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Many Microsoft (MSFT) investors have been quick to draw parallels between the software giant's latest deal with Nokia (NOK), and Google's (GOOG) 2011 partnership with Motorola. These investors are concerned that the Nokia deal might prove to be not as profitable as hoped for, just as Motorola's patents are now feared to be worth a lot less than earlier estimates.' Microsoft has no doubt shot the works with the bold $7.2 billion takeover of Nokia's handset division, an underperforming business segment that has been dragging down Nokia's overall profitability. Both the Microsoft-Nokia and Google-Motorola deals share some similarities. The biggest common point is they both involve two software firms licensing their operating systems to rival hardware firms. But Microsoft's deal is also fundamentally different from Google's partnership, and will very likely add significant value to the former's business.

Microsoft deal structured differently from Google's

Google paid a staggering $12.5 billion in the Motorola partnership. The firm gained Motorola Mobility's significant intellectual property rights with the deal. The deal was also widely seen by industry observers as Google's way of insulating itself from patent infringement suits from the likes of Microsoft, Apple (AAPL), Oracle (ORCL) and others. Google could now develop true Google devices that are fully integrated with its OSs and its own homegrown content.

Google's partnership with Motorola has, however, turned out to be not so rosy. Motorola's patents are now feared to be worth a lot less than previous estimates.' Motorola Mobility was embroiled in a fierce battle with Microsoft long before it was bought by Google, insisting that the latter needed to pay about $4 billion per year to use Motorola's patents related to the use of its 802.11 Wi-Fi standards and H.264 video standards. Seattle U.S. District Judge James Rabart ruled in April this year that Microsoft should only pay $1.8 million per year, way less than the 2.25% of retail price Motorola wanted Microsoft to pay, bringing into question the exact worth of Motorola's patents.

Microsoft stands to benefit from some of Nokia's extensive patents, and will gain access to a whopping 8,500 patents with a ten-year license, after the Nokia deal is consummated sometime early next year. Microsoft paid Nokia $2.3 billion as licensing fees. Microsoft will gain Nokia's patent licensing contracts with IBM (IBM), Google's Motorola Mobility, Qualcomm (GOOG), Apple, LG (LG), Nortel (OTCPK:NRTLQ), Kodak (KODK) and Motorola Solutions (MSI).

But Nokia's patents are not the main reason why Microsoft purchased Nokia's smartphone division.

Smartphone business: Windows Phones and Asha

The biggest reason why Microsoft wants to buy the whole Nokia smartphone division is to further consolidate the gains it has already made in the smartphone market. Nokia commands a huge 82% market share of the Windows Phone market, according to IDC. Windows phone devices are currently third in terms of devices sold, behind Apple's iPhones and Google's Android phones. Nokia smartphone sales have been steadily rising over the quarters.


(Click to enlarge)

Microsoft has made decent progress in the smartphone business ever since it made the $1billion 2011 deal with Nokia to have the latter's smartphones run on Microsoft's Windows Phone software. The deal helped Windows Phone finally trounce long-term rival BlackBerry (BBRY). Microsoft will now be in a better position to grow its Windows Phone OS market share by buying out Nokia's smartphone division than simply by partnering with it.

Worldwide Smartphone Sales by Operating System in third-quarter 2013 (Thousands of Units)

Operating System

3Q13

Units

3Q13 Market Share (%)

3Q12

Units

3Q12 Market Share (%)

Android

205,022.7

81.9

124,552.3

72.6

iOS

30,330.0

12.1

24,620.3

14.3

Microsoft

8,912.3

3.6

3,993.6

2.3

BlackBerry

4,400.7

1.8

8,946.8

5.2

Bada

633.3

0.3

4,454.7

2.6

Symbian

457.5

0.2

4,401.3

2.6

Others

475.2

0.2

683.7

0.4

Total

250,231.7

100.0

171,652.7

100.0

Source: Gartner (November 2013)

Nokia deal to dramatically improve smartphone gross margins

Microsoft expects the Nokia acquisition to help it grow it smartphone market share from the current 3.6% to 15% by 2018, but more importantly, expects to make $40 per each smartphone sold compared to under $10 currently. IDC is a bit more pessimistic and expects Microsoft to grow its smartphone market share to about 10.2% by 2017. Either way, Microsoft will end up becoming a significant smartphone player, and not the marginal player it currently is.


(Click to enlarge)

Credit: Microsoft

Nokia's handset division made the company $3.9 billion in third-quarter of 2013. Microsoft hopes the deal will finally be profitable by 2016 as shown below.


(Click to enlarge)

Microsoft can hedge its bets

Admittedly, things might not quite work out as expected for Microsoft and other OEMs might choose to ditch Windows Phone OS in favor of upstarts Firefox and Sailfish. But Microsoft can still hedge its bets by choosing to go the Apple route and make Windows Phone OS the exclusive operating system for all Nokia-branded handsets. Microsoft would have an advantage over Apple here since it has a wider variety of handsets which can potentially help it to exploit more price points.

Bottom-line

Although there is a certain risk element involved in Microsoft's purchase of Nokia's underperforming smartphone division, in my humble opinion, the potential rewards far outweigh the underlying risks. At the very least, Microsoft can use the acquisition as a stepping stone to finally become a force to reckon with in the smartphone business. I do not see any genuine reasons for the excessive pessimism by investors about the deal.

Source: Microsoft-Nokia Deal Will Play Out Better Than Google-Motorola Deal