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The Microsoft-Nokia puzzle

Will the tie-up create a new mobile behemoth?

While Microsoft has hinted at new form factors and innovation in the tablet and smartphone space after its €5.44 billion acquisition of floundering Nokia's phone unit, the market is waiting to see how Microsoft will leverage Nokia's innovation abilities.

Microsoft's unexpected bid for the Finnish maker's handset division has been seen as a way to solve Nokia's flagging smartphone situation and a boost for Microsoft's lagging mobile strategy. Microsoft sees the bid aiding its smartphone strategy, which will boost tablet sales and aid PC movement.

IDC expects the global PC market to decline by 9.7% this year as mobile devices continue to explode at the expense of PCs. "The market as a whole is expected to decline through at least 2014, with only single-digit modest growth from 2015 onward, and never regain the peak volumes last seen in 2011."

"It's a bold step into the future – a win-win for employees, shareholders and consumers of both companies. Bringing these great teams together will accelerate Microsoft's share and profits in phones, and strengthen the overall opportunities for both Microsoft and our partners across our entire family of devices and services," says Microsoft's outgoing CEO, Steve Ballmer.

"Nokia brings proven capability and talent in critical areas such as hardware design and engineering, supply chain and manufacturing management, and hardware sales, marketing and distribution," says Ballmer.

Nokia makes more than 200 million phones a year, but has fallen out of favour and is now a shadow of its former self after failing to capture the smartphone market the same way it did with feature phones.

As part of the change, Stephen Elop will step aside as Nokia CEO to become Nokia executive VP of devices and services at Microsoft. "Building on our successful partnership, we can now bring together the best of Microsoft's software engineering with the best of Nokia's product engineering, award-winning design, and global sales, marketing and manufacturing," says Elop.

"With this combination of talented people, we have the opportunity to accelerate the current momentum and cutting-edge innovation of both our smart devices and mobile phone products."

Nokia and Windows Phone have less than a 10% market share in nine markets, but the handsets are outselling BlackBerry in 34 markets. This is not surprising, as BlackBerry has been battling to keep the top position in the smartphone segment.

The ailing company has also put itself up for sale, but expects to report a huge loss in its next quarterly figures and is desperately cutting back on costs, with plans to axe 4 500 staff.

In the second quarter, BlackBerry expects an operating loss of between $950 million to $995 million as it writes down stock worth between $930 million to $960 million, a situation it says is due to "the increasingly competitive business environment impacting BlackBerry smartphone volumes".

Boosting growth

In a presentation to stakeholders by Microsoft's top team, the group said its purchase of the cellphone maker would accelerate growth and boost its share of the phone market. The software giant says its deal with Nokia provides clarity, which will help make the "market" for Windows phone. Microsoft also said it would accelerate innovation, hinting at new form factors. High-value services, including geospatial, are key, it says.

The software giant sees a family of devices with integrated services that "best empower people and businesses for the activities they value most", it says in the presentation.

While Microsoft will continue to support iPhone and Android phones with its services, it says it "cannot risk having Google or Apple foreclose app innovation, integration, distribution or economics". Microsoft will also take "additional" steps to promote the app ecosystem for Windows, it says.

Buying Nokia gives Microsoft access to device design and engineering, as well as a globally scaled supply chain. It also gives it an in to key growth markets and improved unit economics.

Nokia, which dates its existence back almost 150 years, has seemed to lag in innovation, and is no longer the darling of the mobile world. Overall, it had 14.1% of the mobile market, behind Samsung, as of the end of the second quarter, according to the IDC.

Samsung and Apple are battling it out for the top spot in the smartphone sector, while Microsoft says its Windows Phone is number three globally. It says the deal will grow the original equipment manufacturer opportunity.

Microsoft, which sells more than 300 million devices a year, sees success in phones being vital to success in tablets, which will help PCs.

Ballmer is famous for, among other things, dismissing the iPhone out of hand in 2007, saying it would fail to gain market share. He has also been blamed for Microsoft's failure to gain traction in the tablet space despite initially having an edge.

The giant that is Microsoft anticipates a worldwide smartphone market of 1.7 billion shipments by 2018, and anticipates having 15% of that. This will give it revenue of about $15 billion and break-even will happen when smart device units go past 50 million.

However, Arthur Goldstuck, MD of World Wide Worx, says Microsoft is making a fundamental mistake if it sees the deal igniting PC sales. He says PCs are suffering at the hands of tablets.

Nokia is innovative, adds Goldstuck, although it has yet to really capture the attention of the market at the top end. He says its mid- to low-tier products are doing well, but this is not where the margin is.

While Nokia is innovating at the top end, this has yet to translate into sales, says Goldstuck. He says Nokia is a long-term player and will trend upwards as it started off a low base, and the company was waiting for the market to understand its vision; unlike BlackBerry, which was waiting for a white knight.

Innovation is coming, what is needed now is for Microsoft to leverage it, says Goldstuck. He says Microsoft has deep pockets and should pump money into marketing Nokia to compete with Samsung.

In February 2011, Nokia and Microsoft signed a strategic partnership under which Nokia would only make Windows phones. That November, it shipped its first handset under the deal, the Lumia 800.

This was followed a year later with the launch of the Windows Phone 8, and, in April 2013, the Lumia 520, which shipped at an entry-level price point. In July this year, what Microsoft calls the "best camera phone in the world", the Lumia 1020 shipped.

Goldstuck says the 520 must be watched as it is a sub-R2 000 smartphone and is cleaning up the market left by BlackBerry's Curve.

Financial gains

The deal will add to Microsoft's earnings per share – measured as non-generally accepted accounting principles (GAAP) – by the 2015 financial year, and to GAAP earnings per share the following year. Microsoft expects to book annual cost synergies of $600 million within 18 months of wrapping the deal up, with competition approval expected early next year.

Microsoft's latest quarterly results show revenue of almost $20 billion for the three months to June, while net income was $4.97 billion, despite a $900 million charge after it wrote down Surface stock.

Nokia, however, has seen better times. In its latest quarterly results, it said handset units fell 27% in the second quarter. The group, in the midst of a turnaround, saw some margin improvements quarter-on-quarter.

It said net sales fell 24% year-on-year and 3% quarter-on-quarter to €5.7 billion. Nokia generated negative cash from operations, losing €196 million compared to a gain of €102 million in the previous quarter.

For Nokia, the deal is expected to significantly add to earnings, strengthen its financial position, and provide a solid basis for future investment in its three continuing businesses.

Valuable intellectual property

Of the total sale value, €1.65 billion relates to patents that will be transferred in the Nokia deal. Mike Sharman, owner of digital communications agency Retroviral, says this points to the fact that the patents are almost more valuable than the hardware.

As part of the deal with Microsoft, the software company agreed to make available €1.5 billion in financing to Nokia, which is currently listed as junk by credit rating agencies, through three tranches of bonds.

Around 3 200 staff will move to Microsoft as it gets the bulk of Nokia's devices and services business, its design team and production facilities; as well as operations that generated €14.9 billion, or half, of Nokia's total sales for 2012.

Under the agreement, Microsoft will get Nokia's phone business as well as its Qualcomm and other "key" intellectual property licences, including more than 8 500 design patents. It will license Nokia's patents for use across all its products and has a 10-year licence to use the Nokia brand on feature phones.

Nokia's portfolio has about 30 000 utility patents and patent applications, which Microsoft considers to be "one of the two most valuable portfolios relevant to wireless connectivity". Nokia is also assigning its existing licence with Qualcomm, the other valuable patent portfolio company, to Microsoft.

In addition, Nokia is conveying rights under its agreements with IBM, Motorola Mobility and Motorola Solutions to Microsoft, giving the software company the benefit of attractive royalty arrangements negotiated by Nokia.

Microsoft notes that, unless managed creatively, patent royalties can add more than 10% to cost of smartphone materials.

Microsoft will also be able to broadly use Nokia's Here in its products, and Nokia is left with its map unit, Here, Nokia Siemens Networks and Advanced Technologies. Goldstuck notes the deal is a serious hardware move for Microsoft and could be what it needs to solve its mobile dilemma. In a way, the agreement could be Microsoft's answer to Google and Apple, both of which have their own brands, comments Goldstuck.

Vestact analyst Sasha Naryshkine thinks Microsoft can "do it", although it will not be easy to topple Apple and Samsung off the pedestal "that is hundreds of rungs up the ladder".

All change

Naryshkine says, while Nokia may have lost dominance over the past five years, it still sold 53.7 million phones in the last quarter. However, he notes it is not about numbers, but profitability. "Nokia used to chop down trees and produce paper; this is probably just another chapter."

In Nokia's second fiscal quarter, it sold 7.4 million smartphones, a 27% year-on-year drop. Its mobile phone sales, at 53.7 million units, also fell 27% from the same period in 2012.

In February 2011, Nokia migrated operating systems from Symbian to Windows Phone.

In the second quarter of this year, according to the IDC, the Windows Phone OS posted the largest year-over-year increase among the top five smartphone platforms and reinforced its position as the number three smartphone operating system.

"Driving this result was Nokia, which released two new smartphones and grew its presence at multiple mobile operators. But beyond Nokia, Windows Phone remained a secondary option for other vendors, many of which have concentrated on Android," says IDC.

Nokia's low- and mid-end phones have provided it with a powerful business, but the group has not made it at the top end, where the profit is, says Goldstuck.

Risto Siilasmaa, Nokia chairman, and now interim CEO, says the deal is "an important moment of reinvention and, from a position of financial strength, we can build our next chapter".

Nokia expects to "book" a gain of €3.2 billion; adding to its earnings. After the sell-off, it will focus on NSN (Nokia Siemens Networks, which it has owned outright since August); Here; and Advanced Technologies, which is in the technology development and licensing space. It will keep its headquarters in Finland and will have staff of around 24 000.

Goldstuck says NSN is the jewel in its crown and is highly profitable.

Nokia's board is evaluating strategies between its three remaining businesses, including possible synergies.

"Today is an important moment of change and reinvention for Nokia and its employees," says Siilasmaa. "With our strong corporate identity, leading assets and talent, and from a position of renewed financial strength, we will build Nokia's next chapter."

Nokia also expects to gain financially from the deal, boosting its net cash reserves from the €4.1 billion it ended the second quarter with, to €7.8 billion, assuming the agreement had been wrapped up during the quarter.

Sharman notes the deal is a solution to Nokia's pending cash issues, although it is a little late.

Naryshkine points out that Nokia is a shadow of its former self. "The stock is down 84% in five years as the company lost handset dominance to a wave of newer smartphones that left the Finnish company… well, finished?"

Timeline:

1865: Mining engineer Fredrik Idestam sets up his first wood pulp mill at the Tammerkoski Rapids in south-western Finland, with a second a few years later on the banks of the Nokianvirta river, which inspires him to name his company Nokia Ab in 1871.
1898: Eduard Polón founded Finnish Rubber Works, which later becomes Nokia's rubber business, making everything from galoshes to tyres.
1912: Arvid Wickström sets up Finnish Cable Works, the foundation of Nokia's cable and electronics business. In 1962, it makes its first electronic device in-house: a pulse analyser for use in nuclear power plants.
1963: Cable Works starts developing radio telephones for the army and emergency services – Nokia's first foray into telecommunications.
1979: Joint venture company Mobira Oy is launched in conjunction with Finnish TV maker Salora.
1981: The launch of the Nordic Mobile Telephone service, the world's first international cellular network and the first to allow international roaming.
1982: Nokia introduces the first car phone – the Mobira Senator – to the network.
1984: The Mobira Talkman portable car phone is launched followed by the first handheld phone three years later.
1987: GSM (Global System for Mobile communications) is adopted as the European standard for digital mobile technology.
1 July 1991: Finnish prime minister Harri Holkeri makes the world's first GSM call, using Nokia equipment. A year later, its first digital handheld GSM phone, the Nokia 1011, is launched.
1992: Nokia starts to sell off its rubber, cable and consumer electronics divisions.
1994: The 2100 range is launched, the first feature phones to feature the Nokia Tune ringtone. The tones are based on Gran Vals, a classical guitar piece composed by Francisco Tarrega in the 19th century. The 2100 series sells more than 20 million phones globally, after an initial target of 400 000.
1998: Nokia is the world leader in mobile phones.
1999: The Nokia 7110 is launched. It is capable of rudimentary Web-based functions, including e-mail.
2001: Nokia launches its first phone with a built-in camera.
2002: The group launches its first 3G phone.
2005: Nokia sells its billionth phone – a Nokia 1100 – in Nigeria, and global mobile phone subscriptions pass two billion.
2010: Nokia falls off the top of the leader board, appoints Stephen Elop as president and CEO, and starts with a rethink.
February 2011: Nokia joins forces with Microsoft to strengthen its position in the smartphone market and starts adopting the new Windows Phone 7 operating system, with the Symbian platform gradually being sidelined.
October 2011: Launches its first Nokia with Windows Phone, the Nokia Lumia 800 and the Nokia Lumia 710.
2013: It has a full portfolio of Windows Phone 8 smartphones, from the Lumia 520 through the flagship Lumia 920.
(Source for timeline: Nokia)


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