The Exchange

Microsoft’s Nokia Leftovers Might Be a Better Bet Than Phones

The Exchange

The headlines are abuzz with Microsoft (MSFT) CEO Steve Ballmer’s final play – buying Nokia’s (NOK) phone business for $5 billion. But what remains of Nokia actually might be the more interesting piece of the deal.

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Ballmer and Elop in 2011

The new, slimmer Nokia shifts away from being one of the most iconic consumer phone brands and becomes a top behind-the-scenes vendor of mobile telecom gear and services. Instead of slugging it out against the likes of Apple (AAPL), Google (GOOG) and Samsung, it might be able to benefit from their booming sales.

Microsoft agreed to pay $5 billion for Nokia’s tiny but growing Lumia smartphone line along with a massive but shrinking portfolio of dumb phones. Microsoft will also pay another $2.2 billion for a 10-year license on Nokia’s patents and a bit more for rights to its mapping service. What’s left of Nokia after Ballmer gets the phone division?

The company will be a leading maker of the equipment mobile carriers need to provide fast LTE-based Internet service. It also owns one of the most complete global mapping services, known as Here, and thousands of patents critical to mobile phones.

The metamorphosis

The metamorphosis comes as a shock to fans of Nokia phones. Before Apple introduced the iPhone in 2007, Nokia sold one out of every two smartphones in the world. In an era before touch screens and mobile apps, Nokia’s candy bar phones and Symbian operating system were ubiquitous.

But the company was slow to adjust to the changing landscape and its market share dwindled away to almost nothing. Even the 2011 partnership to sell phones running Microsoft’s upgraded Windows operating system has so far done little to reverse the slide.

Now that’s Ballmer and his successor’s problem.

The remaining businesses still generate big revenue and far more profits than the phone unit. The telecom equipment side reported sales of 5.6 billion euros ($7.4 billion dollars) in the first half of 2013 and an operating profit of 11 million euros ($14 million). Excluding restructuring charges, the unit made a profit of 524 million euros ($690 million).

A Well-Worn Path

The unit had been a joint venture with Siemens until Nokia decided to take full control in July. Though few saw it coming, Nokia’s move to get rid of its mobile phones follows a well-worn path trod by other leading equipment makers including Ericsson (ERIC), which got out of a joint venture with Sony, and Motorola Solutions (MSI), which split off its phone unit before Google bought the business.

Much will depend on sales of Nokia’s cutting edge gear to provide LTE service. Eventually, Nokia hopes to woo mobile carriers away from today’s set up of huge boxes lashed to towers and skyscrapers. Instead, networks will be built with a broader array of large and small transmitters spread throughout major metropolises.

Ultimately, Nokia and its competitors are racing to offer a mobile Internet experience with 1,000 times the capacity of today’s technology at a fraction of the price. Nokia faces tough competition from market leader Ericsson as well as up and coming Chinese firms such as ZTE and Huawei Technologies.

The remaining company will also try to exploit the mapping unit created with the $8 billion acquisition of Navteq in 2008. Apple has struggled to build a mobile mapping service to compete with Google Maps, and Nokia is the only third party service with comprehensive global coverage.

But Apple hasn't decided to become a savior and Nokia has struggled to spread the service much beyond its own phones. It had first-half sales of 449 million euros ($591 million) and modest profits excluding non-cash amortization charges.

Possible Target: Carmakers

Microsoft agreed to continue using Here for the phone brands it is acquiring. And Nokia, already strong in the car industry, could target carmakers looking to add more-robust navigation systems for future growth.

Valuing the slimmer Nokia is no simple matter. Evercore Partners analyst Mark McKechnie estimates the remaining company will have about 13 billion euros ($17 billion) in sales with earnings per share of 0.25 to 0.35 euros (33 to 46 cents). The company will also be flush with 1.9 euros per share ($2.50) of cash, McKechnie says.

The structure of the deal surprised Bernstein Research analyst Pierre Ferragu, which he says is “very advantageously” set up for Nokia. “Nokia offloads the problematic child to Microsoft,” Ferragu wrote in a research note. “Nokia is left with an interesting string of assets.” The company’s shares could be worth 3 to 4.8 euros ($4 to $6.32). Nokia shares already jumped 31% to $5.09 in midday trading on the Microsoft news.

And whither Microsoft?

The Windows and Office monopolies are still generating massive profits and server and cloud software have done well. But the whole enterprise is under threat as mobile phones and tablets eat into sales of traditional computers. Ballmer’s early forays into mobile devices have flopped – the company took a $900 million write-off for lackluster sales of its Surface tablet last quarter.

Can taking ownership of Nokia’s less-than-stellar handset business turn things around? It’s a risky bet by an outgoing executive.

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