Handset sideshow doesn't solve Microsoft's core problems

Facing the expiration of the distribution agreement with its main mobile phone licensee, Microsoft bought Nokia. The deal fulfills Steve Ballmer’s ambition to recast Microsoft as the next Apple by allowing it to vertically integrate downstream into hardware.

Here’s the key passage from Ballmer’s press conference Tuesday:

The company I joined 33 years ago was a company focused on software for personal computers. And software is a great skill and will always be a core strength of Microsoft. The PC is an important device, the most productive device on the planet, and will continue to be so. And yet for us not only to grow but for us to really fulfill the vision of what we can do for our customers, we've evolved our thinking.

We need to be a company that provides a family of devices in some cases we'll build the devices, in many cases third parties, our OEMs, can build the devices but a family of devices with integrated services that best empower people and businesses for the activities that they value the most.

Like the dog who caught the car, now what? Microsoft under its next CEO will be a hardware company, but is there any evidence it will be a successful hardware company?

One of the problems is that Microsoft had more than a decade to offer a compelling mobile platform. Its smartphone market share has been falling since before the iPhone and Android.

Now with Windows Phone 8, it has a good product, but so what? Four years ago, another dying mobile company — Palm — brought out an innovative device to great reviews, but it didn’t matter. Less than a year later, the company — the US smartphone pioneer and onetime market leader — was gone, like Nokia bought up at a firesale price.

Microsoft has already had a chance to try its fully integrated mobile strategy with its Surface tablet, which enjoyed great reviews and a huge marketing push. In one year, Microsoft spend $900m to advertise the Surface and WP8, but generated only $850m in sales and took a $900m write-off on inventory.

Fortunately for MSFT shareholders, Nokia’s handset division is available at a firesale price, less than 10% of the company’s cash on hand. Unfortunately, the man who ran the division into the ground will be heading it for Microsoft and is now a favorite to become Ballmer’s replacement

The deal would also reward Nokia’s CEO Stephen Elop, the ex-Microsoft executive who torched Nokia’s Symbian platform in favor of Windows, and led the failed effort to regain share using Windows. (In mid-2012, Nokia’s Symbian platform had a higher market share than Windows had then or now). Elop has shrunk the company , cutting the company’s market cap in half from $40b to $20b.

Perhaps Elop won’t rewarded for his Nokia failures, but the early betting is that Microsoft’s board (a captive of Ballmer and founder Bill Gates) will pick a conventional leader who, as the WSJ put it, “won’t rock the boat.” Because of this influence, the article predicts the board will go for more of the same, someone who can run a large bureaucratic Fortune 500 company, rather than a visionary leader who will break free from the lost decade of stagnation under Ballmer. The company needs a Lou Gerstner but (at best) will end up with another Lew Platt.

The problem is, Ballmer has historically confused monopoly profits with premium pricing. People pay more for Apple products because they want to; people pay more for Microsoft products when they have to, and they don’t if there’s a good alternative.

While Nokia didn’t get software, they historically were a hardware innovator with screen, cameras, sensors and other features. Now Samsung has assumed that mantle — along with overall market share leadership — while Apple remains the software and integration leader.

The Nokia deal will reduce near-term EPS and long-term profitability ratios. The company hopes to save $600m annually, presumably by laying off 3,000-5,000 workers. I would expect most of those would be in Finland, where Nokia has for the past few year playing a shrinking role in the local economy.

Even if Nokia is a modest success, it will at best replace Microsoft’s declines in its slowly dying PC business. Buying the former market leader — which now longer even ranks in the top 10 in global market share — won’t transform it into a major player in the industry. Given its huge cash hoard, Microsoft’s phone business will last longer than Blackberry’s, but that’s not saying much.

As with all such mergers, the odds of actual success are large. Two quotes from this morning’s WSJ illustrate the problem:

When executives "can't figure out what to do, they go buy something, particularly when they have a lot of cash," says Jeffrey Pfeffer, a professor at Stanford University's Graduate School of Business. "It seldom works."
…
Juan Alcacer, a Harvard Business School associate professor who has studied Nokia, says companies with small market shares typically "are in a bad position for a good reason." Combining two of them, rarely works, he says: "Two bad companies don't make a good company."

The stock has given back the gains that it had with Ballmer’s retirement announcement. Hopes that Microsoft would fix its broken corporate culture, becoming faster and more responsive are now dashed. We long-suffering Microsoft shareholders own a utility, that pays out a fraction of its declining monopoly profits with no replacement in sight.