Microsoft (MSFT) has just announced that it will purchase the phone business of Nokia (NOK) for 5.44 billion Euro or roughly $7.2 billion. The sale comes at a time when Lumia series is slowly gaining traction in a highly competitive smartphone industry. This sale also puts the earlier purchase of NSN into perspective for Nokia investors. This shows that Nokia was trying to move away from its phone business and focus more on location and NSN segments.
This is perhaps the biggest news in the smartphone arena since the advent of the iPhone. Microsoft has already proven its flair for hardware with the commercially successful Xbox and critically lauded Surface tablets. The company was already a crucial part of the Lumia series which supports the Windows Phone 8. This move also answers the critics who have for a long time questioned Nokia's prudence in not launching a Lumia Android device. It shows that Microsoft was more closely entrenched in Lumia than initially perceived.
There have been some significant changes in Microsoft's structure over the last few months. The world's largest software manufacturer has been trying to find more growth opportunities due to slowdown in PC business. Microsoft's leader Steve Ballmer has been under consistent criticism for failing to diversify away the troubles of Microsoft. On the verge of being ousted, Ballmer did have an ace up his sleeve after all. Now, the real questions for Nokia and Microsoft investors are the long-term implications of today's development.
Microsoft has been facing a growth decline in its Windows segment. This has been spurred by the decline in the PC industry, fuelled by the popularity of handheld devices. This has left Microsoft no choice but adopt the 'Apple model'. The company has been trying to control its hardware and has recently launched Windows 8 Surface tablets. The consumer reception for the devices was 'cool' at best, but they did win points with critics. The purchase of Nokia will enable Microsoft to use its financial might to control the destiny of the Lumia series.
In an industry where Android is fraught with security concerns and Apple is still too expensive, Microsoft's Nokia can carve out a market share. The Lumia has already enabled Microsoft OS to surpass BlackBerry (BBRY), by gaining a market share of 3.3%. Using its superior marketing abilities and brand image, Microsoft has the potential to surprise the Samsung (SSNLF.PK) and Apple (AAPL).
Nokia, Where art thou?
Nokia has ruled the cellular phone market for over a decade, it has fallen behind as faster, more efficient competitors like Samsung have overtaken it, in terms of technology as well as sales. Nokia, however, is not only limited to the communication devices that it produces, but also produces technologies like HERE, which is the provider of digital map data and location services for automobiles and cell phones, and also owns Symbian, the operating system found mostly on Nokia phones until it was scrubbed in 2011 and replaced with Windows Phone. In addition to all this, Nokia also operates another subsidiary by the name of Nokia Solutions and Networks (NSN), previously Nokia Seimens Networks B.V. which produces networking and telecommunications equipment, and is the fourth largest company to operate in the said product category.
The acquisition of the phone division by Microsoft will totally transform Nokia as an investment. Nokia, was once a leader in the global mobile device market, was now facing challenges both financially and in thbe competitive market despite a healthy cash position as well as a strong balance sheet. The primary culprit was its Devices and Services division which has been reporting losses, in addition to losing its market share in the mobile devices market, where it has reported a non-IFRS operating margin of ($1.2%) in the second quarter this year.
However, both of its other businesses, i.e., HERE and Nokia Siemens Network (NSN) have been profitable and have reported non-IFRS operating margins of 3.4% and 11.8% respectively in the second quarter of 2013.
NSN and HERE
An upside for Nokia and its investors alike is the increase in the profitability of Nokia Siemens Network. While Nokia's mobile phones have been giving it a hard time, NSN has been keeping the company afloat. In the second quarter of 2013, NSN reported a non-IFRS operating margin of 11.8% which is well above Nokia's expectations of an operating margin of 5%. NSN has been showing continued progress and is proving to be the saving grace for Nokia Group. What's even better is that Nokia has decided to buy out Siemens' stake in NSN and that too for a truly modest price considering the revenues and profits that the business is making. The driver behind the purchase is Siemens' inclination to sell its share in the business as well as Nokia's wish to take complete control of the business. Therefore, investors are looking quite positively at Nokia's complete acquisition of the NSN joint venture.
However, the telecom vendor industry is also in a major decline. The price competition from Chinese telecom vendors and approximately 100% network converge, in most developed and developing countries, have slowed down growth. The main 'business opportunity' lies in upgrading networks to 4th generation capabilities. In some good news from the industry, China Mobile (CHL) is upgrading its entire network to 4G, a deal worth billion. Although Huawei and Ericsson have won almost 50% of the contracts, Nokia has been awarded a sizable contract of approximately 10%.
Nokia's HERE has also reported an increase, of 8% QoQ, in Net Sales in the second quarter and is thus proving to be a growing business for Nokia. Nokia's NSN, which would probably be renamed after Nokia buys Siemens' share in the joint venture, as well as HERE have thus far proved to be businesses that have not let Nokia fall even when its devices and services unit has been going through a tough time fighting the smartphone war in the mobile phone market.
Value and Price Target
Microsoft has agreed to pay around $7.2 billion for Nokia's Phone business. This would amount to around $1.94 per share. The devices segment was its weakest link due to high risk and consistent operating cash requirement. After this sale, the new valuations are as follows:
The total value of Nokia comes down to approximately $23 billion. If we argue that NSN valuations should be lower than Ericson, using a P/s of 0.7x, the value of NSN will be $7.7 billion. Under the two assumptions, Nokia's new price target should be $6.2 per share and $5.58 per share.
The purchase of Nokia's phone division is one of the biggest news items in the smartphone industry. Microsoft is now in a position to become a leading player in the smartphone industry. The company will try and use Apple's model to control its own software and hardware. However, it will continue to lend its OS to other OEMs, unlike Apple. This is because Microsoft will be targeting to become not only a serious player in smartphone industry but also the leading 'ecosystem' in the world.
Nokia has struck gold with the sale of its devices segment for $7.2 billion. Although it's sad news for long term Nokia investors and consumers, it's a reality that smartphones are no longer sold only on device capability but strength of the ecosystem and Microsoft is in a much better position to make Lumia a winner. This sale also presents an excellent opportunity to buy Nokia at cheap valuations. The new price target for Nokia should be somewhere between $5.5 and $6.2, depending on how you value NSN.