Microsoft (MSFT) recently announced its acquisition of Nokia's (NOK) mobile phone business. The instant analysis of the deal suggests that it is a bad deal for Microsoft and a good deal for Nokia. Is the instant analysis correct?
To some extent, the instant analysis is correct. Modeling the deal using an NPV model over the next five years suggests this deal won't create wealth for Microsoft investors. After five years, estimating the cash flows from the deal becomes more challenging. Consequently, I model Microsoft spinning off the Nokia business at the end of the fifth year.
At that point, Microsoft should have increased its global market share of the smartphone industry, and the mobile phone business should be generating an operating profit. I estimate that Microsoft will be able to sell the business at a 1.5 times sales multiple. Consequently, the acquisition would generate Euro 5 ($6.5) billion of wealth for Microsoft's investors.
I think it is a good deal and that Microsoft should have entered the hardware business a long time ago. I continue to be bullish on Microsoft, which is trading in my accumulation zone. Next, I'll discuss some of the details of my model.
Forecasting Nokia's Phone Business
For fiscal 2013, I'm modeling net sales of Euro 11.1 ($14.43) billion with Euro 5 ($6.5) billion coming from smart devices and Euro 6 ($7.8) billion coming from mobile phones. I think the pace of decline of smartphone sales slows as increasing Lumia sales offset declines in Asha sales; the back half of fiscal 2013 should be positively impacted by sales of the Lumia 1020. The pace of decline of mobile phone sales is forecasted to increase as consumers switch to purchasing smartphones.
I think mobile phone sales will continue to decline; my forecast is for a 50% annual decline between 2014 and 2017. Mobile phone net sales are forecasted to be Euro 375 ($487.5) million in fiscal 2017.
In terms of smart device sales, IDC is forecasting a 70% increase in global smartphone sales with Microsoft's OS increasing its market share from 3.9% in 2013 to 10.2% in 2017 IDC is forecasting sales of Windows phones to grow faster than the industry. Consequently, I'm modeling smart device sales in the Euro 8.5 ($11.05) billion to Euro 11.5 ($14.95) billion. The Euro 8.5 billion forecast assumes sales grow at the rate of the smartphone market. Both sales estimates refer to FY 17.
Using the conservative growth rate assumption, I have net sales bottoming in fiscal 2015 at about Euro 8 billion and increasing in fiscal 2016 and 2017 as increases in smart device sales offset declines of mobile phone sales.
Next, applying a gross margin of 22.5% with operating expenses of Euro 3 ($3.9) billion in fiscal 2013 and Euro 2.5 ($3.25) billion between fiscal 2014 and fiscal 2017, the phone unit would lose about Euro 500 - Euro 600 million per year. This forecast assumes the conservative growth rate.
Assuming the IDC growth rate, the operating loss would be slightly less than Euro 500 million in fiscal 2014 and 2015 and would shrink to about Euro 250 million in fiscal 2016. In fiscal 2017, there would be almost Euro 200 million of operating profit.
The cash flows after 2017 are more uncertain. I think of this deal as a 10-year to 20-year Microsoft investment, but with the highly uncertain cash flows after 2017, I'm going to model the Nokia acquisition as if Microsoft sells the company at the end of 2017. I assume an effective tax rate of 20 percent, a discount rate of 8%, the higher growth rate, and a price/sales multiple of 1.5. At the end of 2017, Microsoft would sell Nokia for Euro 17.8 billion and create Euro 5 billion of shareholder wealth from the acquisition.
At the end of 2017, Nokia would be generating an after-tax profit and would have about 10% of the smartphone market. Thus, I think the company would command a 1.5 times sales multiple in the market.
In comparison, Microsoft's management models Nokia being accretive to GAAP EPS in FY 16 while I model Nokia being accretive to GAAP EPS in FY 17. Both models assume Windows gains market share in the smartphone market. Also, I assume less annual revenue, a smaller market share and a lower NPV than management assumes.
Microsoft's acquisition of Nokia's phone business is similar to Google's (GOOG) acquisition of Motorola. Consequently, I'll take a look at Motorola Mobile and use some of Google's disclosures to compare the operations of Nokia and Motorola.
Motorola Mobile generated just over $4 billion of revenue in FY 2012. Nokia's phone business should generate about $14.4 billion of revenue in FY 2013. In FY 2012, Motorola had a gross profit margin of about 14% and Nokia should have a non-IFRS gross margin of about 24% in FY 2013. Also, Motorola is on pace to generate about an $800 million loss from operation in FY 13 while Nokia could generate a similar size loss, but generates substantially more revenue. Nokia is the larger more profitable of the companies.
Microsoft purchased a better company than Google purchased. Nokia is more profitable and has a larger revenue base than Motorola. Looking forward, if Microsoft can increase its market share, Nokia should have a positive impact on Microsoft's results of operations.