Microsoft's Nokia Acquisition: Too Early, Too Cheap

Sep. 4.13 | About: Nokia Corporation (NOK)

On Tuesday, as soon as Microsoft (NASDAQ:MSFT) and Nokia (NYSE:NOK) announced the acquisition, I wrote an article summarizing my thoughts about the acquisition. Since then, more details emerged and I had more time to think about the acquisition. It looks like Microsoft might have hurt itself and Nokia by acquiring the latter's handheld devices business too soon (at a too cheap price).

First of all, Nokia's Lumia phones have been gaining momentum in the last couple of quarters and Microsoft's acquisition can slowdown or kill this momentum. On Monday, Kantar WorldPanel announced the new market share statistics for the smartphone market. For those that don't know, Kantar tracks and publishes monthly data in market shares and I try to cover this data every month as it gets published.

In the US, Windows Phone's market share was up to 3.5% compared to the 3.0% obtained the same month of last year. Android's (NASDAQ:GOOG) market share was down from 58.7% to 51.1% and BlackBerry's (NASDAQ:BBRY) market share was down from 1.9% to 1.2%; whereas, Apple's (NASDAQ:AAPL) iOS grew its market share from 35.6% to 43.4%.

In EU5 area (the largest 5 markets of European Union which include Germany, the UK, France, Italy and Spain), the market share of Windows Phone was 8.2%, almost double from last year's 4.9%. BlackBerry's market share fell sharply from 6.7% to 2.4% and Symbian's market share fell from 4.3% to 1.1%. As for Android and iOS, both of the operating systems scored 3% growth rate as Android reached a market share of 69% (up from 66%) and iOS reached a market share of 18% (up from 15%).

If we look at specific European countries, Windows Phone has a market share of 8.8% (up from 6.2%) in Germany, 9.2% (up from 4.2%) in the Great Britain, 11.0% (up from 3.6%) in France, 1.8% in Spain (up from 1.7%) and 7.8% in Italy (down from 8.3%). It seems like Windows Phone is far more successful in northern parts of Europe than in southern parts of Europe. Android enjoys a market share of 71% in Italy and 90% in Spain, which might explain lack of success for Windows Phone and iOS in these two countries. Android pretty much owns these two countries.

In Australia, Windows Phone's market share was 7.0%, up from 4.6%, in China, the operating system's market share was 2.4%, down from 4.6%, and in Mexico the market share was 12.5%, up from 2.0%. It looks like Windows Phone is gaining a lot of fans in Latin America but the operating system's growth is slowing in China.

Nokia accounts for much of the growth as it continues to account for 86% of all Windows Phone devices sold. More specifically, Nokia's cheapest Windows Phone device Lumia 520 (known as Lumia 521 in the US) is selling like hot cakes and this phone alone accounts for a significant portion of Windows Phone's growth.

Keep in mind that Nokia always enjoyed a very strong brand name in Europe, Latin America and Asia. While Microsoft's brand name is very strong with the enterprise clients, the same can't be said about the consumers' side. "Microsoft Lumia" simply doesn't have the same appeal as "Nokia Lumia." In the last 18 months, I bought a Nokia Lumia 900 and a Nokia Lumia 920 for myself and I bought a few Nokia Lumia 520s as gifts to other people. Would I have bought a Microsoft Lumia? It's very doubtful. In fact, I was considering buying Lumia 1020 but now I'm leaning towards the next version of iPhone because I am not sure about what Microsoft will do with this brand. If Windows Phone could simply sell itself, Samsung, HTC and Huawei would have seen similar success to Nokia; however, we don't see this happening. The recent success of Windows Phone was almost fully attributable to Nokia.

The acquisition also throws Nokia in turmoil because it takes the company's CEO as well as some executives away. While the investors are currently celebrating a short squeeze, when the dust settles, Nokia will have to spend the next several months looking for a new CEO and some new executives, which is always filled with uncertainties. Basically, Microsoft threw Nokia under the bus by acquiring some of the company's very important executives.

So, what happens to Nokia's phone division? For the time being, Nokia's phone division will consist of a patent portfolio. According to the agreement between Nokia and Microsoft, the former will be able to start building phones under its brand name after 2015. Here is the problem though, anyone who knows how to design and build a phone at Nokia will have already moved to Microsoft by then. While Microsoft is paying Nokia about $5 billion for its devices division, it would cost Nokia more than that to build a mobile phone division from scratch (it would have to hire tens thousands of engineers who have experience and expertise in designing and building high-quality phones) when the time comes for Nokia to get back in the phone business. This is also very important for the company's patent portfolio, because Nokia wouldn't really be able to generate new patents without an ongoing phone business, which would diminish the value of the company's patents over time.

By the way, if Nokia decides to build phones again after 2015, what operating system will it pick? Will it stick with Windows Phone, go Android or do a little bit of both? Will it even be too late in the game for the company to gain any meaningful market share? These are questions to consider.

Then there is the issue of Nokia's newfound cash. What will the company do with this money? I keep hearing about a "special dividend" that might come in the way of the shareholders. I really don't like the sound of it. Special dividends never accomplish anything. Don't get me wrong, I like the idea of growing dividends or at least consistent dividend payments that come every quarter, year or month. On the other hand, paying a one-time high dividend accomplishes pretty much nothing for shareholders because that amount gets deducted from the share price and the company's cash gets wasted. A massive buyback would be more useful than a one-time dividend because it would reduce dilution and make each existing share more valuable. Also, keep in mind that the share price has appreciated by about 35% on Tuesday alone, which means that the shareholders were already rewarded handsomely because of the acquisition and a special dividend would have been redundant and would accomplish nothing.

Some people also suggest that Nokia should buy Alcatel (ALU), but I don't like the idea of Nokia merging with a company that hasn't posted a profit in forever. Nokia just got rid of a marginally profitable business division and it makes little sense for it to buy a business that keeps losing money. A more suitable merger for Nokia would be Ericsson (NASDAQ:ERIC) who became a major player in network infrastructure after selling its phone business to Sony. Last year, Ericsson generated $34 billion in revenues, $10.91 billion in gross profit and $870 million in net income. Keep in mind that Ericsson's market value is twice as large as Nokia's, so we would look at a merger rather than an acquisition if the two companies would want to get together. By the way, Nokia Solutions and Networks is more profitable than Ericsson even though its current value is around $20 billion compared to Ericsson's value of $40 billion.

On November 19, the investors of Nokia will be voting on the merger. I expect the merger to be approved even though Nokia's phone business is being sold at a cheap price. I expect the deal to be approved because most investors that are against the acquisition will have sold their shares by then since they will be taking advantage of this rally. By the time voting day comes, the investors holding the stock will be mostly those that believe in the merits of the acquisition and they will probably vote for it rather than against it.

If Microsoft doesn't play its cards correctly, this might turn into another acquisition that ends up as a write-off. The company will not be able to use Nokia's logo on its smartphones, which means some of the marketability in those phones will be lost in process. Smartphone business comes with tiny margins unless the company in question is Apple. If Microsoft's Nokia acquisition is successful, it will result in tiny gains compared to what it would have already gained from Nokia in licensing fees. If the acquisition doesn't turn out to be very successful, the company will have to write off billions of dollars. This is a high risk investment with limited return potential and makes me uncomfortable as a Microsoft investor. Nokia was already priced for bankruptcy; so it didn't have much of a risk for investors; however, Microsoft can tank badly if this acquisition ends up failing.

I sold my Nokia shares to a good profit and I might come back once the dust settles. I expect a lot of volatility for Nokia in the short term. If Nokia can hold onto a value above $5 per share, it will be able to attract more institutional investors, which is nice in the long term.

Disclosure: I am long MSFT, BBRY, AAPL. 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.