Seeking Alpha
Value, tech, momentum, event-driven
Profile| Send Message|
( followers)  

A week has passed since Microsoft (NASDAQ:MSFT) announced a $7.17 billion ($5.44 billion euros) offer to buy Nokia's (NYSE:NOK) Devices and Services division. The deal will give Microsoft ownership of Nokia's complete feature phone and smartphone business, a 10-year licensing agreement for Nokia's expansive patent portfolio, as well as a 4-year arrangement to use Nokia's HERE maps (the financial details of which have yet to be disclosed). Also embedded in the offer was a $1.98 billion (3 tranches of $500 million euros) financing opportunity for Nokia, which was exercised a mere 4 days later.

Microsoft Just Telegraphed Its Hand

It's no secret that the success of the Windows Phone platform, and therefore Microsoft's mobile ambitions, is highly dependent on the success of the Nokia Lumia lineup. Data from Adduplex indicates Nokia owns approximately 85% of the Windows Phones (WP) market share. Simply put, if Nokia phones did not exist, Microsoft would own a pathetic 0.5% of the smartphone OS pie on in the US. However, the inverse is was also true as Nokia was purely dedicated to the WP platform. Nokia CEO (now ex-CEO) Stephen Elop has publicly stated, on multiple occasions, that they were sticking to WP8 as the go-to OS. In other words, Nokia was also dependent on the WP8 for survival.

If Nokia was already investing a tremendous amount of time, effort, and capital to grow and ensure the survival of WP8, then why does Microsoft need to purchase Nokia's phone division? Some have opined that Nokia was ready to abandon WP8 because of an imminent adoption of the Android OS or because of the intense cash burn of its phone business. The latter thesis prompted Moody's to downgrade the long-term debt rating of Nokia on August 26th, as well as Sanford Bernstein analyst Pierre Ferragu to reiterate an underperform rating on shares of Nokia a day later. Fellow SA authors (here, here and here) had also believed that cash burn was accelerating, which may have prompted sale of the D&S division by Nokia. In the end, Microsoft decided not to take any chances by making a pre-emptive strike and acquired Nokia's phone business. Having just announced the imminent departure of Steve Ballmer within the next 12 months, this seems like a move of desperation and a last ditch effort to ensure survival of the WP operating system.

Headwinds Against Microsoft's Purchase From Nokia Shareholders

In its latest quarterly earnings report, Nokia disclosed that it had sold 7.4 million Lumias in 2Q13, an impressive 32% increase over the previous quarter. This represents the largest Lumia volume in any single quarter in the company's history. Although Nokia did not give any guidance for Lumia volumes in 3Q13, data from IDC and KWP paint a bullish picture for devices sold in recent months, especially in Europe and Latin America. Nokia followers have estimated that roughly 3.7 million Lumias might have been sold in July only, which represents a run rate of 11.1 million Lumias for Q3. This bullish sentiment was echoed by a number of SA authors (see here and here for examples).

If Nokia's D&S division was indeed on the cusp of approaching break-even or profitability, then the $3.79 billion euros price tag seems relatively low. In the first half of 2013 alone, Nokia's D&S division had revenues of $5.6 billion euros; thus Microsoft's buyout offer pegs Nokia's phone business at a P/S of merely 0.34 (and that assumes static revenue for Q3 and the seasonally strong Q4). Powerhouses like Apple (NASDAQ:AAPL) and Samsung (OTC:SSNLF) command P/S ratios (trailing 12 months) of 2.66 and 0.97 respectively. Even Blackberry (NASDAQ:BBRY), who is in their death spiral, has a P/S ratio of 0.50.

Not surprisingly, a number of shareholders have expressed displeasure, through the Yahoo Finance message boards and Seeking Alpha, for the low price being fetched for Nokia's D&S division. Fellow author Abu Bakr Hussain has succinctly outlined 26 questions which the Nokia Board of Directors should answer before shareholders vote on the deal. This sentiment is also reflected in SA articles published here and here. It is apparent that Microsoft wants and needs Nokia's D&S division in order to make the WP OS flourish. If Nokia shareholders vote "no" for the sale of the D&S division, Microsoft will have no choice but to increase their offer. Once the excitement settles in the coming weeks, we should hear from large shareholders such as Dodge & Cox, who owned 314 million shares of Nokia (8.4% of outstanding shares) as of June 30th.

Other Smartphone Players May Raise The Pot

Warning shots were fired. In Nokia's press release, the company stated that it would "expand its industry-leading technology licensing program." Without a phone division and the fear of being counter sued, Nokia can be more aggressive in seeking royalties from companies that are infringing on its patents. Apple and Blackberry already have licensing programs in place with Nokia, which leaves smartphone vendors who rely on Android as obvious targets. If successful, this would drive up the cost of manufacturing phones that run Google's (NASDAQ:GOOG) Android OS. If Google feels its mobile ambitions are being threatened, it would not be surprising to see a hostile offer that trumps Microsoft's as an insurance policy. A bitter battle between Google and Microsoft had, in fact, already begun on the YouTube playground even before this week. Google might simply be acting upon its childish instincts...but what if the company felt that the Microsoft-Nokia combo was gaining too much momentum? If this were true, Google, with its huge cash reserves, could also tender an offer for Nokia's D&S division and force Microsoft to up the ante.

Prior to Apple's introduction of the next iPhone iteration this week on September 10th, the company has yet to answer the challenges brought forth by the Nokia Lumia 1020, the Samsung Galaxy Zoom, and the Sony Xperia Z1. These three phones represent a substantial technological leap over the 8MP camera that is currently on the iPhone 5. There have also been rumors that the Apple Board is putting pressure on CEO Tim Cook regarding the lack of innovation at Apple. If Apple wants to become the new king of photography in the smartphone war, now would be the time to step up the plate. The differential in money "saved" by Apple versus the money spent by Nokia in R&D in previous years is more than enough to offset the acquisition cost for Nokia's D&S division.

Microsoft Should Hope That Its Opponents Will Fold

On the surface (no pun intended), Microsoft appears to have negotiated a favorable deal for some of Nokia's most renowned assets. The Nokia Lumia line is gaining accelerated traction, especially the Lumia 520/521, which is showing strong sales volume, and Lumia 1020, which is in the top 3 best-selling smartphone at AT&T according to Canaccord Genuity. Increased marketing of the Lumia 1020, vis-à-vis coverage in National Geographic, a photoshoot with respected photographers David Bailey and Bruce Weber, and product placement in Katy Perry's latest video "Roar", are all good indications of the increasing popularity of the Nokia Lumia phones. Unfortunately for Microsoft, this will actually hurt its chances of acquiring Nokia's D&S division as it faces a potential rejection from existing shareholders and/or a hostile bid from another competitor. I am a Microsoft shareholder, and I am on the edge of my seat, hoping that November 19th (Nokia's Extraordinary General Meeting to vote on the deal) will come to pass without any trouble.

Source: Why Microsoft Investors Should Be On The Edge Of Their Seats