The Microsoft/Nokia Phased Merger Theory: Not As Effective As It Might Seem

| About: Microsoft Corporation (MSFT)

We usually do not love conspiracy theories, but we cannot completely ignore the fact that there has been much speculation about the former Nokia's (NYSE:NOK) CEO, Elop, being nothing more than an instrument for Microsoft (NASDAQ:MSFT) to control Nokia's fate since the original partnership between the companies was announced in 2011.

If you Google "Elop Trojan horse", you'll get about 31,000 results that mostly state the same:

With $7.17 Billion Nokia Buy, Microsoft Brings Its Trojan Horse Home

A Phased Merger: Elop effectively turned Nokia into a division of Microsoft before Microsoft bought it.

Readers beware: while reading the following lines, forget about ethics and a company's board of directors being responsible for protecting shareholders' interests in the company - it may not apply here.

One of the most interesting theories we've found on the web about what may have happened between Microsoft and Nokia is to be found in an article by Rob Enderle:

What Microsoft did with Nokia is very different from a typical large merger. I really haven't seen this method before. Nokia was in deep trouble when Stephen Elop was recruited to take over the company. Typically, in a merger, the costs of cutting the company and restructuring it are mostly borne by the buyer. But Elop effectively turned Nokia into a division of Microsoft before Microsoft bought it. Microsoft did co-fund transferring around a billion dollars into the process, but given that Microsoft is profitable, the cuts needed would have been incredibly expensive for the company (most European nations put a high burden on companies that are profitable and do layoffs). By keeping Nokia separate, Elop was able to radically downsize the company, which remained unprofitable more inexpensively. Without doing that first, Nokia would have been too expensive for Microsoft to buy. This minimized the cost to Microsoft of turning an overweight company into a division and reduced the risk; once downsized, had the firm been unable to function, which was a possibility, Microsoft would have been left with another vastly more expensive failure.

Mr. Enderle goes on describing the relationship as a "trial marriage" between the parties, and praising Ballmer for the idea:

What Microsoft and Nokia did was hook together in a trial concept, demonstrate that the relationship could work, and then execute the merger once proof was clearly in hand. It is actually a rather brilliant move by Microsoft's outgoing CEO Steve Ballmer and one that hasn't been covered.

Even though Steve Ballmer will likely leave Microsoft under a cloud, this move showcases that the guy has unique talents and would be very valuable on a board or as an executive advisor. You just don't see this kind of creativity often.

We'd probably use the expression "secret marriage", rather than "trial marriage", as the former better describes what happened, while the latter is at least known to everybody.

Risks associated with phased mergers

Nothing like a chart can illustrate well how the secret marriage worked out in the mobile market:

Chart from Statista

Microsoft's Joe Belfiore, Microsoft corporate vice president in charge of Windows Phone, recently explained why a phased merger has some risks, too, associated with most people not knowing about "the dirty little secret":

While building new phone hardware and software together, Microsoft and Nokia could once be compared to two ships passing in the night.

The companies often touted their deep partnership on smartphones, but it turns out they still kept many secrets from each other. Sometimes those secrets caused one or the other to scramble to change features before a phone launched, and led Microsoft to rethink core aspects of its mobile operating system.

"There are real-world examples of situations where Nokia was building a phone and keeping information about it secret from us," said Joe Belfiore, a corporate vice president at Microsoft who's in charge of the company's Windows Phone project.

"We would make changes in the software, or prioritize things in the software, unaware of the work that they're doing. And then late in the cycle we'd find out and say, 'If we had known that we would have done this other thing differently and it would have turned out better!'"

We are not even sure that the "restructuring being relatively inexpensive for the buyer " theory is completely correct (while fascinating), as it doesn't include an analysis of the potential value of the acquired company's NOLs (now lost), and the negative effects of the "vacuum" caused on some key operations (and people) by this unethical/ambiguous situation.

WinPhone: "The OS that brought the largest handset producer to the verge of bankruptcy".

In a previous article, we described Nokia's strategy as being the following:

We have always been very critical of Nokia's strategic decision to bet the whole farm on Windows phone, with no plan B.

Actually, it sounds like the company's only plan B in place sounded something like: if we go broke, then it's Microsoft's problem to come and rescue us, or they'll also disappear from the market.

In the comment section, SA reader Transcripts&10-k's properly developed our thinking:

Actually, that doesn't sound like a ludicrous plan B.

In the WP market, Nokia became the market; although this wasn't assured in their initial entrance into the space, it's become the reality. Assuming that Microsoft didn't abandon the space entirely (essentially no chance of that happening), Nokia always had a backstop in this arrangement, as well as serious financial commitments from the start from a partner with deep pockets.

This offered downside protection, and the ability to eventually benefit from being tied to the OS that will likely be shared across 1B+ devices (with a big help from PC's, and growing help from tablets). While the second benefit proved more difficult than originally envisioned (hindsight is 20/20), the downside protection held.

The first WP phone from Nokia was announced in October 2011, with the stock essentially unchanged from then to now; consider this in comparison to someone like Blackberry, which is off about 50% over that same period.

To be clear, this likely didn't go as planned; rather than betting the entire company, I think Nokia smartly positioned themselves to essentially be bailed out by MSFT if things didn't go as planned.

We still prefer to believe this is what happened: a (failed) partnership turned into a (forced) merger, as Microsoft did not want to disappear from the mobile sector (or admit a defeat, as we presumed in our headline). Nokia, without the resources to compete on the wrong OS front, tried to maximize the outcome of the sale, and got much needed short term financing. The company will now need to re-invent itself once more, under a new leadership.

However, the fact that the merger was announced by Nokia's new interim CEO, Risto Siilasmaa, shown shaking hands on stage with Ballmer, while Elop seems to have played just a supporting role in the negotiations and he was immediately announced as re-joining Microsoft, might represent a clue that the "phased merger theory" may not be completely baseless.

From external to internal candidate: or just an internal candidate brought back?

According to Microsoft's exiting CEO, Steve Ballmer, Stephen Elop will now go from an external candidate to internal candidate for the position of CEO:

With Elop's move back to Microsoft, "Stephen will go from external [candidate] to internal," Ballmer said. "The board will continue [to look at] all appropriate candidates through that process."

It would be sad to see Elop rewarded for his dirty job in the "phased merger theory" - at a time when Microsoft needs a visionary as its new CEO, to avoid becoming completely irrelevant in the new market that counts, connected devices sales (PCs plus smartphones and tablets vs. the desktop only as in the past).

Will the trial merger turn into a happy, official one?

We are skeptical that the merger really solves Microsoft's problems in mobility.

Microsoft will have to deal with a market - the non smartphone, or dumb phone one - that is falling, with razor-thin margins and not strategic for the company. We doubt that it will help bring new customers to a Windows ecosystem, in the long term. This strategy has already failed at Nokia.

As to the smartphone sector, we share many concerns about the validity of Microsoft's existing business model, expressed by several analyst, like Michael Vakulenko:

It's too late for Microsoft to hope for a meaningful position in mobile computing. It's over. Android and iOS have won. Network effects inherent to the ecosystems business models of the leaders are making direct competition impossible.

The acquisition of Nokia Devices by Microsoft can bring the company some new resources and processes, but it brings nothing in terms of a value proposition or a profit formula.

Nokia's Devices business model is as broken as Microsoft's. In other words, Nokia won't help Microsoft to get out of its business model dire straits.

Mobile computing will continue to evolve in the coming years with the emergence of new business models where hardware is not the source of profits but a distribution channel (more in our recent blog post here). Chances are that the new Microsoft together with what's left of Nokia devices will not be part of this future.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.