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Microsoft and Nokia: The Math Behind the Deal


Some simple math shows why this deal makes more sense than you think.

This morning, Microsoft (NASDAQ:MSFT) announced that it would pay EUR 5.44 billion, or $7.17 billion, in cash to buy Nokia's (NYSE:NOK) devices and services business and license Nokia's patents and mapping services.

The question, of course, is, why?

Well, Microsoft spells it out plainly in the press release:

Microsoft aims to accelerate the growth of its share and profit in mobile devices through faster innovation, increased synergies, and unified branding and marketing.

But the bigger news, which isn't receiving enough attention, is Microsoft's disclosure of a dark truth about its Windows Phone business: In its current state, it is never going to make any money.

Way back in June 2010, I wrote an article entitled Microsoft's Mobile Mathematics, within which I did some rough eighth-grade math to determine how much money the company can make in smartphones.

Figuring out a royalty rate for smartphones using Microsoft operating systems is much trickier, but I'll use a range between $20 and $30 as a very rough guesstimate here. Windows PC royalties are thought to be about $65 per unit, and netbooks about half that. I'd imagine that Google's (NASDAQ:GOOG) free Android giveaway could make it hard for Microsoft to get anywhere near top dollar.

So here are the best- and worst-case scenarios laid out using these criteria:

Best Case: 600 million smartphone units, 25% market share, $30 royalty rate = $4.5 billion.

Worst Case: 400 million smartphone units, 10% market share, $20 royalty rate = $800 million.

The good news is that software-derived revenue can be extremely high margin, and both numbers could be boosted by ancillary businesses like apps and mobile search. There's also a strategic benefit to keeping customers away from the iPhone and Android ecosystems.

The bad news is that even a few billion dollars in high-margin revenue isn't all that much for a company as big as Microsoft.

As it turns out, the reality was much worse than even my worst case scenario. Note that at the time, these guesstimates were for 2014.

Smartphone growth has outpaced expectations, but Microsoft has not built meaningful market share and its royalty rates are at rock-bottom levels.

As of Q2, Microsoft had 3.3% smartphone market share, in third place behind Google Android and Apple (NASDAQ:AAPL) iOS.

Additionally, we learned this morning that Microsoft is making almost no money from its Windows Phone. In its investor presentation, Microsoft disclosed that under its current partnership agreement with Nokia, it was making a gross margin of less than $10 per unit while spending what was probably a lot of money on marketing.

This was an unsustainable arrangement.

As of April 2013, Gartner forecast global smartphone shipments of 1 billion in 2013. At 3.3% of the market with a $10 per unit (rounding it to $10 to keep it simple) gross profit, Microsoft could be expected to generate $330 million in gross profit from Windows Phone royalties this calendar year.

Heck, bump the market share number up to 5% and it still does not come remotely close to moving the needle, as Microsoft had $14.3 billion in gross profit last quarter. When factoring marketing and development costs into the equation, Windows Phone almost certainly loses money.

With the Nokia deal, Microsoft aims to bump that gross profit per unit number to over $40.

Assuming that a combined Microsoft/Nokia would help build market share through a more concentrated marketing effort and better hardware/software/app integration, the company at least gets a chance at building meaningful profitability in smartphones.

So while there are an awful lot of naysayers out there hating on this deal -- Microsoft's stock has now given back all of the gains from the Steve Ballmer retirement announcement -- the company has no choice. It has to go for the whole enchilada because $10 per unit will never pay the bills.

However, this deal is no obvious home run. In fact, it may not be the best way, but simply the least worst way, to move forward.

Let's break it down.

Nokia accounts for about 80% of Windows Phone shipments, with other suppliers like Samsung (OTCMKTS:SSNLF) and HTC (TPE:2498) accounting for the remainder.

Since Microsoft is more or less choosing itself over its hardware partners, the Windows Phone platform could lose third-party support, and this would hurt its growth, which is currently the fastest in the industry (largely the product of growing off of a small base).

And the smartphone market, while growing rapidly (+46.5% in Q2), is actually a fairly rough environment in which to compete. Even Apple, while better than average in this regard, is seeing falling average selling prices, and the leading Android phonemakers Samsung, HTC, and Motorola are all struggling with rampant competition.

Twitter: @Minyanville

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