Microsoft and Nokia: The dust has settled…

Windows Phone has long been key to Microsoft’s continued sustainability and relevance. Nothing reinforces that sentiment more than the acquisition of its largest smartphone hardware partner.

For many in the industry the acquisition of Nokia’s Devices and Services business by Microsoft comes as little surprise. As early as 2011, people were speculating that the newly appointed Nokia CEO, Stephen Elop, was a Trojan Horse for Microsoft. His role, the conspiracy theorists suggested, was to tie the ecosystems of the two companies together so closely that Nokia could later be acquired for a bargain price by the Redmond giant.

Of course, while that’s quite a far-fetched idea the two companies have shared a common trajectory for more than two years. Unification was inevitable.

In monetary terms, the deal is far from Microsoft’s largest. In 2011, the company paid US$8.5bn for Skype ( than $1bn more than the $7.2bn value of the Nokia deal). That’s for a company contributing $2bn in annual sales compared to Nokia’s Devices and Services’ $19bn in 2012. However, the fortunes of the two companies are very different. Nokia’s slide in market share is documented well enough not to need further commentary here. Needless to say that in the first quarter of this year its shipments fell by 27% (YoY).

Yet while this deal is not Microsoft’s largest in monetary terms, in almost every other aspect it’s beyond transformative. Aside from growing its existing workforce by a third (the deal will see the transfer of 32,000 Nokia employees), the move is strategically significant. In July this year, Microsoft CEO Steve Ballmer announced the company’s strategy for transformation, and the sentiment was clear; Microsoft must deliver on the need for a unified and consistent experience across multiple platforms and hardware types.

“Going forward, our [Microsoft] strategy will focus on creating a family of devices and services for individuals and businesses that empower people around the globe at home, at work and on the go, for the activities they value most,” Ballmer stated.

This would be achieved through a portfolio of partner and first-party devices. “Our devices must share a common user-interface approach tailored to each hardware form factor. They must deliver experiences based on a common set of services,” the announcement explained.

Ensuring this consistency by taking control of the hardware ecosystem was a logical move; the company quickly needed to bolster its portfolio of first-party products.

Of course, as Microsoft pushes further into the hardware space it risks alienating its long-term, traditional hardware partners. This is a common argument, but not one that I believe Microsoft need fear. Google’s acquisition of Motorola Mobility in 2012 set the precedent for closer OS and hardware integration and, of course, Microsoft has already shown its hand with regards to hardware ambitions and a desire to control the Windows ecosystem. Many viewed the Microsoft Surface tablet as something of a “name and shame” exercise, an antithesis to the cheaper, lower quality products being manufactured by some OEM partners.

The Nokia acquisition points to a similar desire. The Finnish company has long held the reputation for building some of the best designed and well-engineered smartphones on the market. Maintaining control of the hardware ecosystem can only bring tighter integration with the Windows Phone platform; at least to the extent achieved by Apple and by Android through its Nexus devices.

As an additional bonus it also gives Microsoft access to Nokia’s design team who will almost certainly be set to work on the next generation of Windows tablets (Nokia’s Head of Product Design, Stefan Pannenbecker, will remain and will lead design for the business).

It was a surprise to many that the first generation of Microsoft tablets excluded Nokia. This will now change and, from here on in, we’ll see a far more cohesive design language through both smartphones and tablets. In fact, leaked documents already point to a “Lumia-inspired” tablet in development.

As for causing disruption among its OEM partners, Microsoft can probably afford that risk, after all Nokia controls 85% of the Windows Phone market.

Remember Steve Ballmer’s transformative statement? He also referenced the need to deliver experiences based on a common set of services.

Indirectly that makes reference to the threat posed by Google’s Android OS. The two companies have fought several legal battles recently, including an accusation that Google unfairly pushes hardware manufacturers towards the implementation of its services (such as search, YouTube and Maps). For a company that was this year fined $731m by the European Union over antitrust disputes related to web browser availability, you can understand Microsoft’s caution and desire for its service assets not to be hobbled by the market leader.

Whether it is enough to help Microsoft achieve its desired tripling of market share by 2017 is difficult to answer. If it can achieve this growth it’ll deliver a $45bn a year business unit. That’s the sort of scale that demands efficiencies in the value chain; at present Microsoft realizes less than $10 per shipped [Nokia] device. With production now in-house, that will grow to +$40.

A slide deck posted on Microsoft’s investor site suggests that the deal will see operating income breakeven once device volume exceeds 50m units and save $600m in costs after 18 months. (Nokia last year shipped 38m smart devices).

Let’s not also forget that under the terms of the original partnership agreement in 2010, Microsoft pays Nokia a “platform support payment”. In Q4 2012, this totaled $250m. At that rate we could have expected payments for 2014 to be in the region of $1bn.

Together there are significant cost efficiencies to be realized and, coupled with the use of offshore cash to fund the deal, Microsoft is showing confidence that this will have no impact on its ability to return capital to shareholders and that the deal will be accretive to its [Non-GAAP] Earnings per Share by 2015.

It’s an indictment of the industry that much of the anticipated cost saving comes from reducing exposure to patent royalties and litigation. Microsoft’s own data suggests that 10% of a smartphone’s Bill of Materials is consumed by patent royalties.

The Nokia deal provides access to 8,500 design patents and over 30,000 utility patents (at a cost of $1.65bn) and their exclusive use for a ten-year period (Nokia Group will retain ownership of the patents, which goes someway in explaining the low deal value. However, the $1.65m paid by Microsoft includes an option to convert the agreement to a perpetual license).

However, the benefit goes both ways. Microsoft has itself used its own patent portfolio to bolster its earnings. It’s Q2 2012 earnings report went so far as to combine its smartphone OS licensing revenue with the patent royalties is receives from third parties. This lack of transparency, many suggest, points to the fact that royalty payments from Android OEMs and ODMs (such as Foxconn) equal (and perhaps exceed) the revenue it generates from its own OS.

Under the terms of the Nokia deal, Nokia Group will assign benefits [to Microsoft] of more than 60 patent licenses with third parties. These include IBM and Motorola Mobility and give Microsoft the benefit of royalty arrangements originally negotiated by Nokia. This will provide coverage for new devices without additional cost.

Branding is likely to be one of the most emotive elements of the deal. For many, the Nokia brand is synonymous with the wireless industry itself. However, it’s likely time to say goodbye to Nokia’s logo adorning a gleaming new Lumia.  The Lumia brand will continue to be applied to smartphones, however the Nokia name will be applied only to feature phones. Considering Nokia still ships upwards of 300m feature phones a year to emerging markets (against 35m smartphones), preservation of the Nokia brand for this product line is therefore important, at least until the market advances enough to migrate its entire device portfolio onto the Windows phone platform.  The ten-year agreement to license the Nokia brand (from Nokia Group) for feature phones suggests that this ambition should be achieved by 2020 at least.

Few directly outside of the industry fully appreciate the importance of Windows Phone to Microsoft’s wider ambitions. The platform’s importance is not limited solely to its own financial success, but to the success of the wider business. The Windows Phone platform is vital to protecting the core cash generators that are Windows and the Office suite, I wrote about this two years ago and it remains true today.

If you can’t see the connection, think about Apple and Android. These aren’t just operating systems, these are ecosystems. Both Apple and Google leverage their smartphone platforms as springboards to complimentary products and services, both on and off the mobile platform. Android users quickly tie themselves to Gmail and cloud-based Google Docs. No more Outlook and Microsoft Office for them. And iPhone users, once bought into the brand and experience, will be less inclined to dismiss a Mac as a second-runner when it’s time to buy a new desktop or laptop. No more Windows for them.

Microsoft must to protect its wider business and it needs millions of eyeballs on the world’s most pervasive computing platform – the mobile device – to do this. With that in mind, acquiring Nokia’s Devices & Services business is undoubtedly the company’s best way of securing this future.

 

Full Disclosure: I wrote this on behalf of my employer, WDS, A Xerox Company

 

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