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With the purchase of Nokia's (NOK) phone business, Microsoft (MSFT) demonstrated that it really is serious about becoming an integrated devices and services company as it announced last July. Apparently many MS shareholders who hadn't bought into this had a rude awakening Tuesday morning and promptly sold their shares. But even with three times the normal volume of shares changing hands, the stock only dropped 4.5%, demonstrating that there were many willing to buy into the new Microsoft.

The New Microsoft

Vertical integration will be the hallmark of the new Microsoft, as it brings together in a single business OS and application development, device hardware design and engineering, and device manufacturing. When it completes the purchase and integration of Nokia's Devices and Services division, Microsoft will have achieved a greater level of vertical integration than even its rival Apple, which has shied away from in-house manufacturing in favor of contract manufacturing for some time.

Microsoft will achieve not only economies of scale but economies of organization, as corporate level administration and marketing can be shared by all its operating units. Bringing manufacturing into the company also allows MS to keep the profit it would have paid to contract manufacturers.

As I pointed out in my previous post, Microsoft has been driven to this new business model by competitive pressure from device makers that use Google's (GOOG) Android OS. As I discussed previously, Android device makers have a built-in cost advantage compared to Microsoft's mobile device partner OEMs by virtue of getting their OS for free. The tried and true model of the Windows commodity box makers simply wasn't working against Android.

Time Runs Out for Elop

Just the fact that Nokia was so anxious to dump its mobile phone business, including feature phones as well as smartphones, shows how difficult profitability is for Microsoft's mobile device OEMs. Even though Nokia was getting Windows phone licenses basically for free by virtue of compensating "platform support payments" from Microsoft, its Devices and Services division posted an operating loss of $43.6 million on revenue of $3.595 billion in Q2.

Despite claims by Microsoft and Nokia of "progress" and "momentum" in Windows Phone, time had run out for CEO Stephen Elop and the Windows Phone strategy that was supposed to replace Symbian with a vibrant and growing ecosystem. Selling smartphones had become a zero sum game for Nokia, in which steeply discounted Lumia phones cut into sales of other Nokia non-Windows smartphones, but didn't produce a significant increase in smartphone sales, as the table drawn from Nokia's quarterly reports shows:

Quarter

Lumia Units in million

Asha Units in millions

Symbian Units in millions

Total in millions

2012 Q4

4.4

9.3

2.2

15.9

2013 Q1

5.6

5

0.5

11.1

2013 Q2

7.4

4.3

0

11.7

Windows phones achieved only a 3% worldwide market share in the first half of 2013, according to Gartner's Q1 and Q2 market share reports. The market share failure of Windows phone was a failure of the commodity OEM model that Microsoft tried to apply to mobile devices. The formula that had worked so well for PC boxes of distributing a competent, low cost, OS on commodity hardware couldn't compete with Android commodity hardware featuring a competent and free OS.

The predicament of Nokia is likely to be repeated among Microsoft's other mobile device OEM partners in the coming months, but Microsoft will not be there to rescue them. Nokia had just what Microsoft needed: a ready made smartphone design and manufacturing capability not to be found anywhere else at any price. The $5 billion MS paid for the Devices and Services business plus the $2.12 billion for a 10-year license for Nokia's patent portfolio may seem like a bargain in the end.

The Downside

May seem like a bargain. There's plenty of downside risk. Google's recent experience with Motorola demonstrates how risky. Since the acquisition, the Motorola division has yet to turn a profit. Microsoft also has to turn around a money losing enterprise in Nokia's Devices and Services. To do this, Microsoft will have to do what Nokia was unable or unwilling to do, ruthlessly cut costs in order to make the remaining business profitable.

This means reducing the 32,000 headcount of Nokia employees transferring in with the purchase, closing and consolidated manufacturing, and probably spinning off or liquidating the feature phone business at some point. Can Microsoft do this? Sure it can.

Cutting costs is only part of the solution. Microsoft still has to find a way to compete directly with the host of Android OEMs. Without the equivalent of Google's advertising-based subsidy of Android, the cost of Windows Phone OS is never quite going to equal free, no matter how much cost cutting is done.

Microsoft's new Windows phone hardware will have to provide more of a positive discriminator relative to Android. Can Microsoft do this? Sure it can, but it will probably require hiring some design help from outside either Microsoft or Nokia. Nokia's brightly colored polycarbonate phones came across as toy-like compared to Android phones such as the Samsung Galaxy S4.

The Upside

Though risky, Microsoft's purchase of Nokia's phone business demonstrates Microsoft's commitment to its devices and services strategy. This strategy could easily have suffered a death by half measures at the hands of the Microsoft Old Guard who just want to keep recycling the Windows commodity box strategy forever. Now there's no going back.

There never was anyway. While the devices and services strategy isn't guaranteed success, it's the only strategy that has a chance against Google and Google's Android OEMs. Becoming a vertically integrated, though lean device maker gives Microsoft a good chance to continue to increase market share for Windows Phone while eking out a small profit.

Investors looking for progress in market share will have to be very patient. This is going to be a little like watching paint dry. The deal won't close until Q1 2014, and then there will be the usual organizational shuffling and confusion attendant on such transactions. The first fruits of the New Microsoft may not reach store shelves until Q4 2014.

Source: Microsoft Goes 'All In' With Nokia