Nokia Sends A Message To Microsoft

Feb.26.14 | About: Nokia Corporation (NOK)

No sooner had Nokia (NYSE:NOK) made the announcement of its line of Nokia X Android based phones than an article appeared proposing that this would be good for Microsoft (NASDAQ:MSFT). To his credit, fellow SA blogger Paulo Gorgo did his best to splash water on the notion. As I'll show in this article, there's nothing in Nokia's announcement that Microsoft should like, and no reason to think Microsoft was meant to.

The Fallback

To understand where Nokia is coming from with the Nokia X it's important to keep in mind that developing a new phone platform, even one based on Android, takes time. Product development cycles can run into many months, even for a phone using an OS that the manufacturer is already experienced with, and using hardware based on existing products.

Nokia X features a highly customized user interface, and replaces Google provided services with Microsoft email and search, as well as Nokia Store. Nokia started with the open source version of Android, and developed their own proprietary UI. Given the level of customization, I estimate that it would take at least a year from project start to products on store shelves, and probably more like 18 months. Much of that time is just spent on testing and debugging.

This means that the X project was started sometime in late 2012 or early 2013. Why would Nokia begin the X project? I think the answer is pretty obvious. Microsoft and Nokia had just kicked off the Windows 8 Phone with high expectations in 2012 Q4, and those expectations had not been met, with Nokia selling only 4.4 million Lumia smartphones, less than half of the 9.3 million Asha smartphones that were sold in the quarter, as reported in Nokia's earnings release.

After suffering through a year of lackluster Windows 7 Phone sales, Nokia's board would be getting restive. The X project was the fall back position in case Windows 8 Phone didn't start gaining significant market share. Windows Phone did gain market share in 2013, but Nokia's Devices and Services division lost money every quarter on an IFRS (International Financial Reporting Standards) basis.

Why all the links to Microsoft services? It may have been meant to placate Microsoft. In its arrangement with Microsoft, Nokia had reserved the right to make other platforms. In late 2012, Nokia was still selling Symbian smartphones as well as the Asha line, based on the Symbian derived Nokia OS. But Nokia was very much dependent on platform support payments from Microsoft, as it acknowledged at the time, with these payments essentially negating the Windows phone royalties due to MS. Even if not specifically constrained by contract to Microsoft, Nokia would want to tread lightly.

Was Microsoft aware of X? Almost certainly. Did they like it? Probably not. Joe Belfiore, Microsoft executive in charge of Windows Phone was asked about the Nokia X announcement a few days ago. As quoted by the Verge, he said, "What they do as a company is what they do. Certainly they'll do some things that we're excited about, and some things that we may be less excited about."

The Message

In the context of a "One Microsoft" strategy that unites Nokia's hardware and Microsoft's Windows Phone OS into an integrated product line, X really has no place. The reason is simply the economics of OS development. Once the OS is developed, deployment to devices is almost infinitely scalable, as long as all the devices use the same Instruction Set Architecture (ISA), in this case ARM v7. Of course, there will be slight cost impacts to accommodate hardware differences such as screen resolution, but for the most part it doesn't cost any more to equip a billion devices with Windows 8 than it does to equip a million. The OS maker is motivated to spread development costs over as many devices as possible.

Developing a separate "low cost" OS for emerging markets ends up costing more money than just copying the "higher cost" OS onto the low cost device. Even though MS didn't develop X, it would still be more costly to deploy and maintain the two operating systems in its line of phones than just the single Windows Phone OS.

The only possible benefit Microsoft would derive would be to offer X users the ability to tap into the burgeoning Android app ecosystem as an alternative to Microsoft's own Windows Phone Store. There are many good reasons why MS wouldn't want to go there. First and foremost, it deprives Microsoft of what is becoming a very important revenue stream for mobile device developers. It would also amount to an admission that Windows Phone Store is inadequate. Finally, it would confuse consumers, who would either assume that they could use the Windows Phone Store from within X, or want to continue using Android apps in the case of an upgrade to a Windows Phone device.

Why get in Microsoft's face with X at this juncture? When the sale of Nokia's D&S division to Microsoft closes, X will be dead on arrival. The point of X is to ensure that Microsoft doesn't back out of the deal. It's a message that if the deal falls apart, Nokia will give up on its Windows phones and go over to Android. And of course, all the links to Microsoft services will be ripped out in the process.

Would Stephen Elop really want to do this, given that he'll be transferring back into Microsoft when the deal is concluded? No, but I don't think he had any say in the matter. He's not the CEO of Nokia anymore.

The message speaks volumes about the fragility of the deal. The purchase of D&S was the final stroke of the old Microsoft regime under Steve Ballmer. We now have a new CEO, Satya Nadella, who may be wondering if he really wants to go through with this in light of Google's (NASDAQ:GOOG) experience with Motorola.

Adopting the devices and services business model doesn't mean that Microsoft has to produce its phones in Nokia's old factories. Furthermore, Microsoft would be getting Nokia's feature phone business, which it clearly doesn't need.

A Win-Win Separation?

If the deal falls through, and Microsoft and Nokia part company, it could be a win-win for both companies. Microsoft would not have to pay for a money losing business, as well as pay for the on-going restructuring costs of having to turn that business around. One element of the "Perfect Storm" that I believe Microsoft is sailing into could be avoided. Microsoft could move up-market, offering Windows Phone as a truly premium OS, which is where I think it deserves to be. Ditching the garish plastic phones of Nokia would be a good place to start.

Nokia has the tougher job of making the separation work. Nokia could more readily convert their feature phone customers to Android in emerging markets, where Android "white box" phones are enormously popular. Nokia could merge its feature phones with Android, since Android white box sales are already supplanting feature phones in major emerging markets such as China. Nokia would have a chance of achieving profitability in D&S with a line of Android based phones, but it's not a sure thing.

What are the chances of the deal falling apart? Unfortunately, for Microsoft investors, not very good. Nokia is clearly motivated to sell, and Nadella, despite whatever second thoughts he may have, will find it difficult to overturn the decision of his predecessor. If and when the deal closes, it'll be good news for Nokia, not so good for Microsoft.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.