My Take On Microsoft's Nokia Acquisition

Sep. 3.13 | About: Nokia Corporation (NOK)

It turns out that Microsoft (NASDAQ:MSFT) is acquiring Nokia's (NYSE:NOK) mobile devices business after all. For a long time, I kept saying that this didn't make sense unless Nokia was on the brink of bankruptcy and needed to be saved immediately. The development came as a total surprise to me.

According to the stories floating in the media, Microsoft will pay Nokia $5 billion for its business segment responsible for making phones (in addition to $2 billion for licensing of Nokia's patents for the next 10 years). This is about half of Nokia's current market value of $14 billion. The deal leaves Nokia with its Nokia Solutions and Networks and HERE (the mapping business) in addition to close to $20 billion in cash.

Nokia's CEO Stephen Elop will be rejoining Microsoft as part of the plan and Nokia will be looking for a new CEO. In fact, Mr. Elop will be taking a few other Nokia executives with him and he is still said to be in the race for Microsoft's CEO position, which is scheduled to be open next year.

I am curious to see how investors will view Nokia in light of this development. Many investors bought Nokia because they saw a lot of value in the company's phone business. I don't know how many of those investors will stay invested in Nokia once the company will consist of its network and mapping businesses. As of last quarter, Nokia's network business was profitable with double-digit margins; however, its mapping business posted a loss, business as usual.

Obviously, Microsoft got a really good deal out of this acquisition. Typically, when a company acquires (even a part of) another company, a big premium is involved in the bill. Historically, the premiums paid for acquisitions have been around 30-35% and they had been trending upwards in the last few years, with some acquisition premiums going as high as 50-60%. There are only two times when an acquisition doesn't result in a premium: 1) when the acquisition was already expected and the premium was already baked in the price, 2) when a deeply-troubled company is acquired to save it from its death bed. In Nokia's case, Microsoft hardly paid a premium for Nokia's phone business. When you consider how Microsoft spent nearly $10 billion to buy Skype, a company that generated $860 million in revenues, Nokia's phone business deserves a much better price than $5 billion considering how it generated $20.38 billion in revenues last year. In the coming weeks, we will see how well Nokia's investors will take this development.

As I mentioned in the first paragraph, I wasn't expecting Microsoft to buy Nokia this soon because it didn't make sense to me for both sides. It didn't make sense for Microsoft because Microsoft is a software company with really strong margins and acquiring Nokia's handset business would hurt the company's margins big time. It also didn't make sense for Nokia because the company is known for its handset business (even though its largest segment is Nokia Solutions and Networks, formerly known as Nokia Siemens Networks) and most investors wouldn't really want to own the company if it wasn't for the phone business.

At this point, I don't even know how Nokia will use its $20 billion of cash. Maybe the (remains of the) company will pull another surprise and go private with its cash. Then again, the company's management will have to look for a new CEO and leave the decision to this new person. With the new cash injection, Nokia's balance sheet will look much better than it did and Microsoft's payment will pretty much cover Nokia's acquisition of Siemens' stake in Nokia Siemens Network.

I am also curious to see how much of Nokia's patent portfolio will be passed to Microsoft. We know that about $2 billion of the deal involves Nokia's patents; however, we don't know specifics like whether some patents will be permanently owned by Microsoft after the transaction is complete. Nokia generates close to $1 billion annually from its patent portfolio and it would be very bad for the company if a large portion of the patents moved to Microsoft because of the deal.

Last year, Nokia's network business generated $17.90 billion in revenues, $5.33 billion in gross profit and $1.04 billion in operating profit. The company's mapping business generated $1.43 billion in revenues, $1.13 billion in gross profit and $391 million in operating loss. Combined, the two segments generated $19.33 billion in revenues, $6.46 billion in gross profits and $739 million in operating profits. Considering how Nokia will have $20 billion in cash after the deal, it may be worth close to $30 billion if it can remain profitable. Then again, values of companies are determined by investors and I can see many investors selling their shares because they bought the stock because of the Windows Phone story in the first place.

The details of the acquisition are somewhat complicated and we will not know many of the details until the dust settles. For example, Nokia will keep the "Nokia" brand name and Lumia phones will be called "Microsoft Lumia" rather than "Nokia Lumia." Nokia will not be able to make any phones under its own name until 2015; but we don't know what happens after that. Will Nokia simply start another phone business in 2015 and compete with Microsoft?

I'm tempted to sell most of my Nokia shares (which I held onto through good and bad times, including when the price fell to $1.67 per share) and add to my Microsoft shares. Microsoft definitely got a good deal out of this whole thing and I expect the company to see some benefits even though its strong margins will definitely take a hit as a result of the acquisition.

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