Monday, September 9, 2013

Connecting With Nokia: Microsoft’s Timely Idea?

Microsoft’s decision to acquire Nokia’s mobile business along with a clutch of patents, announced on September 3, 2013, marks the corporation’s big move to reinforce the corporation’s strategic shift into the devices and services domain, from its predominantly software business space.  This move comes days after Steve Ballmer, the longstanding CEO of Microsoft announcing his retirement to take effect in approximately a year from now. This move also follows his earlier announcement on the corporation’s intended strategic transformation into a devices and services company; Ballmer and the corporation are clearly in a hurry. The decision to acquire, expected in some manner or the other ever since Nokia decided to dump its Symbian operating system for its handheld devices and tie its fortunes up with Microsoft’s Windows mobile operating system, is logical from a strategic perspective but is intriguing from a financial perspective. Unlike Blackberry which has not demonstrated its capability to come back into the game, Nokia has demonstrated a distinctive flourish and competency to reassert itself with its new Lumia range of smart-phones, notwithstanding the constraints of a still evolving Windows mobile applications ecosystem.

While all the details of the deal are not available in public domain, Microsoft-Nokia acquisition offers several strategic insights and poses a number of strategic questions to debate for students of strategy and management. The events leading to the acquisition and those that could unfold in future for Microsoft and Nokia mobile businesses post-acquisition and integration are fascinating. Any deal of this nature needs to be analyzed in terms of certain key parameters such as industry evolution, firm-specific factors, business options, strategic synergy, deal valuation, customer response, execution capability, and risk-reward balance.  Some of these are industry level factors while some are firm-specific factors. All are equally relevant as the two firms involved in the transaction aim at a more prosperous future post-acquisition. Given that both the firms are engaged in industries that are at the cutting edge of rapid technological developments, Microsoft-Nokia acquisition promises to be a classic case study in strategic management.
Industry evolution 
Both Microsoft and Nokia operate in industries that are relatively recent and were almost shaped by them in a way from their inception until competition began to enter. The personal computer industry, for which writing the operating system is the mainstay business of Microsoft and the mobile phone industry for which making the mobile handsets is the mainstay business of Nokia have seen unprecedented changes. The personal computer has yielded place to notebook computers a few years ago and together both the devices are set to yield ground for tablets. The mobile phone has moved far past the functional objective of enabling people talk; they perform a host of services from photography and music playing to data and document management. The two industries of software or operating systems (for computers and mobile phones) and hardware (in terms of computers, tablets and smart-phones) overlap, interconnect and need each other more than ever.  Microsoft and Nokia were not ahead of the curve in their respective industries and faced in a sharp fall in market capitalization of both the companies; Nokia’s of course has been far steeper. Microsoft’s market capitalization fell from a peak of USD 642 billion in 2000 to a low of USD 252 billion in 2013 (around 40 percent of the peak value). Nokia’s market capitalization slumped from a peak of USD 245 billion in 2000 to a low of USD 10 billion in 2013 (less than 5 percent of the peak value).
Under the evolutionary scenario, it is evident that the classic vendor-user industry concept has ceased to exist between the software and hardware industries. It is also evident that the operational and economic benefits of control over each other can no longer be achieved through vendor-user arm’s length relationships, at least for the large players. Put differently, computing and communication as well as hardware and software began to merge as one seamless industry. It is no wonder, therefore, that Apple which had its own proprietary operating system and chips, in addition to other proprietary designs in other areas began to achieve industry dominance, challenging Microsoft in operating systems and Nokia in mobile phones. Simultaneously, third party manufacture of hardware, from chips to display panels and open source operating systems such as Linux for computers and Android for mobile phones became available widely, rapidly making both the industries fragmented and highly competitive. The need for proprietary integration across the two industries has become a new strategic imperative for large incumbents. 
Firm-specific factors

Microsoft, founded in 1975, has been a pioneer in developing operating systems for personal computers. Starting with MS-DOS in 1981, it has so far launched eight major operating systems for computers (Windows 3, Windows 95, Windows 98, Windows 2000, Windows XP, Windows Vista, Windows 7 and Windows 8) and four operating systems for mobile devices  (Windows Mobile 5 and Windows Mobile 6, Windows Phone 7 and Windows Phone 8). Without Microsoft operating systems, the personal computer industry would not have grown the way it did over the last fifty years. Without other collaborative tools of software (eg., Outlook, Office and Sharepoint) and hardware (eg., Servers) of Microsoft and other firms, networking and networked computing would not have become a transformative chapter in information technology. That cannot be said of Windows mobile operating systems which did not become popular.  Its latest Windows 8 OS, however, has been developed as a bold cross-device OS platform. While Microsoft led and dominated the personal computer industry, it has been slow to recognize the points of technological inflection that were occurring through the emergence of tablets and smart-phones. As a result, its operating systems failed to innovate for the new devices.
While Windows 8 has been acclaimed for its elegance and efficacy, tilted more towards mobile phones than computers, it has not still been embraced enthusiastically by other phone makers for several reasons. The other operating system Android, free of license fees, became popular and came up with continuous upgrades and updates. The fourth major Android upgrade, KitKat is now on the anvil. Google, the owner of Android, also allowed additional customization through user interface (UI) by individual phone makers.  Android has been able to notch up 800,000 applications, nearing Apple iOS while Windows has only around 150,000. Windows upgrades and updates have not only been less frequent but were often unfriendly to previous generation phones unlike Android. Android mobile OS met 79 percent of OS needs and Apple 14 percent while Windows had a lowly 3 percent.  With a total projected mobile phone sales of 1.8 billion units per annum, of which over 50 percent were smart-phones, strategic lock-in between Windows OS and a strong mobile phone brand became inevitable.
While the story of Microsoft mobile OS endeavors has been one of delayed uphill battle, the story of Nokia mobile phones and its Symbian OS has been one of rapid downhill slide. Nokia, doubtless, has had a hoary history.  Founded in 1871 as Nokia and with a century old history of making tyres, boots or cables, the company pioneered the first handheld mobile phone in 1987 and the first digital handheld GSM phone in 1992, after divesting its non-mobile business. Its first mobile was a runaway success and Nokia quickly became a global leader in handheld mobile phones accounting for over 40 percent market share in 2007. However, by 2012, its share fell to 19 percent (330 million units) compared to Samsung at 22 percent (385 million units) out of total global mobile phone shipments of 1,746 million units. More importantly, Nokia’s share in smart-phones was down at a meager 5 percent (35 million units), compared to  30 percent of Samsung (216 million units) and 19 percent of Apple (136 million units) of global smart-phone shipments of 713 million units in 2012.
Nokia’s decline has been essentially due to its inability (or complacence in) reading technological and market signs in terms of smart-phones, touch screen phones and dual-sim phones, not to mention the lack of synergy from a tablet lineup.  Nokia which prided itself in its superior hardware design and brand leadership decided to fight its way back with the induction of Stephen Elop from Microsoft as its CEO in 2010 who quickly decided in 2011 to disband Symbian OS platform and instead opted to hitch Nokia’s fortunes exclusively with Microsoft Windows platform. Under his leadership, Nokia was quick to launch its new flagship brand of Lumia smart-phones, first on Windows 7 platform and more recently on Windows 8 platform. In addition, it set new benchmarks in camera phones by incorporating 41 megapixel camera sensors and adding new photographic features like optical image stabilization. Its body engineering has also won applause for its durability, elegance and premium looks.  Notwithstanding all these measures, Nokia’s market share continued to fall and share price also  fell dramatically from USD 28 in 2007 to USD 8 in 2010 and to USD 2 in 2012! Clearly, while Nokia technologically was on the right path, the financial resources to achieve global dominance through Lumia and other developments were in question.
Business options
Both companies may have had their respective business options to reinforce and diversify their business models. Microsoft had successful business initiatives such as Servers (from 2003 onwards) and Xbox entertainment device (gaming console) diversification (from 2001 onwards) and moderate success in Search Engine, Bing (from 2009 onwards) but had failures in its tablet computers (in 2002 and again in 2012). Nokia had some successes with its communicator devices (eg, Nokia 7710 in 2004), Nokia Maps (from 2007 as Ovi and now as Here)  and Asha basic phones (2012 onwards). All these were, however, no more than initiatives for consolidating and reinforcing current businesses rather than staying ahead of emerging technologies and businesses. Both companies could have chosen to aim at operational excellence in their basic businesses (Microsoft in terms of faster and better OS upgrades and Nokia in terms of cost-effective basic and premium phones) but such strategies could have meant business downsizing rather than up-scaling. That would also have been a non-option in the face of aggressive moves by the respective competitors.
The Microsoft-Nokia partnership of 2011 was at best a cosmetic move for both the companies, dealing with their core issues at fringes. For Microsoft, Nokia was one more licensee, even if a committed licensee dedicated to Windows exclusively; and for Nokia, Microsoft potentially could provide an added differentiation to its distinctive product engineering and manufacturing build capability. Given the significant business challenge posed by a transforming communication and computing environment to Microsoft and the severe market competition unleashed by aggressive competitors taking rapid strides in smart-phone technologies on a resource-strapped Nokia, clearly a more radical approach was called for. It is still enigmatic why both the companies chose to live on an arm’s length partnership for two years instead of putting all their combined resources in 2011 by making the acquisition happen then itself. Whether it has been due to the complacent confidence that marks the DNA of market leaders that they could still make things work by themselves or it was a deliberate strategy of Nokia to build value through a new smart-phone lineup or it was a carefully crafted strategy by Microsoft to reach an economically optimal deal valuation, that too after a clear internal consensus on a device and services strategy, may not be known anytime soon.    
Strategic synergy
For Microsoft, the buy will assure a world-class mobile device platform which is known for its excellence in hardware engineering and build quality. Apart from Stephen Elop, the CEO of Nokia who will return to Microsoft as the head of its devices division (and even as a potential successor, along with other contenders, to Steve Ballmer), the transaction will bring to Microsoft some of Nokia’s best technical leaders and a human resource base of 32,000 people worldwide, of which 18,300 people are directly involved in manufacturing, assembling and packaging of products worldwide. It also provides access to a distribution, sales and marketing platform in 130 countries, known once for its market leadership whatever the country. It will also get access to all of Nokia’s patents, licenses and mapping services (through licensing arrangements), the maps offering additional potential in Microsoft search engine, Bing.  For Nokia, clearly the transaction is a bailout, providing immediate cash inflow of USD 7.2 billion and additional money of Euro 1.5 billion through three tranches of convertible bonds (In fact, within a week of announcing the deal Nokia has already utilized this offer to fund its buy out Siemens share in the Nokia Solutions and Networks joint venture). Given the somewhat unusual nature of only licensing the Nokia brand for 10 years, and Nokia patents for 10 years rather than buying them out for perpetuity, there could be certain additional funds flow in the long term for Nokia, not only from Microsoft but also from other players. Given that Nokia still gets to retain the existing networks business and about 50 percent of revenues through non-mobile businesses, the synergy for Nokia could be in terms of providing a new life for the residual Nokia.
With the Nokia transaction, theoretically Microsoft would be on par with proven in-house integrated product and operating system platforms akin to Apple and even superior to Samsung (its proprietary Bada OS has not been a success). Unlike several other Android phone providers, Microsoft-Nokia could be a more exclusive, proprietary differentiated option. Also, unlike Apple which depends on its own retail stores or franchises, Microsoft-Nokia would have a more omnipresent sales and distribution space.  And, Nokia with its iconic corporate brand power and Lumia with its emerging product brand power would be available to Microsoft, the former albeit for ten years unless extended.  Importantly, Microsoft can leverage Nokia’s design and manufacturing team to not only develop more mobile phone models but also diversify aggressively into phablet and tablet space.  There is no other handset manufacturer who would provide the same level of strategic synergy to Microsoft, BlackBerry included.  For Nokia too, the deal provides more degrees of strategic flexibility with financial backing for its residual networks business and continued ownership of Nokia brand, Here maps and the patents. Given the rapid changes in technology, Nokia may continue to play a major role in the telecommunications and mobile networks space, with attractive future earnings.       
Deal valuation

The Nokia buy is valued at USD 7.2 billion for Microsoft. It is just half the sale value and 50 percent of the market capitalization of Nokia, which increased by nearly 40 percent to USD 15 billion after the announcement of the deal (Microsoft was down by a few basis points). In financial terms, the acquired business should add USD 15 billion to Microsoft’s current revenues of USD 75 billion (20 percent increase).  Microsoft-Nokia deal value of USD 7.2 billion compares with the deal value of USD 12.5 billion for Motorola mobile phone business, and Motorola was at a much weaker position when that deal happened in 2012. Motorola contributed only USD 6 billion to Google’s annual revenues of USD 56 billion (13 percent increase). The Microsoft-Nokia deal value of USD 7.2 billion which is at 0.5 times of sale value of the acquired business seems very favorable to Microsoft compared to the Google-Motorola value of USD 12.5 billion which is over 2 times the sales of Motorola Mobility division. It may even appear to be a steal, given the strengths Nokia has in design, manufacturing, distribution and marketing.
Deal valuation is not necessarily solely financial or economic arithmetic, notwithstanding multiple valuation models that are available. Neither can they be evaluated in comparison across two time points, like some analysts are doing with Nokia and Motorola deals. Certain deals could be strategic in the overall but mandatory in certain facets. It may be hypothesized that the patent estate of Motorola (17,000 patents and 7,500 patent applications) is much larger and more mandatorily required for Google which had a weak patent position; also, it was  acquired by Google for perpetuity. In contrast, the patent estate of Nokia is possibly narrower and is also subject to certain licensing covenants on Microsoft. Similarly, the iconic Nokia brand remains with Nokia, albeit licensed for ten years to Microsoft, in comparison to Motorola Mobility brand perpetually acquired by Google. Overriding all these, Android mobile platform is reportedly weak in terms of intellectual property and the vast Motorola patent estate adds strategic assurance to Google far more than the deal value would suggest. Given that the smart-phone battles are being fought in law courts based on patents, Google probably paid fair value, and probably Microsoft is also paying fair value to Nokia, despite the apparently higher and lower frontend values in each case respectively.
Customer response
In any market facing deal, the response of the customers to product integration in the marketplace would be a wild card. A distinct marketing plus for Microsoft is the huge multi-million customer base of Nokia which may still be using a Nokia phone or could have used it at one time or the other. An overwhelming proportion of Nokia population has been basic and feature phones. It may be Microsoft’s tempting gambit to upgrade the huge Nokia base to Windows smart-phone, a gamble which may or may not work. Nokia, as brand, has a clear emotional appeal to its fans, rich and poor alike. Microsoft’s strategies would need to have a significant Nokia brand equity to provide continuing appeal. Any preemptive or presumptive withdrawal of Nokia brand in favor of Microsoft brand could de-emotionalize the product. Simultaneously, Microsoft would need to ensure that Windows 8 emerges as a much more popular operating system. It would be indeed a Catch 22 question for Microsoft given the conflict between tying up Nokia product and Windows OS exclusively and the tactical advantages of pushing the Windows OS more universally. The more Microsoft brings distinctly superior features to Windows OS, the more would be the chances of its success on the back of a singular Nokia platform.
Microsoft has other challenges as well. Historically Microsoft, with its dominant business of computer operating systems, has been an enterprise oriented company. The mobile phone business, on the other hand, is all about people. Mobile phones, over time, have become an integral part of people’s personalities. With the strides being taken in mobile technology, mobile phone could well represent the electronic control of all human life going forward. To become ubiquitous in that manner, Microsoft needs to create for itself a huge heart share before it can hope to drive up its market share. With electronic giants like Sony, Samsung and LG becoming path-breaking in handset designs and technologies, Apple continuing its formidable position and a host of other companies coming up with follow-on models, Microsoft cannot imagine that the current Lumia mobile phone line-up alone, however impressive it is, will drive a new high. As many as six manufacturers have already moved into smart watches as handy accessories to smart phones while Google is advancing with its Glass. Microsoft and Nokia have to come up with a grand expansive strategy of all-devices, including basic phones, feature phones, phablets, tablets and also a supplemental strategy to develop and market their own models of wearable computers. Nokia acquisition could tempt Microsoft to view it as a Windows OS initiative and lose track of a whole other important canvas of wider customer opportunity. Put differently, Nokia acquisition gets Microsoft a platform that can be developed further to cover the complete canvas of personal devices. Connecting emotionally and technologically with individuals, likely 7 billion subscribers, is both the challenge and opportunity that Microsoft now has.
Execution capability
Most acquisitions achieve their objectives and reap their synergies, or falter in the endeavor, in the execution processes. In any acquisition, the integration, harmonization, optimization and expansion processes that follow the acquisition milestone cannot afford to lose sight of the original strategic objectives unless the environment and strategic drivers themselves have changed substantially. Microsoft and Nokia need to be appreciative of the post-acquisition execution pitfalls. Fortunately, both companies are indeed well-positioned in this aspect, thanks to the two year old partnership for Windows phones and Stephen Elop being the continuing bridging leader. Whether or not there is truth in the rather uncharitable analysis of Finnish media that Elop has verily been the Trojan Horse for Nokia, Elop’s stewardship did provide clear direction to Nokia. He could coalesce the Nokia teams into one nimble organization to rediscover and refine its product engineering skills and also achieve a dramatic reduction in the product development, build and launch cycles at Nokia from 18 months to 6 months. Both Microsoft and Nokia technical teams could understand the hardware and software integration in the process, which augurs well for future post-acquisition processes mentioned above. What probably is required now is leveraging of the execution capability to develop grand product plans to capture the wider market opportunities discussed in the previous section, which can close current segment gaps and create new segments.
In terms of execution capability, it is probably Microsoft that would now need to double up, contrary to the traditional, and often misleading, presumption that the acquirer is more right than the acquired is. Microsoft must get into a virtuous and agile cycle of upgrading its Windows platform every year and providing updates every six months. Such upgrades must be friendly to generations of devices, and also simultaneous with application development. Without such agility in OS development, it is unlikely that the new Nokia mobile business would be able to face the competition from the likes of Apple and Google. In addition, new software needs to be developed for wearable computers. Microsoft would also need to develop the capability for mass customization of its products, across the segments. Both low-end and low-cost devices as well as high-end and high premium devices would be equally important. In addition, the corporation would need different execution models for different countries, particularly for the populous countries like India, as brought out by Nokia India MD in a recent interview. This strategy may require new operational models as well. Traditionally, Nokia made its low cost models in countries such as India. In future, manufacture of such phones may have to be outsourced and the Indian plants upgraded to manufacture more premium products.  Post-acquisition, the execution models would also be challenged by the fact that centre of gravity of Nokia as an organization lies in its Finland headquarters and the growth drivers in the international markets. Execution improved with Elop basing himself in Finland. With Elop returning to Redmond, new execution models which balance centralization and decentralization as well as accountability and empowerment in the combined outfit would need to be evolved.  
More rewards than risks

Any acquisition has its risks. However,  Microsoft’s acquisition of Nokia seems to have more rewards than risks. The developed and developing industry environment clearly points tectonic shifts in computing and connectivity technologies and practices. Players like Microsoft and Nokia who are weighed down by late recognition of, and inadequate responses to, such trends must pool the resources end-to-end to reposition in the competitive game based on design successes. Clearly, there is ample strategic synergy which is also bolstered by attractive deal valuation. Even the challenging arena of execution has had some nice early traction, thanks to the strategic collaboration that was unveiled in 2011. The deal itself is fairly and equitably valued. The risks, of course, are that the dominant competitors who are all hardware giants, ably supported by universally popular operating systems, and who are already ahead of the curve with greater vibrancy across broader product range, would intensify unanticipated product development, taking Microsoft by surprise (once again!). By focusing on prudent and proactive execution and being cognizant of integrated technological trends and playing its part in accelerating and utilizing them with agile business and operational models, Microsoft can make the newly acquired Nokia connection work really well!
Posted by Dr CB Rao on September 9, 2013

1 comment:

Unknown said...

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