Microsoft (NASDAQ:MSFT) acquired Nokia for $7.2 billion last year. While the company expected this acquisition to expedite its entry into the smartphone industry, the short-term effects of this merger can be seen in its latest Q4 results. In Q4, the Nokia devices and services (NDS) division contributed $1.99 billion to revenues, however, it negatively impacted operating income as it reported a loss of $692 million. Nevertheless, we believe that NDS can significantly boost Microsoft’s revenue in the future by targeting regions where it has a stronghold. In this note, we will explore the opportunities that can boost Microsoft’s revenues and profitability in the future. Additionally, we will also look into Microsoft’s Windows ecosystem and how this can be instrumental in increasing its revenues.
Microsoft Targets Emerging Markets
Unlike developed countries where smartphone penetration is above 50%, it is below 25% in many developing countries. While the adoption of smartphones in developed countries fueled the first wave of global growth, strong demand in emerging markets will drive the next phase. Currently, the sale of sub-$200 smartphones is prevalent in emerging countries, and we believe with the availability of cheaper options, smartphone penetration can rise.
According to IDC, global smartphone shipments are on the rise and set to surpass 1.2 billion unit mark this year. High smartphone growth is the result of a variety of factors including steep device subsidies from carriers, especially in developed countries, as well as a growing array of sub-$200 smart phones. Additionally, Reportbuyer.com forecasts smartphone shipments to grow to 3.9 billion by 2018.
Despite the expected increase in smartphone shipment, the expected shipment figure in emerging regions such as Asia-Pacific will be less than 50%. We believe this presents an excellent opportunity for manufacturers like Nokia that have a sizable market share in these regions. Nokia together with Windows phone has recently launched Android-based X series smartphones that cost less than $175 for emerging regions. Nokia’s brand name is still widely recognized in these countries, and we believe that Microsoft can leverage this to push sales of windows smartphones in these countries. According to Q4 results, Microsoft’s devices and consumer licensing earnings were positively impacted by $382 million due to revenue recognition from joint strategic initiatives with Nokia, which concluded in conjunction with the acquisition of NDS, as well as an increase in phone patent licensing revenue. By foregoing the Windows phone royalty margins, Microsoft can subsidize the price of smartphones in the future, which can in turn boost the sales of Nokia smartphones. Currently, Windows phones’ share in smartphone market is 2.7%. If Microsoft can increase its market share to 10% by launching cheaper smartphones, which have an average cost of $130, it can generate $50 billion in revenues by 2018.
Ecosystem to Boost In-store App Revenues
We believe that apart from being a money maker, app stores also drive smartphone sales. While the iOS and Android based smartphone ecosystems continue to rule the market, Windows-based phones have been gaining some traction thanks to Microsoft’s partnership with Nokia. With over 1.2 million active apps, the Apple Store raked in over an estimated $9.5 billion in revenues from app sales in 2013. Google (NASDAQ:GOOG) (NASDAQ:GOOGL) Play currently has over one million active apps and revenues have increased by 2.4x year over year in Q1 2014. In Q1 2014, Windows’ share in the worldwide smartphone operating system market was 2.7%. Moreover, Nokia shipped over 7.6 million Windows smartphones.
Windows 8 kernel-based phones failed to gain traction among customers and OEMs alike. This negatively affected the growth and development of the Windows ecosystem in the past. However, by dropping its licensing fees the platform became more appealing, and the launch of feature rich Windows 8.1 also filliped the app development. The developer community, which had shied away from developing Windows phone apps because returns were not attractive, added over 230,000 apps in the last six months. As a result, Windows Phone store apps grew from 170,0000 in September to over 400,000 apps. It continues to fund and support the Windows 8.1 app development platform with a focus on mobile app development. A stronger Windows Phone OS, with better apps and developer support, could make Windows ecosystem the third platform behind Google’s Android OS and Apple’s iOS. This may help convince customers to persist with Windows PCs and tablets. This can incentivize app development, and create a sustainable and profitable ecosystem for developers and users to thrive in. If Microsoft can grow its sales of smartphone units through NDS, this will grow the Windows architecture user base. A strong OS can translate into higher revenues from Windows mobile store in the future.
Cross Sell Its Nokia Smart Phones To Enterprise Clients
Globally, many companies have Window PCs installed across their offices. We believe that Microsoft can leverage these existing ties with its enterprise client to sell more smartphones. Additionally, these enterprises run ActiveSync, a Microsoft app released in 1996 to synchronize data between mobile devices and desktop computers, for mobile device management and security. The company can exploit this to pitch its smartphone to its enterprise clients. The recent implosion of Blackberry (NASDAQ:BBRY) has left a gap for smartphone manufacturers who can address the needs of security sensitive enterprise client. Microsoft can make security a standout feature for smartphones running on the Windows Phone OS. The company last year released a security feature pack for Windows Phone. These included technology for signing and encrypting email, lock down functionality for more enterprise control and automated triggering of virtual private networks at the app level. With the NDS unit under its control, Microsoft should look to roll out a tightly integrated smartphone that can offer chip level security to enterprise clients.
We have $44 price estimate for Microsoft, which is in line with the current market price.
Disclosure: No positions.