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There are presently several reasons to believe Microsoft (NASDAQ:MSFT) might buy Nokia (NYSE:NOK). These are:

The Institutional Imperative

This is perhaps the strongest reason. There is a little known phenomenon in the market, first identified by Warren Buffett, called the “institutional imperative”. The institutional imperative states that whatever peers do in terms of strategic options will probably be mimicked by other competitors, no matter what the rationality might be.

Now, in Microsoft’s case regarding mobile phones, the direct competitors are Apple (NASDAQ:AAPL), Google (NASDAQ:GOOG) and (less importantly for this article), Research in Motion (RIMM). Of these, both Apple and Research in Motion have always controlled both the mobile devices and its software (the operating system).

As for Google, at first it controlled only the software (Android), but has recently decided to acquire Motorola Mobility (NYSE:MMI). A case can be made that such an option was taken so that Google could control both the software and the devices it would run on, much like Apple and RIMM were already able to do. The objective of this strategic move was obvious: Google wanted greater control over the user experience, something that is best done when a single entity controls both hardware and software, as Apple has shown so extensively.

Now, after Google took this step, Microsoft became the only competitor that has control just on the software side. With there being such a thing as the institutional imperative, the pressure would be great for Microsoft to do precisely as all its peers in this space have done – to also control the hardware its software runs on, ensuring a much more integrated and smooth user experience.

In Comes Nokia

At this point, with Microsoft feeling the pressure to control hardware as well, Microsoft might survey the landscape for hardware opportunities. It is here that Nokia becomes the obvious choice. Nokia is still (but not for long), the biggest mobile phone maker in the world. It also has a large telecom equipment division (accounting for 30% of revenues), and a large pile of cash ($6.6 billion in net cash) together with a rather small market capitalization ($18.4 billion). (source: Nokia's latest quarterly report.)

Nokia is Cheap Enough

In terms of absolute cost, acquiring Nokia would not be incredibly expensive for Microsoft. For instance, trying to do an acquisition at a 50% premium to the market ($7.5 per share) would cost Microsoft just $21 billion ($18.4bn market cap x 1.5 – $6.6bn net cash) – and this would be before Microsoft would most likely sell the telecom equipment business. This is entirely within Microsoft’s capability (MSFT has a $55 billion cash hoard itself), and not much more than what Google spent on Motorola Mobility ($12.5 billion) for what is arguably a worse competitive position.

Indeed, even though Microsoft would be buying a world leading mobile phone maker, it would be committing just around 10% of its own market capitalization ($215 billion) to take that strategic position.

Another alternative

Another alternative Microsoft could face, if truly infected by the institutional imperative, would be to try and buy Research in Motion. This would require Microsoft to ditch RIMM's distinctive OS, much like Nokia is ditching Symbian right now. Buying RIMM at a 50% premium, and discounting its cash, would run Microsoft around half of what Nokia would cost ($10.8 billion). However, the technological integration would be harder and slower, since Nokia is already shipping Windows Phone mobiles today.

Conclusion

Given the institutional imperative and the values involved, it would not seem far-fetched to see the announcement of Microsoft bidding for Nokia in the short to medium term.

I need to stress here that the institutional imperative is so called not because there is some hard logic as to what should be done, but precisely because such logic does not need to exist. One just needs the peers to be doing something, which they are doing in this case - they are all joining hardware and software as a means to better control the user experience, and such will put a lot of pressure on Microsoft to do just the same, by acquiring a mobile phone maker - with Nokia being the obvious choice given its market position and valuation, and Research in Motion being another possibility, although less likely.

Disclosure: I am long MSFT, NOK.

Source: Why Microsoft Might Buy Nokia