Anyone still wondering why Microsoft Corp. (Nasdaq: MSFT) Chief Executive Officer (CEO) Steve Ballmer is being forced into early retirement need look no further than the $7.2 billion Nokia Corp. (NYSE ADR: NOK) deal announced today (Tuesday).
In a note to employees, Ballmer called the Microsoft-Nokia deal "a bold step into the future," but given the already cozy relationship between the two companies, it looks more like a leap of faith.
While the deal does come with some benefits for both companies, it's not going to have enough impact to reverse the eroding fortunes of either.
Rather than buy the entire company, Microsoft is buying Finland-based Nokia's substantial - and at one time market-leading - mobile phone business. The deal solidifies a partnership forged in February 2011 in which Nokia agreed to base its flagship Lumia line of phones on Microsoft's Windows Phone operating system.
Given the precarious position of both companies in the smartphone sector of mobile - each is down to single-digit market share - perhaps such a deal was inevitable.
Money Morning Chief Investment Strategist Keith Fitz-Gerald certainly saw it coming.
"I think Microsoft is going to make a run at Nokia as a means of ensuring that the company doesn't lose its path to mobile markets," Fitz-Gerald wrote in an internal stock analysis in July, making the case that NOK was a buy at about $4 a share.
Still, given the fact that Redmond, WA-based Microsoft has slipped so far in terms of connected devices (from 90% in 2009 to just 25% now), Fitz-Gerald doesn't see any of the company's latest news - from the restructuring to Ballmer's forthcoming departure to the Nokia deal - as offering much hope for MSFT stock.
As Fitz-Gerald explained during a July 12 visit to FOX Business' "Cavuto," the company has been operating under Ballmer's "me-too" marketing plan ever since Windows - and the plan doesn't work.
The MSFT Quest for Market Share
One of the biggest mistakes Microsoft and Nokia both made was that they underestimated how Apple Inc. (Nasdaq: AAPL) would disrupt the mobile phone market. That mistake was compounded when Google Inc. (Nasdaq: GOOG) launched its free Android operating system in 2008.
It was the iPhone-Android juggernaut that inspired NOK and MSFT to pair up back in 2011. Back then the research firms Gartner and IDC made dramatic predictions that the partnership would deliver market share of 10% by 2013 and 19.5% by 2015, but I told you that wasn't going to happen.
Sure enough, the worldwide market share of Windows Phone has gone from 4.2% in 2010, before the deal, to a whopping 3.3% in Gartner's latest report for Q2 of 2013.
That doesn't mean that having both the hardware and software operations under one roof won't help Microsoft make a more competitive product, but that investors need to be wary of the company's wide-eyed predictions that it now will be able to triple its market share to 15% by 2018.
But even if Microsoft does manage to capture much more of the smartphone market as a result of the Nokia deal, it may not matter all that much...
While Ballmer fiddled away the past six years, the most lucrative period for the smartphone has come and gone.
In developed economies like the United States, the smartphone market has matured; users are upgrading less frequently, resulting in slowing sales growth.
And though there's still plenty of growth to be had in places like China and India, few of those customers can afford the high-end, high-margin models that have fed the profits of companies like Apple and Samsung Electronics Co. (PINK: SSNLF).
IDC estimates that since the start of 2012, the average smartphone selling price has dropped from $450 to $375.
"The days of great growth in the high end of the market are gone," Michael Morgan, an analyst at ABI Research, told Bloomberg News. "It's the Chinese companies who know how to survive on tiny margins that are ready for the fight that's about to ensue."
The impending shift in the nature of the smartphone market is why Apple is expected to introduce a cheaper version of the iPhone next week. Smartphones are on the verge of commoditization, just like PCs in the late 1990s and early 2000s.
In the remaining growth markets, price will be king and profits will necessarily shrink. Microsoft may find that any increases it enjoys in smartphone market share will translate to smaller gains in its bottom line than it might hope.
Microsoft itself estimates that it will need to sell about 50 million mobile units (adding tablets to the smartphone mix) to break even; Nokia is currently selling Lumia devices at a rate of about 30 million a year.
What Will Really Come Out of the Microsoft-Nokia Deal
The deal isn't a total waste of money for MSFT, however.
For one thing, Microsoft plans to use some of its overseas cash to finance the deal; that money would have been subject to U.S. corporate taxes had the company repatriated it.
Another positive is the return to Redmond of Nokia CEO Stephen Elop, a former Microsoft executive who now becomes the leading candidate to succeed Ballmer.
Finally, Microsoft probably will gain some smartphone market share, particularly in markets where Windows Phone has shown some strength lately, such as Europe, Latin America, and some parts of Asia.
Plus, bringing Nokia's hardware in-house should help Microsoft squeeze more profit out of each phone sold. MSFT also estimates that its profit on each unit sold should rise from less than $10 to more than $40.
But at the end of the day, selling Nokia smartphones is not going to put Microsoft back on a path to significant growth. To do that, Microsoft needs to make some sort of dramatic move in tech's next growth areas, such as cloud computing and the Internet of Things.
Note: Microsoft may be slow to capitalize on the new opportunities in tech, but you shouldn't be. We've uncovered a tiny, inexpensive device that could end all disease and make early investors very rich...
Nokia, on the other hand, is looking pretty good in this deal. It sheds an underperforming unit for a pile of cash. Some of that cash will end up in shareholders' pockets, but much of it will be invested in the company's remaining operations in telecommunications, locations, and mapping.
Nokia gets an added bonus out of the deal in that it gets to keep all its patents - and the revenue stream its gets from licensing them.
Wall Street's verdict on the Microsoft-Nokia deal was clear: MSFT stock was down about 5%, whereas NOK's was up more than 31%.
"The question is whether combining two weak companies will get you a strong new competitor - it's doubtful," Paul Budde, a telecommunications consultant in Sydney, told Bloomberg. "Both Nokia and Microsoft really missed the boat in terms of smartphones, and it is extremely difficult to claw your way back from that."
Before Keith Fitz-Gerald heard about the Microsoft-Nokia deal, he offered a single chart to answer the question of whether the departure of CEO Steve Ballmer would have any long-term benefit to MSFT stock...
Related Articles:
- Money Morning:
Tech Stocks: Nokia (NYSE: NOK) Getting Squeezed in Smartphone Market - The Verge:
With Nokia, Microsoft Wants to Triple Windows Phone Marketshare by 2018 - Bloomberg:
Microsoft to Buy Nokia's Devices Unit for $7.2 Billion - ZDnet:
Could Windows Phone Ever Squeeze Past iOS in the Smartphone Stakes? - Bloomberg: High-End Smartphone Boom Ending as Price Drop Hits Apple
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