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Why Microsoft Got a Bum Deal


Acquiring a business means acquiring its problems, and Google and Microsoft now face the additional challenge of turning around two brands with a long history of decline.

Microsoft (NASDAQ:MSFT) announced on Tuesday that it has agreed to buy Nokia's (NYSE:NOK) mobile phone division for $7.2 billion. The acquisition wasn't entirely novel; in 2011, Google (NASDAQ:GOOG) made an almost identical purchase of Motorola's mobile business. For better or worse, vertical integration has become a trend in the smartphone industry. Software companies now want to sell you hardware, too -- an approach made famous by Apple (NASDAQ:AAPL), which developed both the iPhone and the operating system that runs on it.

It's a little absurd, then, that both Microsoft and Google owe their success to a lack of vertical integration. Android took off in smartphones for the same reason that Windows conquered the PC: The operating system wasn't tied to the decision-making ability of a single firm. Hundreds of manufacturers have come out with Droid handsets, and almost all of them are losing money. Countless form factors, sizes, and price points have been introduced, and many of them have fizzled. Samsung (OTCMKTS:SSNLF) sells dozens of lines of smartphones, and it struck gold with exactly one of them. This process of trial and error isn't pretty, but it is effective; the market has consistently embraced open operating systems like Windows and Android. More than any other company in living memory, Apple has excelled at anticipating consumer trends; its reward has been a market share of less than 10% in PCs and an ever-dwindling piece of the smartphone market.

Google and Microsoft are now poisoning the well. Their entry into the hardware business means that they're competing with the partners that made them successful -- a conflict of interest that could very easily drive those partners elsewhere. For Google, this means a potential loss of market share to newer, more genuinely open operating systems like Tizen. Samsung is already threatening to take its marbles elsewhere, and other device makers are using such old or heavily-modified versions of Android that, for all intents and purposes, they already have one foot out the door. Microsoft, on the other hand, is faced with the Herculean task of getting Windows Phone off the ground. Nokia's dominance was already a roadblock for other manufacturers looking to enter the race; now that Microsoft has thrown its weight behind the Finnish phone company, that roadblock has become more like a barricade.

There's no reason to expect either Google or Microsoft to design great hardware. They struggle to produce great software; successful side projects are as rare at Google as happy customers are at Microsoft. For both companies, the typical approach to new products has been to throw everything at the wall and see what sticks. Software monopolies live a charmed life; they can generally stumble their way into the future with only a few bruises to show for it.

Hardware firms, on the other hand, live and die by their next product. Apple has one shot each year to debut a compelling iPhone, and a misfire would carry huge consequences. There's little room for trial and error in a world of physical costs, when each new product involves an expensive rollout and heavy marketing costs. Pundits have offered that Microsoft has experience in hardware, and this is true. But the mobile market bears little resemblance to the console gaming industry, where the Xbox has faced only geriatric competition.

Redmond entered a far more competitive space when it introduced the Surface tablets, and the results are well known. The duo achieved only mediocre sales, and the Surface RT suffered a $900 million write-down. Another consequence might also be observed: Microsoft's partners have been avoiding competing with Surface, and instead focused their efforts on convertible and touch-screen laptops. With one product, Microsoft has defined -- and perhaps killed -- the Windows 8 tablet. For all we know, Google may accomplish a similar feat later this year when it releases the Motorola X.

It's unlikely that either Motorola or Nokia will offer much help in the design department. Neither company showed much innovation in life; it would be unreasonable to expect it from them after death. Acquiring a business means acquiring its problems, and Google and Microsoft now face the additional challenge of turning around two brands with a long history of decline.

In other words, the prospect of either company producing a great hardware device is poor, and the risk of them wrecking their OS market share is high. Vertical integration jeopardizes traditional sources of revenue -- software sales for Microsoft, and advertising revenue for Google -- and trades the steady profits of a software monopoly for the more unpredictable returns of a hardware firm. Nokia's mobile assets may have been cheap at $7.2 billion, but it's hard to see Microsoft's purchase as anything other than a bum deal.

See also:

Microsoft and Nokia: The Math Behind the Deal

What Google Inc. Risks With Its KitKat Name

Should You Get a Head Start on Twitter's Rumored IPO?

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