Why Microsoft-Nokia Naysayers Could Be Dead Wrong

Microsoft (MSFT +0.01%) investors have been quick to see red after Google (GOOG 0.58%), recently sold off its Motorola handset division to Lenovo for $2.91 billion, barely three years after the search giant acquired it in 2011 for a staggering $12.5 billion. Google sold off the hardware unit, but kept most of the patents. Microsoft, on the other hand, is still in the process of finalizing the Nokia (NOK 0.70%) handset division takeover, an under-performing segment that has been a major drag on the giant Finnish mobile phone maker's profitability.

Microsoft has certainly shot for the stars with the bold $7.2 billion gambit, and its partnership with Nokia looks eerily similar to the Google-Motorola one. The biggest common point shared by the two deals is that they both involve two software firms getting into partnerships with hardware firms and licensing their operating systems to them. But, closer scrutiny of the tie-ups reveals some fundamental differences, and why Microsoft's acquisition makes better business sense. Although Google announced that it was mainly motivated by the desire to stop competing head-on with smartphone manufacturers that use its Android OS in their phones, it's interesting to note that it kept most of the Motorola patents. 

Microsoft deal is fundamentally different from Google's
Google forked out $12.5 billion for Motorola, in what was widely seen as a means of acquiring Motorola Mobility's considerable intellectual property rights. The deal was also seen as Google's way of insulating itself from irksome patent infringement suits from rival software companies like Apple, Microsoft, and Oracle (ORCL +2.13%). After the acquisition, Google could then go out on a limb and develop true Google devices, fully integrated with its OS and homegrown content.

But, the fairy tale story quickly turned nightmarish when Motorola's patents turned out to be nowhere near as valuable as Google had hoped. Motorola Mobility was already embroiled in a fierce patent battle with software giant Microsoft long before the deal with Google was inked. Motorola was demanding that Microsoft pay $4 billion per annum to use its 802.11 Wi-Fi standards and its H.264 video standards. But, Seattle judge James Rabart delivered a shocker in April 2013 when he ruled that Microsoft only needed to pay $1.8 million per year. The ruling immediately brought into question the true worth of Motorola's patents.

Microsoft will surely benefit from Nokia's extensive patent portfolio. The company will gain access to 8,500 Nokia patents with a 10-year license once the deal is consummated. Microsoft paid $2.3 billion to Nokia as licensing fees for its patents, which will effectively give it access to Nokia's patent licensing contracts with other companies such as Nortel, Kodak, IBM, Motorola Solutions, Apple, Qualcomm, and LG.

While Microsoft can potentially benefit from Nokia's patents, they are not the main reason Microsoft is interested in purchasing the handset maker.

Smartphone business: Windows Phones
Microsoft's primary objective for purchasing the Nokia smartphone business was to consolidate the gains it has made in the smartphone market. According to IDC, Nokia currently commands an industry-leading 82% of the Windows Phone Market. Windows Phone devices are the third most popular smartphones, behind Apple's iPhones and Google's Android phones. Although Nokia's smartphone business has been floundering, overall sales have been steadily climbing.

Microsoft made a $1 billion deal in 2011 that allows Nokia's smartphones to run on Microsoft's Windows Phone software.  By buying Nokia's smartphone business, Microsoft is in a better position to grow its Windows Phone OS market share.

Global smartphone sales by OS in fiscal 2013 (Thousands of Units)

Source: Gartner (November 2013)

Nokia deal to ramp up smartphone gross margins
Microsoft hopes to leverage its Nokia acquisition to grow its smartphone market share from the current 3.6% to around 15% by 2018. But, more importantly, it expects to get $40 for each smartphone sold, four times the current $10 it makes from each smartphone sale. Not everyone is as starry-eyed as Microsoft. IDC is less sanguine about Microsoft's smartphone growth prospects, and expects Microsoft's smartphone market share to hit 10.2% by 2017. Either way, Microsoft now has a decent shot at becoming a significant smartphone player, instead of the marginal player it currently is.

Credit: Microsoft

Nokia sold 8.2 million Lumia smartphones in the fourth-quarter of fiscal 2013. Microsoft expects the Nokia deal to finally be profitable by 2016.

Oracle has pulled off its Sun Microsystem acquisition
Oracle acquired Sun Microsystems, a leading server and related hardware manufacturer, in 2010 for $7.3 billion. On the surface of it, it would look like Oracle's acquisition has bombed out since revenue from this division have fallen from $9 billion in 2009 to $5 billion in 2013.

But, Oracle's acquisition was highly strategic, with the company eyeing Sun's software platform, particularly Java and Solaris, as well as Sun's high-end customers. Oracle has since exited the x86 server business and now concentrates on providing Unix solutions that integrate its software offerings with high-performance hardware. This has helped the company compete favorably with industry leaders IBM and HP in high-priced, high-margin enterprise servers.

Foolish bottom-line
If Microsoft's Nokia acquisition doesn't work out, Microsoft can go the Apple way and make Windows OS the exclusive operating system for all its Nokia-branded handsets. Its wider range of smartphones would help it exploit more price points than Apple currently does. The Nokia deal is quite risky, but worth every dime.