On Sept. 2, Microsoft (NASDAQ:MSFT) agreed to pay €5.4 billion, or $7.2 billion, for Nokia's (NYSE:NOK) mobile business and a license to use many of the company's patents. The deal cements Microsoft's transition into a device and services company, putting it up against Apple's iPhone and devices running Google's (NASDAQ:GOOGL) Android platform. Microsoft plans to bolster profits in key mobile markets by building on its partnership with Nokia. Nokia told its investors that it will focus on its established service businesses and patented technologies after the acquisition to propel future sales and growth.
Expectations from acquiring Nokia
By acquiring Nokia, Microsoft will vertically integrate its Windows Phone OS with Nokia's smartphone brands, such as the flagship Asha and Lumia series. Vertical integration is a business model where a company owns all components of its product line. This model has proved essential to Apple's successful line of smartphones, tablets, and computers. Similarly, Google acquired Motorola two years ago to integrate Motorola's line of phones with its Android software. With the acquisition of Nokia, Microsoft will gain control over software and hardware development and marketing costs.
Microsoft said the acquisition would offer better unit economics and yield greater profits. Nokia sold smartphones at an average gross profit of $30. Microsoft earned about $10 per phone from licensing fees under the previous partnership. Microsoft will realize a gross profit of more than $40 per phone after the acquisition and use earnings to accelerate innovation and marketing.
The company expects operating income will break even with the costs of a new business unit when smartphone sales exceed 50 million units. Nokia has a run-rate of about 30 million units. Nokia sold 7.4 million Lumia smartphones in the second quarter, up 32% sequentially. This compares Apple's 31 million and Android's 187 million smartphones sold in the quarter.
Microsoft expects the transaction to close in the first quarter of 2014, following approval by Nokia's shareholders and regulators. Microsoft will accrue annual cost synergies of $600 million 18 months after the deal closes. The company foresees a loss of $0.12 per share in the current fiscal year, but believes the transaction will add growth to earnings by fiscal 2016. Microsoft projects fiscal 2016 earnings to come in at $0.04 per share.
Current market growth
Microsoft's partnership with Nokia has helped distribute Windows Phone across developed and emerging markets. Windows Phone exceeded BlackBerry's OS in the second quarter to become the third most popular mobile platform in the world. According to Microsoft, Windows Phone has outsold BlackBerry in 34 markets. Microsoft captured 3.7% of the market on shipments of 8.7 million smartphones. Apple placed second with 13.2% market share.
Google's Android platform has rapidly expanded into various price points and markets, attracting large communities of hardware manufacturers and mobile phone users. Google's operating system captured 78.3% of the market.The company recently announced that it activated over 1 billion Android devices since the platform released less than six years ago.
Google has more than doubled the number of activations since last September when the company celebrated 500 million Android activations. Android users anticipate the release of Google's upcoming release of Android 4.4 Kit Kat. Google has not unveiled the release date but tech blogs claim the new Android operating system is slated for an October release.
Strong sales of Nokia's Lumia smartphones in the second quarter boosted its Windows Phone market share against other OEMs. Windows Phone controls over 10% market share in 9 different markets, Microsoft said in a statement. Nokia accounted for 81.6% of all Windows Phone smartphone shipments, ahead of Samsung with 11.5% share. OEMs such as HTC and Huawei, which primarily use Google's Android platform, shipped less than 400,000 Windows Phone units.
Nokia sold 61.1 million mobile phones globally in the second quarter, down 27% Y/Y from 83.7 million and 113.5 million at the end of 2011. Samsung controls 26.2% of the mobile phone market with shipments of 113.4 million mobile phones. Nokia and Apple follows with 14.1% and 7.2% market share, respectively. Nokia released the Asha 501 near the end of the second quarter that targets the competitive sub-$100 mobile phone segment. Nokia believes the new smartphone will attract new customers and recover lost sales from low-cost Android handsets. Nokia sold 4.3 million Asha full-touch smartphones last quarter.
Future market growth
Feature phones represent a large percentage of Nokia's global mobile phone shipments. Microsoft needs to recognize that feature phones do not promise growth in the next few years as consumers shift to low-cost smartphones. In the long term, feature phones present Microsoft a small opportunity for growth, said Francisco Jeronimo, research director at IDC.
"In the short term it is important that Microsoft keeps the segment alive and profitable. This will give it access to markets where feature phones are still the dominant segment and where Nokia's brand is still strong," Jeronimo said.
IDC forecasts the mobile phone market will grow 7.3% in 2013 driven by 1 billion smartphones and expects shipments of 1.7 billion smartphones in 2017. The research firm previously projected 5.8% growth for the year. IDC expects that Windows Phone will capture 3.9% of the mobile market this year and 10.2% in 2017.
Source: IDC Worldwide Mobile Phone Tracker, September 4, 2013
For Microsoft to gain ground in the smartphone market, the company needs to preserve its feature phone base. As feature phone users shift to budget smartphones, Microsoft needs to be ready to offer a low-cost smartphone to attract them. If Microsoft fails to meet consumer demands, Microsoft's feature phone users will shift to Apple iPhone's or other handsets powered by Google's Android platform. With Google and Apple planning to release their new mobile operating systems in October, Microsoft will face tough challenges to hold its user base from defecting to competing brands.
Christopher DeSousa has no position in any stocks mentioned. The Motley Fool recommends Google. The Motley Fool owns shares of Google and Microsoft. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.