Sunday, March 6, 2011 4 comments

Nokia and its Risky Strategic Bet [VERY LONG]

(Source: Illustration by Peter Kraemer for Strategy+Business. "Strategic Bets," Strategy+Business, February 7, 2011)

There is a pertinent story about a man who was working on an oil platform in the North Sea. He woke up one night from a loud explosion, which suddenly set his entire oil platform on fire. In mere moments, he was surrounded by flames. Through the smoke and heat, he barely made his way out of the chaos to the platform's edge. When he looked down over the edge, all he could see were the dark, cold, foreboding Atlantic waters.

As the fire approached him, the man had mere seconds to react. He could stand on the platform, and inevitably be consumed by the burning flames. Or, he could plunge 30 meters in to the freezing waters. The man was standing upon a "burning platform," and he needed to make a choice.

He decided to jump. It was unexpected. In ordinary circumstances, the man would never consider plunging into icy waters. But these were not ordinary times - his platform was on fire. The man survived the fall and the waters. After he was rescued, he noted that a "burning platform" caused a radical change in his behaviour.

We too, are standing on a "burning platform," and we must decide how we are going to change our behaviour.
— Stephen Elop, "Burning platform" employee letter

I have only been seriously investing and following business news for a few years. I think I have just seen one of the biggest strategic bets in history. A $40 billion market-cap company has just abandoned its core strategy and embarked on something radically new. This company is none other than Nokia (NOK). The CEO of Nokia, Stephen Elop, is literally betting the whole company on a risky strategy. Nokia, for those not familiar, has decided to partner with Microsoft and abandon its internal mobile operating system and mobile services platform.

The move by Nokia reminds me of what IBM did in the 1990's. IBM, which was once a dominant computer hardware company radically changed its business in the mid-90's to that of a 'solutions' or services business. It worked for IBM; its market capitalization was three times higher by the late 90's (admittedly some of it was due to the TMT bubble) than it was at the beginning of the decade. Will it work for Nokia?

Nokia's Alliance with Microsoft

The Wall Street Journal ran a good recap of the deal a while ago:

Last week, Nokia Chief Executive Stephen Elop made his decision. He bet his company's future on smartphones running Microsoft software and snubbed Google's Android.

In the end, Microsoft agreed to pay Nokia billions of dollars over the course of their multiyear agreement to help Nokia market and develop Windows Phone devices, according to Mr. Elop. It is unclear how much Google may have offered Nokia.

Intel Corp. CEO Paul Otellini said Mr. Elop went with the highest bidder. "Between Microsoft and Google he was getting incredible offers, money, to switch," Mr. Otellini told investors Thursday. Microsoft bid more, he said.

...

Among Microsoft's inducements: It was willing to use a mapping service in its products called Navteq, offered by a company Nokia had spent $8.1 billion to acquire several years ago. Google, on the other hand, had far more invested in its own mapping service than Microsoft and was less willing to use Nokia's service, according to a person familiar with the matter.

Also, Nokia urgently wanted to reach an agreement with one of the companies in time for a London meeting with investors and analysts last Friday, and Microsoft moved more quickly than its rival to strike an alliance in time, this person said.

Nokia will also get to participate in the advertising revenue generated by Microsoft location-based services enabled by Navteq—for example, when someone searches for pizza on a Windows Phone and gets an ad for a nearby restaurant.
Essentially Nokia is giving up on its internal mobile phone operating system and has decided to bet on Microsoft's mobile phone OS. The CEO of Nokia, Stephen Elop, claims that Microsoft will be paying billions to Nokia but no details have been released. It's still not clear if the billions are real cash or some "theoretical" amount that may be earned.

The stock market did not like this deal. The market sold off Nokia's stock and it has been trending down, losing around 20% of market cap (around $8 billion in market cap) over the last few weeks. Some market participants were expecting Nokia to pick Google's Android OS but I believe the stock would have sold off even in that case. When I started following about an year ago, I recall reading some comments from analysts and investors suggesting that some long-time Nokia investors will sell if it picks the Android OS or Microsoft OS. So the sell-off isn't surprising to me.

A Classic Fallen Angel

Nokia is a fallen angel. The question is can it get up and fly again?

In an article at SeekingAlpha, Peter Mycroft Psaras, wonders if Nokia is like Apple in 2003? I would say the answer is a big NO.

I don't see anything in common between what Apple went through and what Nokia is facing. Although situation doesn't look good for Nokia, it isn't as bad as what Apple encountered. By the late 90's, Apple was essentially side-lined and it went nowhere throughout the early 2000s. Using the data provided by Peter Psaras, you can see how badly Apple was doing (look at the CF per share and owner earnings):


In contrast, Nokia's situation is nowhere near as bad:



Apple actually posted losses whereas Nokia is still posting profits and has good, positive, cash flow. Nokia's balance sheet is also fine.

I would say Nokia is more akin to IBM in the early 90's. IBM wasn't facing a total collapse—if Microsoft didn't inject some money in the late 90's, Apple may have gone bankrupt or ended up irrelevant, like Commodore or DEC or Sun—but it was facing a radically-changing business environment. IBM used to dominate the highly profitable computer hardware business but profits were slowly dissapearing and it was starting to lose its market-leading position. It embarked on a major strategic change whereby it successfully morphed into a services/solutions/consulting company. The rest is history and many articles and books have been written on it.

Major strategic shifts are risky and often fail but they are, as Stephen Elop elloquently described in his burning platform analogy, necessary at times. Nokia will succeed as IBM has, or it will fail like Kodak, which wasn't able to adjust.

I think the proper comparison is IBM in the 90's and not Apple in the 2000's.

What Does Nokia Lose?

With the Microsoft alliance, Nokia will lose control of the mobile operating system. Nokia will be at the mercy of Microsoft with respect to software upgrades, bugfixes, and the like. Financially, the impact is likely a wash-out, with Nokia paying Microsoft licensing fees while it cuts its workforce that was developing the internal OS. This will, however, have a negative impact on worker morale and may be disruptive until the transition is complete.

Differentiating its software and user experience will be more difficult going forward. All of Nokia's phones will become more commoditized—there is nothing to stop, say, Samsung or HTC from providing a near-similar experience as Nokia. I would argue that this isn't as big a deal as it seems. Except for the late-90's/early-2000s period, Nokia has generally dominated the low to mid-end and their products are very close to commodities anyway.

Also, by ditching its internal OS, Nokia is going to get to shut out of the tablet market. Microsoft's mobile phone OS isn't suitable for tablets (although it's not clear if Nokia may decide use any future Microsoft tablet OS) and Nokia will be one of the few major handset manufacturers without a tablet presence.

Perhaps more importantly, Nokia will give up most of the revenue from mobile phone services (such as app sales). It's not clear to me how the revenue-sharing works but using Microsoft's mobile OS ecosystem clearly means that Nokia won't be earning much—at least directly.

Nokia is also taking on some risk by picking Microsoft. As Horace Dediu at Asymco points out, Microsoft has had a less-than-stellar record with its mobile operating system efforts. Microsoft has probably spent billions and seriously tried at least 5 times to dominate the mobile phone OS market with all of them ending up as big failures. If Microsoft fails, what does Nokia do?

Benefits for Nokia

I. Superior OS and Development Platform

Although Nokia will give up on internal operating system development (except for some future experiemental projects), one can argue that they never had much competency in OS development. The fact that MeeGo, their future OS, had been delayed and nowhere near competitive shows their shortcoming in this area. By picking Microsoft, which has strong competency in OS development, Nokia may finally have a solid platform, not just today or tomorrow but for decades. Microsoft also tends to provide superior application development environment for 3rd party developers so Nokia will likely attract more development houses.

II. Finally a Shot at the US Market

In North America, Nokia has practically no market share (less than 5% and practically 0% in smartphones). The Microsoft alliance may open some doors in the US market. Nokia has a greater opportunity to enter the US market with Microsoft's help. Microsoft tends to spend a lot of money on advertising and carriers may take a more favourable view towards Microsoft.

III. NAVTEQ Should Improve

As The Wall Street Journal article quoted above alludes to, Microsoft will start using Nokia's NAVTEQ mapping services and share some revenue with Nokia. NAVTEQ has been a disaster for Nokia, with it paying $8.1 billion for a money-losing business with no hope in sight. The following segment breakdown, from the 4Q 2010 presentation, shows how badly NAVTEQ has performed in the last two years:

The alliance with Microsoft should allow NAVTEQ to post profits going foward. I would be truly surprised if NAVTEQ doesn't post a profit in 2 or 3 years. My guess is that NAVTEQ will produce around $250 million in profit in a few years.

(On an unrelated note, do note from the table above how Nokia Siemens, the wireless infrastructure equipment provider, is a big drag on Nokia. That's another problem senior management has to tackle if mobile devices business is stabilized. Nokia has been trying to exit this business but no one wants to buy Nokia Siemens at a decent price.)

IV. Potential to Penetrate the Business Market

Although too early to say, for the first time ever, Research In Motion's Blackberry platform may face serious competition in the business market. If Nokia can successfully leverage Microsoft's Office software offerings, such as Excel, Outlook, and Bing search, it may be able to make a compelling offering for business users. Historically, business users have valued Blackberry's strong e-mail capabilities but I suspect smartphones, which have the power of personal computers, can offer a lot more. Whoever that integrates office productivity applications will likely have a big winner.

If Office productivity offerings take off, Microsoft, which owns and controls the software services, will likely make a lot more money than Nokia but at least Nokia can finally enter the business-user market. Investing in Nokia is sort of like investing in Intel (as opposed to Microsoft, Oracle or Google, all of whom have higher ROE, better profit margins, etc).

Is Nokia a Worthy Investment?

Not sure. I'm still not sure how the mobile phone market will look 10 years from now. Will anyone still use a portable device in ten years? Or will something like a tablet replace the mobile phone? I'm still thinking about these issues so I'm not comfortable with Nokia.

Another problem with Nokia is that, even with the collapsing stock price, it is not exactly cheap. It is still a $30-billion company and the upside is limited. It earns around $2 billion now so even if it increases that to $3 billion (50% increase), the company probably isn't worth more than $45 billion. The current strategy will also make it more of a commodity supplier so its P/E multiple should be lower than what it has been in the last 15 years.

Miscellaneous

Other Interesting Articles...

Nokia's cultural problems from a former Nokia designer. I think the author is biased towards design and worships Apple's strategy a bit too much. Nevertheless interesting inside account of Nokia.

Is Nokia pursuing a burning ships strategy? I think the strategy isn't quite as desperate as it seems; but something had to be done.

Video interview with Nokia CEO. Everyone considers Stephen Elop as a Microsoft guy but I believe he only worked there for a few years. I think he is better thought of as someone from the Internet software business, Macromedia (now part of Adobe).

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4 Response to Nokia and its Risky Strategic Bet [VERY LONG]

Modulo Man
March 7, 2011 at 9:46 AM

I don't see how anyone could not like Nokia's decision unless they're personally invested in Symbian.  Bottom line is that Symbian was going nowhere, so what is the loss?  WP7 already has more market share than Symbian.  No other company builds the phone and writes the OS except Apple, with that in mind, lets celebrate Nokia freeing themselves from competing against unbeatable magical devices.  

There is going to be a merging of the two halves of computing here in a couple years, the dominant PC side, and the upstart mobile side, the PC side is going to move into mobile rather than the reverse.  (Only Apple can resist that because they're closed off).  Android is decent, but its kind of a joke too.  You know that thing Steve talks about, fragmentation?  Its hellaciously bad for Android, the future looks dim for Android IMO.  Look, I spent $600 on a phone 7-8 months ago and Android has progressed through 3 iterations and I've gotten one of those iterations a full 3-4 months after everyone else.  Likely my $600 phone will never be updated again making it an outdated brick in mere months (also motorola's fault).  MS understands how to make an OS run on millions of different combinations of hardware, so I think they will focus on creating that sort of ecosystem again.  I would love to see a phone ecosystem where you can install an OS of choice just as you can with current PC's, I think a lot of people would naturally expect things to head that way because people are going to start demanding that they get more out of their hardware...

Sivaram Velauthapillai
March 7, 2011 at 8:59 PM

I think Nokia optimists were expecting the Symbian+MeeGo combination to succeed. If I was a Nokia shareholder, I would be hoping for that as well. The problem with going with Windows Phone 7, at least from Nokia's perspective, is that they lose control and potentially significant mobile service/app revenue.

As for Android, I agree with you and think Nokia was better off with a Microsoft OS. It would have been difficult for Nokia to differentiate with so many Android phones, not to mention some really poor cheap ones out there.

Do you think tablets will be a threat to smartphones? Do you see yourself carrying around a small tablet (may work in a work or school environment) instead of a mobile phone?

Ashish Gupta
March 16, 2011 at 12:11 AM

Notice MRH is your big holding. what do you thing MRH IV is ? Are you buying it on dip due its still not known losses on Japan tragedy?

Sivaram Velauthapillai
May 9, 2011 at 8:29 PM

Sorry about the late reply...

Montpelier Re is my biggest holding but if I made some mistakes with it. I'm positive since purchase but return hasn't been great. I overpaid for it a few years ago.

I am not sure how to value insurance companies but I would only buy MRH at 0.7x book value or thereabouts. These mega-catastrophe companies deserve a discount. Right now book value is around $23 vs a share price of 18, for a P/BV of around 0.8.

If I went back in time, I wouldn't buy Montpelier Re again. I came to the conclusion that I have no idea of the risk inherent in a company like this. It's a black box and who knows if it's going to blow up when the next hurricane hits. I have thought about buying MRH recently (after the Tokyo losses), as well as during the financial crisis when it was very cheap, but I had no confidence in the company. I have come to the conclusion that if one doesn't have confidence in the company during crises, the company isn't for me.

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