Nokia (NYSE:NOK) recently acquired French rival Alcatel-Lucent (UNKNOWN:ALU.DL) for €15.6 billion ($16.6 billion). The combined company will be the second largest telecom equipment company in the world with a market share of 35%. Ericsson is the current leader with 40% of the market, while Chinese networking giant Huawei holds a 20% share, according to Bernstein Research.
The deal will give Nokia better exposure to the North American market, since AT&T and Verizon both hold major contracts with Alcatel-Lucent. Nokia also gains its optical transmission and Internet routers, which help telecom operators handle high volume traffic. Nokia expects the acquisition to cut operating costs by €900 million ($969 million) by 2019.
The deal could also help Nokia profit from the growth of the Internet of Things, or IoT, and future upgrades to 5G connections. Let's look at how these two growing markets fit into the company's long-term strategy.
Old Nokia vs. new Nokia
After Nokia sold its handset division to Microsoft last year, it agreed to not launch any new smartphones until 2016. Meanwhile, its telecom equipment business, Nokia Networks, took center stage.
At the end of fiscal 2013, Nokia Networks was in bad shape. Revenue fell 18% year-over-year, though operating profit rose 39%. By the end of 2014, the situation had stabilized. Revenue only slipped 1% annually as operating profit rose 25%. Mobile broadband revenue, which comes from sales of telecom equipment for cellular connections, increased 13%, thanks to robust demand for LTE upgrades.
Yet the LTE penetration rate remains low across the world. Last year, the North American market had the highest LTE penetration rate at 36%, according to 4G Americas. Western Europe and Asia have respective penetration rates of just 8% and 3%. As more countries upgrade their 3G networks to LTE, Nokia broadband revenue will improve. Those foundations will help Nokia profit from eventual upgrades to 5G connections, which are expected to happen by around 2020.
The Internet of Things in 2020
That is expected to be a particularly big year for the IoT market. Cisco forecasts the number of connected devices will double from 25 billion in 2015 to 50 billion in 2020. Research firm IDC expects the value of the IoT market to soar from $1.9 trillion in 2013 to $7.1 trillion by 2020. Google believes driverless cars will hit the streets by 2020.
In a prepared statement, Nokia CEO Rajeev Suri said Nokia and Alcatel-Lucent have "hugely complementary technologies and the comprehensive portfolio necessary to enable the Internet of Things and transition to the cloud."
For that transition to go smoothly, Nokia needs to accelerate its research and development of 5G and "small cell" technologies. The upcoming merger will bring together Alcatel-Lucent's Bell Labs and Nokia's FutureWorks, two innovation centers that are researching 5G technology, sensors, cloud services, and other technologies. In France, Nokia will establish a €100 million ($108 million) investment fund for start-ups focused on IoT technologies. Nokia also plans to hire "several hundred" new employees to work in its research and development department on IoT and other "future technologies."
Combining Nokia and Alcatel-Lucent's telecom equipment businesses seems like a solid long-term investment in the Internet of Things, but investors should be aware of some potential pitfalls.
First, Chinese rivals such as Huawei and ZTE are also eyeing the IoT market. In addition to telecom equipment, both companies have a growing presence in machine-to-machine 2G, 3G, and 4G LTE modules. If Huawei and ZTE start using bundling strategies to gain market share, Nokia could face significant pricing pressure. Second, Nokia and Alcatel might need to eliminate redundancies in areas such as mobile broadband and small cells, which could increase restructuring costs.
Lastly, Nokia's long-term goals are unclear. Although the company is now mainly focused on expanding its telecom equipment business, it is also clinging to the hope that it can reenter the smartphone and tablet markets. Last October, Suri hinted that Nokia will manufacture its own smartphones again in 2016. Nokia also licensed its brand to Foxconn for the N1 tablet that launched in China earlier this year. It might be tough to juggle all those plans with its telecom equipment and IoT efforts.
A win-win situation . . . for now
The Alcatel-Lucent acquisition is a logical move. Nokia diversifies its portfolio between fixed and mobile telecom equipment, gains a better foothold in North America, and shores up its defenses against rising threats such as Huawei. Meanwhile, the true long-term value of the partnership will be realized over the next few years as the IoT market matures.
Leo Sun has no position in any stocks mentioned. The Motley Fool recommends Cisco Systems, Google (A shares), Google (C shares), and Verizon Communications. The Motley Fool owns shares of Google (A shares) and Google (C shares). 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.