Microsoft (And Nokia's) Window Of Opportunity To Close The App Gap

| About: Microsoft Corporation (MSFT)

The Chicken-and-Egg Apps Dilemma

There have been many media articles that have suggested that if only Microsoft (NASDAQ:MSFT) could fix the apps problem, it would sell many more Windows phones. I agree with this sentiment - in fact, solving this problem would remove the single, largest barrier to success for Windows Phone. But getting developers to build apps for Windows Phone at or near the same time that they roll out for Android and iOS is, of course, a most difficult problem for Microsoft to solve.

Apple (OTC:APPL) and Google (NASDAQ:GOOG) share an early-movers' advantage in the mobile handset market that will not easily be overcome. Developers remain reluctant to develop apps for platforms that have modest market share - it just is not worth their time. Consequently, new OSs have a hard time gaining market share without a rich apps environment.

Consider the plight of Windows Phone which is not only missing the breadth of apps of iOS and Android, but is also still missing these three high profile apps today:

  1. Instagram
  2. SnapChat
  3. Pinterest

While third-party apps are available on Windows Phone to deal with these missing apps (for example, a third-party app called Instance integrates well with Instagram on Windows Phone), they are viewed as inadequate by many users. Some fret that the latest features will not be available as soon on the copycat as the original or that the third-party may go out of business or be forced to pull the app for copyright violations or other reasons. Even when alternative apps are available that are superior to the popular ones, there remains a huge marketing issue for Windows Phone as long as the more popular app remains absent.

But even if the three key missing apps listed above were made available to Windows Phone tomorrow, that would not solve the longer-term issue for this fledgling OS. As new apps are inevitably developed, their availability on Windows Phone will continue to lag - often by several months. Consider that DropBox and Candy Crush were only added to Windows Phone long after their debut on the duopoly platforms.

Recently, Microsoft has put into place financial incentives to get the developers to build apps for Windows Phone more quickly. While this may help close the gap for smaller apps, it is unlikely to compel a company the size of Facebook (NASDAQ:FB) (Instagram's owner) into porting its popular apps to Windows Phone.

There is, I believe, only one long-term solution to this app gap - Windows Phone must increase its market share. I believe that market share in the 10%-15% range should be the tipping point to force developers to take notice and no longer ignore the platform.

World Larger Than Just the US, but US Market Still Critical

The US market appears to be more app-focused than most others. This may be one reason why Microsoft is having a more difficult time gaining market share here versus Europe.

On the recent quarterly conference call, Nokia's (NYSE:NOK) CEO Steven Elop was asked how much longer he was going to keep trying to improve market share in the US given that Nokia has sold approximately 500K handsets here for each of the last 8 quarters despite introducing several new innovative products over this period. He answered succinctly with the following points that I am paraphrasing:

  1. The introduction of high end technology in the US sets the stage for media coverage from both traditional media sources as well as the blogosphere. (He mentioned the newest camera technology in the Lumia 1020 as an example.)
  2. The deployment of new handsets with the US operators provides the company with critical intelligence for their introduction in other markets.
  3. The introduction here provides a high profile which encourages developers to build apps.

In summary, he said that the US market "... has high signaling value."

Now consider the awkward and uncomfortable position Nokia finds itself in the United States at the start of the third quarter:

HSN recently began selling the Lumia 521 for $99 including several accessories. Meanwhile, just hours into the start of the pre-ordering process for the soon-to-be-released Lumia 1020, AT&T is already reporting sell-outs.

This means that Nokia is effectively selling its mid-tier Lumia 521 near cost (one Wall Street analyst note suggests a BOM of $100 for the 521) to generate volume and improve its US market share. At the same time, Nokia cannot meet demand for its higher margin Lumia 1020 even though demand is clearly present. How did it get itself into a knot like this?

Generals Always Prepare for the Last War

Only hours after the start of pre-orders of the new Lumia 1020 at AT&T a few days ago, their website displayed the all-too-familiar SOLD OUT status. Those of us who follow Nokia closely have become all too familiar with this trend as each new Lumia model gets introduced. While these early sell-outs do create some excitement on the Internet, it has become all too clear (given the pattern), that these shortages are much more due to a lack of supply rather than an excess in demand. To take an extreme case, the Lumia 920 did not roll out in certain European countries for nearly 9 months after its initial introduction in other markets.

I still do not know what fraction of these shortages is due to component procurement issues versus working capital constraints (i.e. Nokia's cash crunch) versus an active strategy by management to avoid obsolete inventory. But I suspect most of it is due to the latter.

This is for two reasons: First, management has hinted to this on previous press releases. Second, Nokia has recently felt the pain of such obsolete inventory.

After the initial release of the Windows 7 phones, Nokia eventually found itself with large amounts of unsold inventory. (Some of this issue was exacerbated by the revelation that Windows 8 phone would be incompatible with the previous generation.) Thus, Nokia was forced to unload this inventory at a deep discount. As an aside, a lot of this inventory was sold in Italy which may explain why that country's Windows phone market share spiked disproportionately to the rest of Europe.

I think to avoid this inventory issue, Nokia has been purposely limiting its initial build rates. Only after a handset has established demand has management been willing to commit capital (i.e. Lumia 520/521). But this has had the adverse effect of causing severe shortages when introducing new models. No doubt they have left some money on the table as many consumers have likely chosen to buy a different handset rather than wait for the Nokia handset to arrive in the mail weeks hence.

Subsidize Ultra-Low-End Windows Phones to Drive Market Share

As far as I know, the exact licensing terms for developing a Windows Phone have never been made public. But some estimates place the cost around $23-$35 per handset. While such a fee may be tolerable on a high end handset such as the Lumia 92X or 1020, no manufacturer of a sub-$100 handset could afford such a fee.

But if Microsoft would consider deeply discounting (or even giving away) its licensing fees for ultra-low-cost handsets which currently constitute the feature phone portion of the handset market, it could not only accelerate the worldwide move from feature phones to smartphones but also gather up much of this transitional market share.

Say Microsoft agreed to charge 5% of the handset average selling price as its Windows Phone licensing fee. A $60 handset would therefore yield a $3 fee to Microsoft - probably a tolerable cost to the manufacturer for not having to develop and maintain its own OS software. Regardless, I am not arguing what the exact percentage of the fee should be (5% versus 10% or whatever), only that Microsoft needs to provide a deep discount - enough to entice developers such as Nokia into building on a single platform for all mobile handsets.

Consider what would happen if Nokia could transition from its Asha and other feature phone platforms to a single, unified Window Phone platform:

  1. Nokia would have to pay slightly more in fees to Microsoft but could avoid some development costs on these phones - no more development dollars on Asha.
  2. Microsoft would increase its licensing fees slightly. While the overall dollars may be low (per handset), the contribution margin should still be reasonable.
  3. As low-end Windows Phone users transition to mid-tier products, they would already be familiar with the Windows platform, thus making them less likely to switch to Android. (iOS is not really a possibility for this market segment unless Apple intros a lower end handset).

More importantly, such a move would drive volume in a portion of the market that would otherwise be inaccessible to them anyway.

Volume All at Low End of Handset Market

Nokia recently introduced its new flagship, the Lumia 1020 with a revolutionary 41 MP camera. One might think that the Lumia 1020 would, therefore, be the most popularly searched Lumia on the Internet recently. But this Google Trends chart shows it is not the case.

Even with all the recent hype surrounding the Lumia 1020, the queries on the older Lumia 520 remain stronger and are still building.

Conclusion: To Compete Effectively at the Mid- and High-Tier, Microsoft Must be Prepared to Subsidize at the Low End

What I am suggesting in this article is a strategy for Microsoft to pursue to enhance its market share in Windows Phone. In that sense, Nokia will have little say in the matter. But without such a move, I believe both companies will continue to find the going tough in the competitive world of mobile. So far, the partnership has tried conventional means to increase market share. While this has had some modest success outside the US market, they have not been able to make a significant dent here. By following traditional marketing techniques, they have tried to work on the numerator to the problem. But by lowering the licensing fees on the low end, Microsoft can, instead, work on the denominator to the problem by increasing the size of the smartphone market - thereby attracting more app developers by increasing their market share. Given Nokia's strong brand in the low end of the handset market, such a strategy seems a good fit for this partnership.

Disclosure: I am long NOK. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

About this article:

Tagged: , , , Application Software, , Expert Insight, SA Submit
Problem with this article? Please tell us. Disagree with this article? .