Why Microsoft Backtracked on Selling Low-End Nokia Phones

Last month, Microsoft (NASDAQ: MSFT  ) announced that it would discontinue the Nokia X Android phone, Symbian 40, and Asha handsets in developing and emerging markets to clear the way for low-end Windows Phones. Many people assumed that Microsoft would discontinue all of Nokia's low-end "dumbphones" as well, but apparently that's not the case.

Microsoft recently backtracked and announced a new low-end handset, the Nokia 130, which will cost $25 when it launches in September. Microsoft's Jo Harlow, speaking to Re/code, stated that the company still needs a low-end device to reach consumers at the lowest end of the market. The company also hopes that positioning the 130 as a "first cell phone" will lead to future purchases of low-end Windows Phones like the Lumia 530, which starts at $144.

Nokia 130. Source: Company website.

While selling low-end Nokia phones will definitely generate additional revenue for Microsoft, it won't help halt the spread of low-end Android and Firefox OS phones that are flooding lower-income markets. Let's take a look at how Microsoft should approach this challenging market instead.

Why Microsoft still needs Nokia's feature phones
Nokia is still the world's second largest handset brand after Samsung, thanks to its massive footprint in developing and emerging markets. Gartner reports that Nokia sold 251 million handsets in 2013, compared to 444 million from Samsung. However, the two brands are headed in opposite directions -- Nokia's shipments fell 25% from the previous year, while Samsung's shipments rose 16%.

Nokia's market share is falling, but Microsoft won't simply shut off that stream of revenue, considering that the Surface lost $1.7 billion since 2012, and the Xbox One has struggled since last November. That's why the company needs feature phones like the Nokia 130. The 130 would have been considered outdated a decade ago -- the only "extra" features are Bluetooth, a microSD card, a media player, and FM radio. It doesn't have a camera or 3G connectivity.

But these phones can be sold at respectable margins. According to IHS iSuppli, the Nokia 105, which cost $20 last year, was sold with a hardware and manufacturing margin of 29%. That's certainly a much smaller profit per phone than Apple's iPhone 5S or Samsung's Galaxy S5, but Microsoft should certainly milk those profits while it still can.

You'd be surprised how far $25 goes
While Microsoft shouldn't just pull the plug on low-end Nokia feature phones, it should realize that $25 goes a lot farther in developing markets than before.

Mozilla is working with Indian handset makers Intex and Spice to launch a $25 Firefox OS phone later this year. Unlike the Nokia 130, the low-end Firefox phone will be equipped with a camera, GPS, a touchscreen, and Internet connectivity. Another Indian phone, the Celkon Campus A35k, is a full-featured Android 4.4 device that costs $50. Even without a data plan, these devices can access the web via Wi-Fi connections, making them more attractive alternatives to the Nokia 130.

Celkon Campus A35k -- a $50 Android 4.4 phone. Source: Company website.

That's why Microsoft shouldn't discontinue the Asha, which costs $60 to $100 and runs web-based apps over a 3G connection. The Asha flopped due to competition from low-end Android phones, but Microsoft could still save the brand by relaunching it as a low-end smartphone -- running either forked Android or S40 -- and equipping it with web-based apps for Bing and OneDrive.

If Microsoft follows Intex, Spice, and Celkon's footsteps in hardware, it could possibly launch a new Asha that costs less than $50. If it then lowers the price of the Nokia 130 to around $15, it could turn the tables on low-end Android and Firefox OS devices in emerging markets. Microsoft needs to act soon -- customers in India and China are expected to buy over 500 million smartphones this year, accounting for half the total sold in 47 key markets, according to research data provided by research firm Mediacells reported in The Guardian.

The Foolish takeaway
It's easy to see why Microsoft is launching new low-end Nokia feature phones, but it's not a sustainable long-term strategy. Cheap Android and Linux-based phones wiped out the Asha, and they will wipe out feature phones as well -- causing revenue to dry up a lot faster than Microsoft might expect.

In my opinion, Microsoft needs three tiers of low-end devices -- the Lumia 530 at the top, the Asha in the middle, and feature phones at the bottom. However, Microsoft is giving up on the middle tier and letting $25 to $50 Firefox OS and Android devices expand unopposed. If Microsoft wants to survive that onslaught, it needs to cut the prices of all three categories of phones.

Microsoft will certainly sacrifice margins that way, but at least it can draw customers into the "One Windows" system championed by CEO Satya Nadella.

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