What Do Nokia's Results Mean For Microsoft?

| About: Microsoft Corporation (MSFT)

Earlier this week, Nokia (NYSE:NOK) announced its quarterly results which made the company's investors very happy. This was the fifth quarter in a row where Nokia posted operating profit and Lumia sales continued to grow in double digits. Since Microsoft (NASDAQ:MSFT) will own the Lumia brand starting next year, Nokia's recent results have direct implications on Microsoft in the near future as well as in the long term. Let's examine what these results indicate for Microsoft.

In the quarter, Nokia sold 8.8 million Lumias and most of the growth was attributable to the cheapest model, Lumia 520/521. The volume of Lumias sold was up 19% quarter-to-quarter and up 40% year-to-year. Because the mix contained cheaper models more than more expensive models, the average sale price fell from $202 to $186 since last quarter.

The company's feature phones also showed a sign of bottoming as it demonstrated the first quarter-to-quarter volume growth in a while. Nokia sold roughly 65 million feature phones, up from 61 million in the last quarter but still sharply down from 85 million in the same quarter of last year.

Year-to-date, Nokia's mobile phone division reported an operating loss of $200 million and an operating margin of -1.9% (actually Nokia's mobile phone division has an operating margin closer to -3.0% when we exclude the patent income, which Nokia will be keeping after the acquisition). Microsoft is buying a business that's not highly profitable, but seeing a lot of growth. Interestingly enough, feature phones seem to be more profitable for Nokia with a gross margin of 21.5% but this business sees nearly no growth. On the other hand, the smart phone business enjoys a lower gross margin of 16.4% but there is more growth potential there.

The question is, can Microsoft keep Lumia's positive momentum going? This is a very tough question to answer. Last year, when Nokia was barely launching its Windows Phone 8 devices, many people were wondering if the company would be able to sell many of these phones. As I've been covering Nokia's turnaround with several articles, I predicted that Nokia's brand name would sell it a lot of phones. I said that "people will not necessarily buy Lumias because they run on Windows Phone 8, but many people will buy these phones despite they run on Windows Phone 8." I always thought that the selling point for Lumia phones would be Nokia's strong brand name rather than anything else. At the end of the day, Nokia claimed 85% of the market share in the Windows Phone ecosystem and no one else besides Nokia was able to sell a significant number of Windows Phone devices. Personally, I bought 3 Nokia Lumias in the last 2 years and convinced several friends to buy their own Lumias. Would I buy a Microsoft Lumia instead of Nokia Lumia? It is very doubtful.

Even on Seeking Alpha, when people were commenting the articles regarding Nokia, a lot of people said that they would buy a Lumia if only it ran on Android instead of Windows Phone. Also, the fact that Microsoft wasn't able to sell a lot of tablets under its own brand name also raises doubts that Microsoft will be able to grow the Lumia brand in any meaningful way beyond what Nokia already accomplished.

I'm sure Microsoft will throw a lot of marketing power behind the Lumia brand in order to capture as much market share as possible; however, Microsoft has never been a consumer-favorite company, with the exception of Xbox.

Microsoft has been and will be throwing in free stuff with Lumias, such as free subscription to Pandora (comes with high-end Lumias) and a free subscription to Netflix (in the UK with Lumia 1020). This is an attempt from Microsoft to make up for the lack of a variety of applications in the Windows Phone ecosystem. As much as applications go, the Windows Phone ecosystem suffers from its own version of a catch-22: there aren't many applications because application developers don't think it's worthwhile due to the small market share of the Windows Phone; yet, there aren't many users of Windows Phone devices because there aren't enough applications. Microsoft can throw more money at the problem and hire some application developers to close the gap.

No one really knows how Microsoft plans on using the feature phones division of Nokia. The company will probably have little interest in Nokia's feature phones since they are not a part of the Windows Phone ecosystem. Microsoft might be looking at spinning-off or selling this business unit in the near term. I'm sure they bought it unwillingly when Nokia told them that the only way they can have the company's smartphone division is if they also buy the feature phone division.

So, Nokia's results are somewhat encouraging for Microsoft but the company will probably have to face its own challenges to grow the Lumia brand beyond what Nokia already accomplished. This will not be an easy task and Microsoft will have to deploy all the marketing power it has behind the project. Basically, the company will have to gain attention and trust of the consumers, and this will be something Microsoft hasn't achieved in a long time (with the exception of Xbox product).

Despite being skeptical of Microsoft's chances with Lumia, I am still long with Microsoft because the company is fundamentally cheap and it is one of the biggest cash cows in the world.

Disclosure: I am long MSFT. 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.