Nokia: Microsoft's Last Ecosystem Piece?

| About: Nokia Corporation (NOK)

Nokia (NYSE:NOK) is burning money, has a weak product line, is losing smartphone market share, has no presence (yet) in the tablet sector and recently sacrificed its own disliked operating system for one that has since failed to set the smartphone world alight. Unsurprisingly, Nokia's stock price has fallen 82% since its new CEO came on board in September 2010 and the company had to announce last month it was cutting 10,000 employees.

General consensus seems to be "Nokia is in free-fall". "The company is no longer able to make money from its handset business". "Nobody wants to own one" (the Lumia was effectively given away for free in the U.S. and sales were still unexciting) and "it will never again compete with the iPhone".

I think there is an alternative view to be considered. Currently there seems to be a race to own and control gateways to content. Apple (NASDAQ:AAPL) has a smartphone, tablet, operating system and music/apps store. Google (NASDAQ:GOOG) has a search engine, smartphone, operating system and recently announced a move into tablets (Nexus 7). Amazon (NASDAQ:AMZN) has a tablet, content store and is rumored to be viewing an entry into smartphones. Microsoft (NASDAQ:MSFT) has a search engine, console, operating system and recently announced tablet (Microsoft's first significant foray into the hardware market).

In fact the only link to complete Microsoft's ecosystem (a term Microsoft has been pushing a lot with its forthcoming Windows 8) is a smartphone presence. Smartphone and tablet growth is expected to grow exponentially over the next decade and the major players are positioning themselves to ensure they benefit from this growth.

Nokia offers vast and well developed distribution links, strong tie ups with service providers around the globe and a platform to build from that has already adopted Microsoft's operating system.

It is estimated that Microsoft currently pays Nokia $1 billion annually to use Windows on its phones. That deal was agreed when the market cap of Nokia was $40 billion. Today, Nokia's market cap stands at $7 billion. of which $4.2 billion is held in cash. Nokia's patent portfolio is one of the largest in the business (approximately 30,000 patents) with very few phone/device makers able to make a move without having to pay Nokia some sort of ongoing royalty. Last year, Nokia earned $615 million from patent revenue. Steve Ballmer has a track record of building up Microsoft's patent arsenal with Microsoft's last acquisition of 800 patents from AOL (NYSE:AOL) for $1.06 billion in April.

Bearing this in mind, were Nokia to close down its handheld and network businesses (which is at least performing better than the handheld business) the EV/ revenue would still only be 5 based purely on patent revenue alone. Microsoft could buy Nokia with petty cash, sell Nokia's stake in Nokia Siemens Network back to Siemens (SI) (if calculated at 0.5 x 0.5 x '12E sales valuation looks around $4bln.) and gain control of one of the largest patent portfolios in the industry, a global distribution network even Samsung (OTC:SSNLF) and Apple would benefit from and a handheld business that it has the resources to make successful in order to push its own operating system and complete its Windows eco-system. It would also have the $4 billion sitting in Nokia's cash account.

Microsoft also benefits from freeing itself from the annual $1 billion payment to Nokia to use Windows 8. Due to the close partnership between the two companies and the covenants that exist for Nokia's next generation of phones to be tied to Windows, it looks an unlikely target for many of the potential acquirers being rumored.

In early July Nokia's chairman Riisto Siilasma announced that Nokia had a contingency plan in case Windows 8 phones weren't enough to save the company. I believe this plan is most likely to be one of the following: Allow Microsoft to buy part or all of the business in a friendly takeover or to split the handset and networks businesses much like Motorola did so successfully with its mobility and solutions divisions. After suffering a similar stock-price free-fall, Motorola (NYSE:MSI) made the decision to split the business to release shareholder value. The handset division was eventually sold to Google in August last year for $12.5 billion, a 63% premium to its price, and Google's press department released the following announcement:

The acquisition of Motorola Mobility, a dedicated Android partner, will enable Google to supercharge the Android ecosystem and will enhance competition in mobile computing. Motorola Mobility will remain a licensee of Android and Android will remain open. Google will run Motorola Mobility as a separate business.

Microsoft's press office should feel free to cut, change the names and paste in the near future. The hole in product line-up that Google needed to fill is exactly the same Microsoft faces currently. Such a split would satisfy the Finnish government of the continued existence of the country's largest private employer and retention of its global brand name.

The number of possible strategies Nokia can explore as part of such a contingency plan is further limited by the Finnish prime minister's comments in late June that the government would not support Nokia by purchasing shares:

This is not our business. We are developing Finland into a country where companies can do well, but this is not the way of support along which the government will go.

I believe two major catalysts are currently at play that may expedite a buyer to step forward in the short-term. Firstly, Nokia has announced that it has been working on a tablet for the last six months. Since Microsoft, Amazon and Google all have or are about to release tablets of their own, it would suggest any interested parties would have to act soon.

Secondly, if the rumours that Amazon is looking to build a presence in the smartphone sector are accurate, this could flush out a buyer keen to avoid any potential bidding war.

I believe there are enough reasons to view Nokia as an attractive and viable buy-out target. While these reasons exist, I believe the stock will be buoyed by bid speculation over the coming months.

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