Microsoft Wants To Outdo Google And Apple, Buying Nokia Helps With Neither

So the deal that should have been done 2 years ago is at last completed: Microsoft Microsoft is buying most of Nokia Nokia to take control of its smartphone destiny. Despite saying kind words about having other partners in Windows Phone, though, this move will effectively end the Windows Phone licensing business. It will position Microsoft as a clear number three in the smartphone wars, but with a difficult decision. In combining the operating system and hardware under one roof, Microsoft’s smartphone division now looks like its increasingly go-it-alone Windows RT group and more like Apple Apple. But unlike Apple, the phones Nokia has been successfully selling aren’t high-margin, high-priced models. And they aren’t selling to Microsoft’s corporate customers either. Microsoft claims they are now a “devices and services” company, but this is the least attractive part of the device business. And if it tempts Microsoft’s worst impluses about its services, helping the company sell more Windows Phone might ultimate thwart what should be its larger aims.

When Steve Ballmer announced he was resigning, The Wall Street Journal asked a bunch of technology executives what the next CEO of the company should do. While the frontrunner for that jump is clearly Nokia’s Steven Elop, the advice from former Facebook CTO Bret Taylor, who currently runs Quip, crystallized the problem for whoever takes over.

Microsoft’s recent strategy shift was to focus on “services and devices”—essentially to become a hybrid of Microsoft’s biggest competitors, Google and Apple. I am skeptical such a strategy will succeed because the services model and device model are so different. The device model is based on tight, vertical integration of software and devices, with profits coming primarily from hardware. In contrast, the services model is based on ubiquity—making your service universally available across devices, operating systems, and regions to reach the maximum number of potential customers. I would advise Microsoft’s incoming CEO to take a critical look at this new strategy and pick a single path with a single, simple business model.

What Google does

Taylor’s point is that Google and Apple are so different, it’s not apparent there’s a lot of overlap. The search-engine giant is happy to see iOS succeed so long as Google Maps, GMail, and Google’s search are available on Apple devices. In fact, nearly everything Google does is centered around getting more data about users and continuing to refine the process of delivering the best targeted advertising based on that data. While Google owns Motorola, it has so far shown limited willingness to go downmarket with the brand to attract users to its own smartphones. Whether or not the new Moto X (and a rumored cheaper cousin to it) marginally increases Google’s smartphone market share is almost irrelevant. And if Google’s rumored nine-figure marketing budget behind the Moto X doesn’t yield results, it wouldn’t be at all surprising to see the company more or less give up on the Motorola brand.

What Apple does

The iPhone maker has eschewed ubiquity for profits, consistently garnering between 1/2 and 3/4 of the smartphone industry’s total earnings despite a much smaller market share. It builds phones that have roughly $200 in parts and sells them to carriers for an average of more than $600. While that doesn’t mean the company is earning $400 per phone, it’s getting close to $300. The new low-cost iPhone 5C expected to be introduced on Sept. 10 won’t radically alter Apple’s modus operandi. Apple will seek a somewhat larger share of the market, but only if it continues to make significant profits every time the company sells a phone. And while that installed base of iOS users has led to a software business selling apps, music and movies that is worth billions annually, everything flows from the sales of the iPhone and iPad.

What does Microsoft want to do?

So Microsoft buys Nokia, which is selling Lumia phones at an average gross margin of just over $30. (Microsoft is figuring that since Nokia has been paying it about $10 per phone in licensing fees, that will rise above $40 once it owns both sides of the equation).  Given that it requires a lot of people and marketing to run a phone division, that effectively doesn’t yield any profits at all. In fact, Nokia lost hundreds of millions last quarter selling Lumias despite hitting a high in Windows Phone sales. While the company has high-end product, in the form of the 41-megapixel Lumia 1020, it doesn’t sell much of it. Nokia has been relying on deep discounting and emerging economies to grow its smartphone business. Objectively, there’s nothing wrong with that. In terms of stated strategy, though, it seems unlikely to get Microsoft where it wants to be.

Windows Phone isn’t demonstrating much ability to win over Android and iOS users. If it wants to expand from a distant third-place position, it will need to successfully broaden the platform’s appeal beyond bargain-chasing first-time smartphone customers. In facing a related problem with its Surface tablets, Microsoft decided the best way to win people to its hardware was by keeping its Office software proprietary to its own platform. While it doesn’t have the same specific issue with phones — limited versions of Office exist on iOS and Android — there’s a real risk to doubling down on that kind of thinking. (This doesn’t even begin to address that Microsoft is also buying Nokia’s huge “dumbphone” division, which was doing OK until recently. While it provides some limited leverage in component buying to own, the strategic implications for Microsoft are difficult to value much above zero.)N

Microsoft instead should be trying to expand the Office franchise and its cloud-computing efforts to every device on earth. The company already has a presence in nearly every Global 5000 organization and those organizations have almost all deployed iPhones, iPads and Androids. There’s nothing inherently preventing Microsoft from selling cheap smartphones and also pushing services like Office 365 across everyone else’s devices, but it seems unlikely doing one the first will lead to the second.

And that gets us back to Taylor’s diagnosis of Microsoft’s problem. It’s buying a smartphone maker whose current success is predicated on hollowing out the smartphone business: selling cheap phones at low margins. The more successful that strategy is, the less profit in phones there is for anyone. It simultaneously finds itself desperate to sell Windows Phones and RT tablets that nearly no one else is behind and Surface Pro tablets that are alienating its remaining PC OEMs, yet less focused on pushing its very successful services everywhere. If Elop, who has been running that Nokia business for a while now, takes over the whole company, the direction will tilt farther in that direction.

What you wind up with is a low-profit version of Apple running a low-ubiquity version of Google. It’s not clear that any profits flow from this, but it is clear a lot of distraction does. This is the kind of distraction that causes you to keep losing money on Bing despite making minimal inroads against Google. It’s the kind of distraction that leads to endless ads for the Surface that tout features iPad buyers don’t care about. Whether it gets Microsoft any closer to compete in a world where PC sales keep falling is another matter entirely.

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