By Marek Pawlowski

The agreement between Microsoft and Nokia is more complex than an outright acquisition, comprising a cash payment to acquire Nokia’s devices and services business, ongoing commitments by Microsoft to license certain Nokia products, patents and brands, as well as Microsoft making available short-term loans.

It is a strategic win for Microsoft and a rescue package for Nokia, made necessary by several years of executive mistakes and poor oversight by its board. It has the potential to bring together many of the ingredients required to create an attractive, integrated digital experience for customers across multiple touchpoints, from mobiles to home entertainment, but carries the risk of poor execution by a Microsoft still wedded to an outdated computing legacy.

This article examines the implications for 3 groups:

1. Microsoft and Nokia employees and shareholders
2. Users of Microsoft and Nokia products
3. Competitors

Microsoft stakeholders

Microsoft’s shareholders should be delighted. For USD 7.16 billion, less than 10 percent of the approximately USD 77 billion it holds in cash and short-term investments, Microsoft is acquiring the most talented mobile devices team in the world and taking a bet on finding new growth in mobile as users’ digital lives migrate away from PCs.

While Nokia’s devices business has made losses in the last couple of years, the most recent quarterly results showed it to be on the cusp of a return to modest profitability. Two years of restructuring amid falling market share had finally left the business in a position where it could turn a profit on sales of about 10m smartphones a quarter, a level it would have reached this quarter or next if it continued the 30 percent or so growth trajectory it had recently enjoyed.

Viewed in this light, and compared to the USD 12.5 billion Google paid to acquire Motorola’s smaller and less healthy business 2 years ago, this transaction represents the best use Microsoft could have made of its cash pile if it hopes to grow shareholder returns in the future.

Nokia’s stakeholders

Nokia’s stakeholders – employees and shareholders alike – face a more complex calculation. Prior to announcing a strategic partnership to use Microsoft’s Windows Phone platform in February 2011, Nokia’s shares stood at about EUR 8. Yesterday, before the Microsoft acquisition was announced, Nokia’s shares traded at just below EUR 3, a 63 percent fall in value over the two and a half years of working with Microsoft. Not once since the original Microsoft deal has Nokia’s share price risen above the pre-agreement level.

Taken at face value today, Microsoft’s proposed acquisition represents a modest premium, and the 37 percent rise (at the time of writing) in Nokia’s share price this morning reflects this. In contrast, Google paid a 63 percent premium to acquire Motorola in 2011.

This also does not address the destruction of value presided over by Nokia’s board and executive leadership team over the last several years.

Nokia employs fewer people, sells fewer devices, has less cash and generates lower earnings for its shareholders than it did before the board and CEO Stephen Elop engineered the original partnership with Microsoft in 2011. This course saw Nokia abandon control of its own software, including Symbian – at the time the most widely used smartphone platform – and Meego, the next generation platform it had invested in building over several years.

The agreement saw Nokia committing irrevocably to Microsoft’s Windows Phone, a platform which held virtually no market share at the time of the agreement. Windows Phone has since grown to represent approximately 3 percent of the worldwide market for smartphones, almost entirely driven by Nokia (80 – 90 percent of Windows Phone sales), with minor contributions from HTC and Samsung. By the end of Q2 2013, Nokia had sold a total of just 27.3m Lumias in about 2 years. This contrasts with the 24.2m Symbian OS-based smartphones it sold in the single quarter of Q1 2011, when the Microsoft deal was announced.

By tying its future to Windows Phone, Nokia committed to a software platform it did not control and was not ready to compete against better offerings from Google and Apple. As a result, Nokia has had to spend two years fighting a losing battle for customers and market share. While Nokia’s own software teams have gradually introduced additional applications and system-level features into Windows Phone, the pace of change has been slow compared to Android, primarily because Microsoft remained in overall control of the operating system.

Today, Nokia’s Windows Phone devices are just becoming competitive in the wider market, but almost all of that can be attributed to Nokia’s own efforts to add innovative new hardware (such as the remarkable Pureview cameras), quality industrial design and software like the HERE maps suite. From a consumer perspective, Windows Phone itself looks almost unchanged in two and half years, and while Microsoft has provided a new release about every 12 months, they have concentrated primarily on under-the-hood changes invisible to customers.

I stated at the time in an interview for BBC, and I continue to hold the view, that Nokia would have fared better if it pursued a strategy where it maintained control of its own software.

The long-term opportunity in digital is providing an architecture for users to create and employ data in myriad forms across numerous different touchpoints, from embedded sensors and wall-mounted displays to handheld devices. The original February 2011 agreement between Nokia and Microsoft was never going to facilitate this, instead focusing on a misguided, short-term bet that adding a significant new hardware partner like Nokia would accelerate growth of Windows Phone and capture a medium term opportunity to sell smartphones.

It failed to do this and it has failed to position Nokia and Microsoft, either separately or as a combined entity, to strive for the long-term objective of being able to provide multi-touchpoint digital experiences.

The result has been a narrowing of choices for Nokia that has left it in the position it finds itself in today. Nokia alone no longer has the cash reserves or the strategic software control to grow its market share in an increasingly diverse digital landscape, where consumers expect an integrated portfolio of devices and services, from smartphones to tablets, PCs, gaming and home entertainment.

These short-term financial concerns come through clearly in the wording of the announcement and the press conference Nokia held in Helsinki this morning. The point was stressed by Nokia’s Chairman Risto Siilasmaa, CTO Timo Ihamuotila and Stephen Elop, who steps down as Nokia’s President and CEO while the transaction plays out. Siilasmaa stated: “We don’t have the resources required to fund the acceleration needed.” Elop, meanwhile, talked of Microsoft providing the ‘financial muscle’ needed to become the 3rd ecosystem and his frustration of being ‘so far behind two larger competitors [iOS and Android]’.

It is also evident in the three tranches of short-term financing Microsoft is making available to Nokia as part of the deal. The Finnish company will be able to draw up to EUR 1.5 billion from Microsoft in exchange for convertible notes, even if the deal does not complete. The notes carry reasonable interest rates, below what Nokia might expect to pay in the open market, ranging from 1.125 percent annually for the first EUR 500m tranch, 2.5 percent for the second and 3.625 percent for the third tranch. These notes are essentially advance payments in anticipation of the deal closing and will be set against Nokia’s net proceeds from the deal if it completes, or – if it does not – could be converted to shares by Microsoft a minimum of 2 years after the funds are first drawn.

Risto Siilasmaa, Nokia’s Chairman, also made a telling statement with regards to Microsoft’s motivations. He talked of Microsoft’s recent announcements that it would move into producing its own mobile hardware, a strategy first evidenced in the Surface tablets, and how, after they begun negotiations in February 2013, Microsoft told him that it could no longer justify the approximately USD 20 investment it was making in Windows Phone for every USD 10 it receives in licensing fees.

Put simply, it was in Microsoft’s short-term interests to obtain Nokia’s commitment to creating Windows Phones and use Nokia’s hardware talents to establish Windows Phone as a reasonable ‘third choice’ after Android and iOS. All the while, however, it was also in Microsoft’s interests to develop its own bet on hardware, either by creating it independently (which it tried and failed to do with Surface – recording a USD 900m charge on unsold Surface stock last quarter) or by acquiring Nokia at the best price it could. When news of the original February 2011 partnership between Microsoft and Nokia broke, consensus analysts estimates suggested Microsoft would need to offer USD 30 – 40 billion to purchase Nokia. Today, it is paying just over USD 7 billion.

Nokia faced a stark choice: with dwindling financial resources it would have to start competing against Microsoft’s own Windows Phone hardware or it could allow itself to be acquired at a price much lower than it would have obtained had the deal been done two years ago.

The role of Stephen Elop, who joined Nokia as President and CEO from Microsoft in September 2010, must be closely scrutinised. Today it was announced that he would step down temporarily from Nokia’s board and his resign his role as CEO and President while the transaction closed, to avoid a ‘conflict of interest’. During this time, he will continue to lead the mobile devices business, and anticipates joining Microsoft when the transaction completes. He is also widely touted as the frontrunner to replace Microsoft CEO Steve Ballmer, who has announced he will retire in the next 12 months.

This is obviously rich territory for conspiracy theorists to speculate over his motivations, but we should instead examine the facts. Unfortunately, these are no less palatable. Elop’s tenure at Nokia has destroyed value for its shareholders, while creating value for Microsoft stockholders by allowing the American company to keep a foothold in mobile it would otherwise have struggled to maintain. His leadership has backed Nokia into a corner where low cash reserves and a lack of control over the most strategic part of its products – the software platform – has allowed Microsoft to acquire 32,000 employees with the knowledge to run a global hardware business.

If the transaction closes, Nokia will be centred around three businesses, all of which pre-date Elop’s period at the company. HERE, its location services platform, will continue developing its data sets mapping the world and license these to customers, of which Microsoft will be one of the largest, as it continues to use HERE apps and services in Windows Phone. NSN, which supplies infrastructure products for mobile broadband networks, will focus on its existing LTE (4G) business and developing new technology for the next generation (5G) networks. There will also be an R&D and technology licensing arm, primarily geared towards extracting value from Nokia’s patent portfolio, which includes about 1200 ‘essential communication’ patents licensed by numerous players in the mobile industry and currently generating about EUR 500m a year. Around two thirds of these patents remain enforceable for at least ten years, creating an ongoing revenue stream.

Without the mobile devices business, Nokia’s shareholders will find themselves invested in three profitable, cash generative activities and with the prospect of special one-off dividend to distribute some of the cash proceeds from the Microsoft deal.

In this sense, the deal is a short-term boost for Nokia shareholders, but only when measured against a share price mired by several years of strategic errors by Nokia’s executive management and ineffective oversight by the board.

Implications for end users

Turning to what this might mean for existing customers and, in the longer term, potential new users of Microsoft’s products, the prospects are mixed.

Nokia’s hardware business is split into two separate strands, one selling legacy Asha products based on its Series 30 and Series 40 platforms to emerging markets and the other selling Lumia smartphones. While these two divisions have seen a more unified approach in their design language in recent years, they are very different.

During this morning’s press conference, Stephen Elop stated that Microsoft would take a ten year, non-exclusive license to continue selling Asha phones under the Nokia brand and remained committed to this business.

However, sales of Asha products have been declining and the devices themselves are rapidly reaching a crossover point where low-end Lumia smartphones are available less expensively than the less capable Asha devices. As such, I would anticipate Microsoft transitioning Asha entirely to Windows Phone within two years. There is no sense in them taking on the costs of developing a second software platform for mobile devices. This marks the beginning of the end for Nokia’s so-called ‘feature phones’.

While not explicitly stated in the announcement, there is another significant ramification for Nokia customers: future Windows Phone products will not carry the Nokia brand. Microsoft’s license pertains to the legacy mobile phones business only, not the Lumia smartphones. It remains to be seen whether they will continue to be sold as Lumias or simply ‘Windows Phones’, but there will be no more Nokia Windows Phone smartphones. The days of carrying a Nokia smartphone in your pocket will soon be over.

Nokia will retain ownership of the brand and, in the unlikely event it decided to do so, may begin using it again on its own devices from December 2015.

As a mobile hardware manufacturer, Microsoft should be able to take a wider view of how it earns money from end users. For the time being at least, Microsoft’s Windows operating system and Office productivity software remain the company’s engines of cash generation. It is the success of these products which has created Microsoft’s cash pile and allowed it the breathing room to fund a series of lacklustre mistakes in mobile dating back to the early 1990s, from Windows CE and Pocket PC to Windows Mobile, Kin and Surface.

In the short-term, this will likely lead to Microsoft lowering the prices of Windows Phone products and Surface tablets in the hope of winning enough market share to keep customers tied into the Windows ecosystem. Longer term, however, it perpetuates the problem which has prevented Microsoft from succeeding outside of its core PC business: as long as the company is able to continue extracting cash from its dominance of the legacy computing business, it will be unwilling to make the major changes in product strategy required to succeed in the future.

Microsoft has diverse assets across the full spectrum of digital, from the Xbox home entertainment system to its Skydrive cloud architecture and Skype communications platform. It also owns a stake in Facebook. In theory it could, and should, accelerate the integration of these into a single approach to delivering a unified customer experience. There is the potential to improve the way customers capture, create and use data in all aspects of their lives.

However, this is contingent on wholesale change in the way Microsoft operates. Under Steve Ballmer’s leadership, it has remained steadfastly committed to a model of digital life increasingly irrelevant in consumer’s lives, a model reliant on 1990s era PC-centric thinking.

Microsoft’s stakeholders should demand that Ballmer’s successor, be it Elop or any other candidate, take immediate steps to phase out the reliance on legacy PC technology and refocus on a multi-touchpoint approach to digital user experience aligned with the reality of customers’ lives.

It should also be noted that, while it merited a mere footnote in the announcement, there will be a significant figure missing from the Nokia team that moves to Microsoft. Marko Ahtisaari, a member of Nokia’s leadership team and its head of design, is planning to leave the company. Ahtisaari is the man responsible for design language employed across Nokia’s device portfolio, arguably the strongest selling point of its products, from the bold colours and ergonomic forms, to the purity of its branding and high quality material choices.

His presence would have been a significant asset if Microsoft is to succeed in bringing human-centred design to the fore in future consumer products and his absence diminishes the chances of Microsoft retaining Nokia’s hard won reputation for exceptional device quality.

Changes to the competitve landscape

If the transaction completes, Microsoft, Google and Apple will be squarely aligned as competitors: each owning operating systems, applications, storing user data in the cloud and selling consumer hardware. It will leave hardware manufacturers like Samsung, LG, Lenovo, Sony, Acer, Asus, Dell and HP in the awkward position of selling Windows PCs into a declining market while watching Microsoft building a competing hardware business in the growth area of mobile devices.

I would expect at least one of Samsung, Lenovo, HP and Sony, to expedite plans to develop their own alternative software platform as a viable ‘fourth ecosystem’ competitor, most likely by making acquisitions, such as Blackberry or Jolla, the small Finnish company which took up the baton of Nokia’s abandoned Meego platform.

Any hardware manufacturer of a certain scale should ask itself whether it should differentiate by narrowing its focus to making the best devices it can, content to rely on others’ software platforms, or whether it has the financial muscle and strategic vision to quickly build its own ecosystem to compete with Microsoft, Google and Apple.

For Google and Apple, Microsoft’s acquisition of Nokia should create mixed feelings. Google’s Android platform, as a freely available and customisable operating system, has never looked more attractive for the third party hardware manufacturers who are essentially now paying to finance Microsoft’s own hardware ambitions through their Windows licensing fees. Apple, with the already tight integration between its products and complete ownership of its ecosystem, will regard Microsoft’s move into hardware as yet another indication that imitation is the sincerest form of flattery.

In the near term, both Google and Apple will be content to see Microsoft and Nokia consigning themselves to at least a year of integration headaches. Once lead times are factored in, it could be two years before the first truly integrated Microsoft hardware products reach the market, handing Google and Apple a window of opportunity to widen their lead.

Looking further ahead, the acquisition of Nokia’s hardware talent does offer Microsoft the potential to offer consumers an attractive digital experience across all the touchpoints in their lives. This could make the competitive landscape more difficult for Google, particularly given the growing popularity of Windows Phone in emerging markets, and further narrow Apple’s appeal to the high-end, limiting wider ambitions it may have.

However, any competitive success will be contingent on two major questions, neither of which Microsoft has proven itself able to answer for decades:

1. Can Microsoft commit to a vision of multi-touchpoint, connected digital experiences more aligned with customers lives without too rapidly destroying its strategic assets in the legacy PC business?
2. Can Ballmer’s replacement significantly improve upon a woeful track record in executing outside the PC business and restructure the company?

If it continues to form, Microsoft’s competitors may do well to remember Microsoft its often its own worst enemy.

Our next MEX event in London on 24th – 25th September explores the user modes at the heart of future digital experiences, offering strategic guidance on user experience and practical, hands-on skills.

By Marek Pawlowski (see previous commentary on Nokia, Microsoft and other aspects of digital strategy)