Phone 8 is...they are in for a rude awakening.

    And Nokia..if you guys are readying this, you are dumb indeed. Elop and Microsoft played you like a tune.

    I wrote a letter to Nokia three years ago telling them what Microsoft was going to do (help sink Nokia), as well as telling them, so as to gain credibility, that Microsoft would try to buy Dell.

    Guess how many responses I got from Nokia corporate? Zero.

    For the record, I also warned Casio to watch out for Verizon, since Verizon was threatened by the G'Zone by Casio. I learned through grapevine recently...Verizon took G'Zone, and killed it.

    You so-called Wall Street geniuses should pay more attention to us tech-heads. We have a perspective that no M.B.A. will ever facilitate.

  • Report this Comment On January 26, 2014, at 12:13 AM, nudnyk wrote:

    Nokia's continuing operations numbers in Q4 were actually very good in all segments, Lumia is having problems getting traction in the market, but that is MSFT's problem. jkirchhoff wrote and I agree

    "NOK did not market or make the effort in this latest quarter for Windows Phones. That is the reason for the soft numbers. MSFT's marketing and distribution strength will broaden the reach of the D&S products and I believe resume the increase in market share that it was establishing prior to the most recent quarter."

    Although I disagree that WP8 has minor problems, a product should not hit the market knowing that later it will need to be fixed, this MSFT's corporate culture is now hard to fly by consumers as more alternatives exist.

    MSFT had no choice but to buy Nokia's D&S. WP8 would be dead in the water if Nokia produced android based Lumias. Nokia's share price decline last week had a lot to do with general market sentiment and less with fundamentals.

  • Report this Comment On January 26, 2014, at 10:07 AM, lee654 wrote:

    Agreed ! All the reply are right on. L& B Nokia!

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