In a surprising move, Nokia and Microsoft decided to enter a strategic relationship for the OEM’s smartphone business. While the marriage appears promising at the outset, Research Director Andreas Constantinou argues that the only way for that marriage to succeed is for Microsoft to acquire Nokia’s smartphone business.
The Elop and Ballmer duo on stage on February 11th was the main topic of discussion at this year’s Mobile World Congress. The reverberations of the Microsoft-Nokia announcement were felt even by the huge green robot tucked away at Google’s stand in Hall 8.
Following the news of the Nokia and Microsoft tie-up, Stephen Elop’s appointment to the helm of Nokia seems like an arranged marriage – and one whose best men were the carriers who wanted to avoid an all-out Android coup. It was also a marriage of desperation, which Elop memorably described in his memo as ‘jumping into the unknown’ from the â€˜burning platform’ that is Symbian.
A marriage of desperation
Microsoft has been desperate to see its mobile business succeed. After a decade of lacklustre efforts at mobile device sales and severe product delays, Microsoft was getting desperate; it needed to stop the churn of Microsoft users to the Apple ecosystem and plug its $1 billion-a-year operational costs for its mobile phone business. Even having spent most of its $500M marketing budget for WP7 it had only got breadcrumbs in terms of sales, with Microsoft reporting 2 million shipments but no comment on sell-throughs (which leads us to suspect this was not more than 1 million of actual end-user sales).
Nokia has been desperate seeing its platform play fail spectacularly in comparison to its newfound competitors; Apple who had amassed a developer ecosystem and operator demand which was second to none, and Android who in 2 short years matched Nokia’s smartphone sales in Q4 2010. MeeGo was trumpeted as the big guns in Nokia’s arsenal in February 2010, but once again Nokia’s software R&D failed to deliver on the promise. More importantly, despite the 10+ acquisitions during 2007-2010, Nokia failed to amass a strong-enough developer and services ecosystem on Symbian, Java or Qt that could compete with Apple or Google. Like Elop said in his now-famous burning platform memo, “our competitors aren’t taking our market share with devices; they are taking our market share with an entire ecosystem”.
It was in an act of desperation that led Nokia to befriend the lesser of two evils in the shape of Microsoft. It is ironic how in mobile the least enemy is a friend, much like how carriers backed Android in 2008-9 to fend off Apple, and backed Microsoft in 2003-5 to fend off Nokia.
Despite the surface-level coverage of the Microsoft and Nokia news, not much has been said about the two giants’ courtship and even less on the prenuptial agreement. According to our sources, Nokia asked both Microsoft and Google to bid for its smartphone business, with the help of a small army of McKinsey suits. Following a long negotiation cycle with both parties, Nokia came to a straightforward conclusion; it would back Microsoft who’s total bid equalled more than $1 billion (including patents, licensing fees, marketing support and revenue shares) and not Google who’s bid was about half that. Funny how cash-rich platform vendors are buying their way into the market these days.
Nokia announced its decision to Microsoft and Google on February 9th , only 2 short days before the Ballmer/Elop press conference – which prompted Vic Gundotra to pen the tongue-in-cheek tweet “#feb11 “Two turkeys do not make an Eagle”, scornful of both Nokia and Microsoft.
#feb11 "Two turkeys do not make an Eagle".
— vicgundotra (@vicgundotra) February 9, 2011
The last-minute decision meant that Intel heard the news at the very last minute, and in turn had to ask its MeeGo partners on Friday night (Feb 11th) to remove the mention of Nokia from the MeeGo PR quotes going out on the following week at MWC. This is the stuff industry disruptions are made of.
A chemistry mismatch
What Nokia announced was not just a marriage; it was a radical change in its business model, from a vertical powerhouse to an assembler – which is what prompted us to question the motivations and the end goal for Elop.
We already knew that Symbian had been demoted to an internal-only OS (see earlier analysis – Symbian is dead, long live Symbian). However we were expecting to see Nokia take a more measured stance; for example using Windows Phone 7 in certain markets (especially in North America where carrier handset subsidies are OS-led) or taking a classic dual-supplier strategy by inking deals with both Microsoft and Google.
Instead Elop presented a terminal picture for Symbian which would be destined to ship on only another 150 million devices until being completely replaced by WP7. Elop knew that an all-out replacement of Symbian with WP7 would mean haemorrhaging valuable brainpower as the 7,000+ Symbian staff had spent 15 years on the anti-Microsoft camp. These are the decisions made by boards with long-term strategy agendas, who see organisations made up of â€˜assets’ and not â€˜people’.
Besides the death blow to Symbian, Elop relegated MeeGo to an R&D project with just a single device launch in the horizon, if any at all (which carrier is going to subsidise a platform that’s dead on arrival?). Moreover Qt’s future seems uncertain as it has no place on Windows Phone (Microsoft wouldn’t allow copyleft software to be used with Windows Phone), plus it is too heavy for S40 class devices and MeeGo is too small an addressable market to justify the Qt ongoing investment. Qt (and its 400 thousand developers) need a new home.
What appears somewhat suspicious is that Nokia went not for a tactical, but a deep partnership with Microsoft, solidified by the multiple revenue streams exchanged between the two companies, a kind of revenue â€˜keiretsu’ that ties the two giants in a longer commitment.
More importantly, the marriage to Nokia’s smartphone business seems like it’s lacking in chemistry. For the last decade, Nokia has operated as a vertical silo, owning and integrating all value elements, from software, UI, industrial design, services, app store and developer ecosystem. That silo has now huge holes punched through so that it can accommodate Microsoft’s horizontal software-licensing business model. This situation is somewhat like trying to fit a square peg in a round hole.
There are fundamental conflicts here, as both Microsoft and Nokia want to own the developer experience (think APIs, support, tools, developer marketplace, conferences, marketing), and the application discovery and delivery process (think Windows Marketplace vs Ovi Store). This is a chemically unstable mix that won’t survive the test of time. It would be like having Nokia owning Office while Microsoft still runs the Windows business. Yet at the same time Nokia has little value to offer other than design, development, manufacturing and sales of handsets in the picture Elop and Ballmer painted. Something’s not right.
Moreover, Microsoft faces a fundamental customer imbalance on its mobile platform. With such a strong endorsement of Nokia, Microsoft has placed too much favour and device sales expectations on a single vendor.
Microsoft did not only hurt the feelings of HTC, Samsung and LG (previously committed to launching 50! Windows Mobile handsets) with such an imbalanced endorsement. More importantly, with Nokia volumes likely to ramp up fast, Microsoft will have to deal with a single-customer monopoly and end up financing Samsung, LG or HTC towards ramping up Windows Phone production to balance it up. Windows Phone may quickly end up looking like a platform of unbalanced OEM interests – much like Symbian Ltd or Symbian Foundation were – and we know how these panned out.
There are two more troubling clues in the way this ceremony was setup. Despite fundamental changes to the handset business, Elop made no reorganization in the NSN business which is performing at marginal profit (operating margin at only 3.7% vs 11.3% for handsets). As Tomi Ahonen points out, Elop seems to be ready to get rid of NSN. Plus there was no announcement of Ovi plans or clear strategic guidance with regards to the Nokia services business.
The acquisition scenario
There have been earlier rumours of acquisition discussions between the two companies. We now believe that the only scenario for the Nokia and Microsoft partnership to succeed is an acquisition scenario; Microsoft buys Nokia’s smartphone business, while Nokia gets more resource to play with what it does best – that is creating mass-market phones at unbeatable levels of supply chain efficiency, unmatched supplier bargaining power and customisation to 100s of variants per handset model for distribution to diverse global regions, channels, carriers and retailers.
From a financial standpoint, Microsoft capitalisation stands at $220B, more than six times Nokia’s market cap of $33B at the time of writing. Microsoft would also acquire a high-profit margin business that would go a long way in helping the Redmond giant push its Entertainment and Devices division at high profitability levels for the first time. Despite Microsoft being a software business, it has experience in running hardware products, with the Xbox business doing well recently on strong Kinect sales.
For Nokia, a joint venture would make more sense than a pure sale of its smartphone business, given that the hardware giant is an important component of the Finnish economy. It would allow Nokia to focus on what it does best and substantially increase its S40 R&D budget (as Elop already announced it would) to rework its aging feature-phone OS. A joint venture would also allow Nokia to make a comeback when they are ready to take on the high-end phone market again.
Besides, with shares recently hitting a 13-year low and Nokia being owned by American institutional investors, the Nokia board has little they can do in the face of potential suitors. This makes Nokia a very interesting acquisition target, not just for Microsoft but for anyone with cash at hand and mobile ambitions, including Chinese, Korean and Japanese suitors.
The acquisition scenario would allow Microsoft to leverage on Nokia’s accounts with carriers across the world to woo them into moving subsidy budgets from Android into WP7. This is all too important, as the Microsoft brand enjoys little consumer awareness compared to Apple and Android, meaning that Microsoft is more dependent on carrier subsidy and marketing budgets than its nearest competitors.
Fundamentally, we believe there is no place for Nokia, an all-in-one integrated handset OEM and services company, in the new telecoms value chain. The old guard of top-5 OEMs are squeezed between leaders (Apple, RIM) who lead in terms of performance & profits, and assemblers (Huawei, ZTE, Dell, Acer) who lead in terms of me-too designs & razor-thin margins (see our earlier analysis on the evolution of the handset value pyramid). Nokia’s business needs to break-up into independent, self-sustained entities, particularly the smartphone business (within Microsoft’s new home) and the mobile phone business as an independent entity that can focus on competing with PC-borne assemblers.
The Microsoft-Nokia acquisition might not have been planned from the outset, but it is a scenario whose viability has been ensured from the outset. There are no conspiracy theories here, except that Elop (as the 7th biggest shareholder of Microsoft) would benefit greatly from trading Microsoft shares with Nokia ones, only to see them boost in value after being repatriated.
Let the debate begin!
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Andreas Constantinou is Research Director at VisionMobile and has been working in the mobile software industry since 2001, when he fondly recalls being a member of the team behind the very first Orange-Microsoft handsets which set the world of telecoms software in motion.