Friday, February 11, 2011

Can Nokia/Microsoft Stop Google, Apple in Smartphones?

After his colorful burning platform memo, Nokia's new CEO Stephen Elop announced a partnership with Microsoft to compete with Google and Apple in the smartphone market. After a 7.25% decline in Nokia's stock Thursday -- with 8% more to go based on pre-market action -- in the wake of this announcement, investors have correctly guessed that this partnership tells us more about how much ground Nokia needs to make up -- I estimate Nokia would need to boost smartphone sales by 33 million from this deal to make up for this week's lost market capitalization -- than about how it will close the competitive gap.

The reason is simple -- after growing at a fraction of the rate of Google's Android, Nokia plans to replace its Symbian operating system with Microsoft's Windows Phone 7. Gartner reports that Nokia's has lost almost half its market share since June 2007 when Apple introduced the iPhone -- falling from 50.8% to 27.1% in the fourth quarter of 2010. During that time, Nokia's market value has plummeted by over 60%.

To assess whether Nokia is making the right move here, I apply three criteria that I use for evaluating corporate investments in new businesses:
  • Is the industry attractive?
  • Can the partnership compete?
  • Will the partnership's future profit flows pay back the investment?
Smartphone Industry Attractiveness: PASS

The smartphone industry is huge, fast growing, and profitable. According to Gartner, in 2010 296.6 million smartphones were sold, up 72% from 2009. And the rapidly growing smartphone industry is very profitable. For example, if we consider Research In Motion as a proxy for the industry -- Fortune estimates that its gross margin is about in the middle of its competitors --  then Research in Motion's five year average return on equity of 92.8% is nearly seven times the 13.4% sported by the average company in the S&P 500. 

Partnership Competitiveness: FAIL

Despite all the hand wringing on Nokia's part, it led the industry in 2010. Its Symbian controlled 37.6% of the market, selling 111.6 million smartphones, according to Gartner. While that figure is up 38% from 2009, Android grew 23 times faster -- its 22.7% share of 2010's market was up 889% from 2009's 6.8 million units.

Competition in the smartphone industry is all about creating an ecosystem of handset and application builders and wireless service providers to deliver the most compelling end user experience. Android's stunning growth is due to its availability on high end handsets. According to Gartner, these include HTC (Desire range, Incredible and EVO), Samsung (Galaxy S) and Motorola (Droid X, Droid 2).

And in that ecosystem battle, Symbian is losing momentum to Android at a frightening rate. According to Ramon Llamas, senior research analyst with IDC's Mobile Phone Technology and Trends team, "Android continues to gain by leaps and bounds, helping to drive the smartphone market. It has become the cornerstone of multiple vendors' smartphone strategies, and has quickly become a challenger to market leader Symbian. Although Symbian has the backing of market leader Nokia, Android has a growing list of companies deploying Android on their devices."

And working with Microsoft is not likely to make up much of that growth difference. That's because Microsoft is a distant fourth in the smartphone market -- and it has been losing ground rapidly. According to Gartner, Microsoft's 12.4 million units sold in 2010 represented a mere 4.2% of the market -- less than half its 8.7% 2009 market share.

Nokia must see itself as being in deep trouble indeed if the best it could do to halt its loss of momentum is to abandon its market leading operating system for a partnership with a company that saw its 2010 market share drop even more dramatically.

Investment Payback: UNCLEAR

While it would be nice to know how much Nokia will invest in its partnership with Microsoft, that information is not available. However, a possible proxy for that investment is the stock market's verdict -- that has so far wiped out $3.3 billion in Nokia's market capitalization ($0.87 per share times 3.74 billion shares).

By that measure, it would take a boost of 16.3 million new Nokia smartphones to make up that loss. How so? The average Nokia smartphone sells for $212 (156 Euros) and has a net margin of 6%  -- yielding a profit per phone of $12.70. If we multiply that by Nokia's P/E of 16, we get a market capitalization per unit of $203. Dividing the $3.3 billion in lost market value by $203 gives us the additional 16.3 million units. And if Nokia loses another 91 cents a share today, it would need to sell a grand total of 33 million new units to make up the $6.7 billion ($3.4 billion more today) in lost market value.

Nokia was founded in 1865 as a Finnish wood pulp company. It has evolved considerably since then -- expanding into "papermaking, rubber, cables, and telephone equipment" before dominating the cell phone market in the 1990s, according to Bloomberg -- and it will need to similarly reinvent itself in order to survive. The partnership with Microsoft is an insufficiently radical departure to assure Nokia's ability to sustain its market leadership.

Elop will need to come up with a better idea -- but he deserves more time to try.


Blogger Venu said...

if you assume the traditional wisdom that app ecosytem effectiveness is a numbers game (i.e more apps is better marketplace) then Nok/Msft have a tough road ahead. but what if good app ecosystems are about 'a good head and broad shoulders' instead of a 'long whippy tail'.

can the two companies bankroll 10,000 apps in an open'ish innovation framework (give proven app developers $5k per app as 'incentive' for trying). Suddenly, a $50M investment gives you a higher quality app ecosystem that is both good enough and somewhat differentiated. What if the two companies applied the same logic, but invested $1B (since at least one of these companies does pretty well on the cash generation side)

10:18 AM  
Blogger Venu said...

This comment has been removed by the author.

10:20 AM  

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