Can Nokia And Microsoft Recapture Their Magic?

By Stephen D. Simpson, CFA | February 10, 2011 AAA

Human beings are nostalgic creatures, and "retro" often plays well. Millions of people enthusiastically played the Pac-Man doodle that Google (Nasdaq:GOOG) offered up on that game's 30th anniversary. More recently, the SyFy channel ran a B-movie reuniting Tiffany and Debbie Gibson and over 2 million people actually chose to watch it.

So then, will the union of Nokia (NYSE:NOK) and Microsoft (Nasdaq:MSFT) bring customers and investors back to the glory days when these were among the leaders in the tech world, or is this just a Wall Street version of "Mega Python versus Gatoroid"?

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Nokia Looking To Shake Things Up
Nokia's new CEO, Stephen Elop, is clearly not pleased with how prior management of Nokia effectively painted the company into a corner. True, the company still has the number one worldwide share of cellphones, but the company has virtually no momentum in the smartphone market and has been effectively no threat at all to Apple (Nasdaq:AAPL), Motorola (NYSE:MMI), Research In Motion (Nasdaq:RIMM) or the Taiwanese and Koreans. In fact, Mr. Elop recently wrote in a memo that Nokia was essentially "standing on a burning platform" and had to make major changes to survive.

Going With Another Also-Ran?
Instead of waiting to see whether the company's new Symbian platform could hold the answer to a recovery, Elop has chosen to ally the company with Microsoft instead. In essence, the two companies will combine assets and know-how to jointly develop new smartphone technology. This is hardly a rerun of the WinTel duopoly that was so successful in the 80s and 90s.

Microsoft had big hopes for dominating the mobile market like it had dominated the desktop market, but the rise of Apple and then Google's Android effectively brought Microsoft's momentum to a dead stop. Now, though, the two companies hope that Nokia's distribution network and hardware capabilities can mesh with Microsoft's software development and create a platform that can challenge Apple, Google and the other smartphone leaders.

Dismal Reception
So far, nobody is really buying this combination. Nokia shares fell more than 10% on the news, perhaps due both to skepticism about the deal itself (and what Nokia is surrendering) and the fact that the Symbian is basically being left to wither. Nokia's CEO also mentioned that the company would be cutting jobs and "substantially" reducing R&D spending. Now while it is true that spending money on R&D does not guarantee success (and that seems clearly true in Nokia's case), it seems a fairer bet to make that not spending on R&D is a good way to get left even further behind.

The Bottom Line
While Nokia clearly needs a new direction, it is hard to see how the company can cost-cut its way into taking business away from Apple or Google-based smartphone companies. Perhaps that is really not the plan. Perhaps Nokia is actually raising the white flag on smartphones and quietly retrenching around being the world's leading provider of utility cellphones - a move that would likely not require nearly so much R&D or personnel.

In that regard, a deal with Microsoft could be a face-saving gesture that conveys the image of a company looking to compete, but actually expecting nothing. Along those lines, the company might see this deal as a call option that gives them a chance at a competitive smartphone with much less investment on their part. Nevertheless, until investors get comfortable with this new strategy, it is hard to see how the stock works well and deep-value/turnaround investors look to be in for a long wait.

For Microsoft too, this deal seems like a "why not?" sort of affair - they do not really give up anything by working with Nokia and they could certainly take advantage of Nokia's incredible worldwide distribution system for mobile devices. As for the stock, Microsoft seems significantly undervalued, but it will take a lot of patience for investors to reap the benefits from a slow-growing cash generator in a sector that prizes growth above all else. (For more on what the future holds for Nokia, check out Nokia Having A Tough Time.)

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