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Skeptics of the Windows Phone operating system have often used the declining ASP (average selling prices) as a proof that Windows Phones aren't doing well. They believe that Nokia (NYSE:NOK) only met its sales target in the most recent quarter because it offered the phones at a significant discount. By looking at the graph below, it is definitely tempting to agree with them.

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Source: Nokia's quarterly reports

But while bears are indeed correct that Nokia offered its phone at a discount and thus has lower margins than Apple (NASDAQ:AAPL), that isn't the only explanation for the lower selling prices. Another important factor is the trend towards cheaper phones. Just a few years ago there was a significant difference in quality between the high-end and low-end phones, while today; the low-end phones are "good enough" for most consumers. Thus, we are seeing an increasing popularity of low-end phones which is putting a further downward pressure on the ASP.

While this trend has severe negative consequence for a successful company like Apple, the effect it has on Microsoft (NASDAQ:MSFT) is more ambiguous. It is true that Microsoft earns less for each time it sells a Lumia 520 relative to a Lumia 925, so it is tempting to believe that the trend is also negative for Microsoft.

However, one clear benefit of the trend, is that it makes it much easier for Microsoft to increase its market share as Microsoft (unlike Apple) with its Lumia 5xx, 6xx and 7xx lineup has a wide range of cheap phones.

While some people argue that market share is irrelevant and only earnings matter, they ignore the effect an increase in market share has on the value of the ecosystem. If more consumers have a Windows Phone, developers will be more interested in developing apps to the operating system, which makes WP a more attractive operating system.

What will happen to Lumia's margins in the near future?

Looking only at the expected results for the September quarter, the trend towards cheaper phones has continued. The below diagrams, which uses data from Adduplex, illustrates this perfectly.

The popularity of the Lumia 8xx phones has declined significantly in Q3 compared to the prior quarter. On the other hand, Lumia 520 is now the best seller and since it is sold at a very low price, I expect Lumia's ASP to decline further in Q3.

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Source: Adduplex.com and my own estimations

In an assessment of Lumia's margins over a longer time period, it is necessary to discuss the logic behind Microsoft's acquisition of the smart device division. The relevant question to answer is whether Microsoft will continue with Nokia's "low price/market-share-oriented"-strategy.

In a previous article, I discussed Microsoft's intention behind the acquisition. I came to the conclusion that Microsoft would actually be likely to offer even cheaper phones than Nokia, as Microsoft's other segments benefit from increased WP popularity. For instance, I expect that earnings of Office, Windows 8, Internet Explorer, Bing and Xbox will increase if Lumia performs well.

Therefore, I expect that Microsoft will be willing to offer phones at very low prices. This will result in lower smartphone margins over the next 1-2 years. The current gross margin of the smart device division is 21%, and it wouldn't surprise me if it under Microsoft's leadership would fall to 16-17% within 1-2 years.

Final remarks

When Microsoft announces results for the Lumia phones for the next quarter, expect bears to continue to point to the lower ASP as a "proof" that WP is a failure. But remember, that Microsoft is trading short-term loses for long-term ecosystem benefits. As long as the market share of Lumia phones continue to increase and smartphone-related earnings doesn't decline further, you should be satisfied as a Microsoft investor.

Source: Microsoft: Why Lumia Earnings Barely Matter