Microsoft’s Smartphone Business Will Continue To Grow

Summary

  • Recently, I covered Microsoft’s acquisition of Nokia’s handset business, citing that although it may seem like a bad move on the surface, it may bear fruit in the long term.
  • Quarterly data shows little improvement with respect to phone hardware revenues and gross margins.
  • On the bright side, units sold increased quarter-over-quarter, reflecting increasing demand.
  • Microsoft is set to launch the low-cost Nokia 435, which seems to be a good play in developing countries.

Operating Results (Phone Hardware)

In a September Seeking Alpha article, I covered Microsoft’s (NASDAQ:MSFT) acquisition of Nokia’s (NYSE:NOK) handset business. I used an ROIC-based approach to show that, as a result of the acquisition, Microsoft’s operating profitability suffered. However, I concluded that by the virtue of being in the tech industry, innovation takes time and investors should not write off the acquisition as a failure without waiting for new data.

Source: Microsoft Investor Relations

Now we have new data.

Microsoft released its 1st quarter fiscal 2015 results with phone hardware sales increasing from $1.9 billion in the 4th quarter of fiscal 2014 to $2.6 billion in the 1st quarter of fiscal 2015. According to the company’s quarterly filing with the SEC, Microsoft sold 9.3 million Lumia phones and 42.9 million non-Lumia phones. These results are an improvement over the previous quarter when phone hardware revenue totaled $2 billion on sales of 5.8 million Lumia phones and 30.3 million non-Lumia phones. This represents a 31% sequential increase with units sold up by 60% and 29% for Lumia phones and non-Lumia phones respectively. Demand for Microsoft’s phones are clearly on the rise.

Source: Microsoft Investor Relations

Gross margin increased from $54 million in the 4th quarter of fiscal 2014 to $478 million in the 1st quarter of fiscal 2015, representing a 7.8 times increase. Currently, the gross margin for the phone hardware segment is 18.3%, up from 2%. These increases in revenues and gross margins are to be expected, given that Microsoft acquired Nokia’s handset business. The question is – have the margins worsened, improved or stayed the same?

Source: Nokia Investor Relations

The above table shows Nokia’s discontinued handset operations (due to the acquisition). Pre-acquisition, gross margins were 16% for the 1st quarter of fiscal 2013 and 21% for the 1st quarter of fiscal 2014. Since these numbers are very close to the gross margins generated by Microsoft’s phone hardware segment in the 1st quarter of 2015, we can conclude that gross margins have more or less stayed the same.

It is clear that the acquisition went off without a hitch. The tech giant did not seem to experience problems integrating Nokia’s handset business with its current business, evident from a total absence of falling revenues and gross margins. If the acquisition had encountered problems, the quarterly data would have surely shown a decrease in phone hardware revenues or an increase in cost of phone hardware sales. The Nokia acquisition is therefore, not a failure, but not a smashing success either.

Growth Opportunities

Just this week, word came that Microsoft will launch a low-cost smartphone – the Nokia 435. This new handset is aimed at the same market segment as the Nokia Asha and X devices. Hence, I expect the phone to retail under $100. Having already been certified in Indonesia, it is clear Microsoft looks to capitalize on smartphone growth in Southeast Asia.

In October, GfK (via ZDNet) released data showing increasing smartphone sales in Southeast Asia, led by Indonesia, Vietnam and Thailand, which reported 70%, 56% and 44% increases in demand, respectively. In terms of dollar value, Vietnam, Indonesia and Thailand posted increases of 52%, 32% and 31% respectively, compared to the previous year.

Microsoft is clearly aiming to establish a strong presence within the fastest-growing markets of Southeast Asia first, which I think is a smart move. Smartphone adopters tend to adopt a follow the herd mentality. Evident from its move to the low-cost smartphone market, Microsoft has made it implicitly clear that it does not believe it can steal much market share from the larger players (think Apple (NASDAQ:AAPL), Samsung (OTC:SSNLF)). Going forward, I expect Microsoft to maintain gross margins as it expands into the Southeast Asia region.

Challenges

However, Microsoft’s moves in Southeast Asia also present challenges. Chinese smartphone makers have continued to penetrate the region with more than 300 Chinese-brand smartphones available. All is not lost however, considering that the average price of these smartphones is $159, while the Nokia 435 is expected to retail under $100. Keep in mind that most residents within the region have lower incomes and higher savings rates compared to the U.S., according to the World Bank. Hence, the obvious smartphone for people residing within this region is one that is low cost. Furthermore, Microsoft has deep pockets, something that Chinese smartphone makers do not. Engaging in price wars and competing on volume is certainly a viable option to drive out the competition. Therefore, I expect Microsoft’s new smartphones to be sufficient competition within Southeast Asia.

With time, I expect the phone hardware segment to contribute meaningfully to Microsoft’s business. The smartphone market is one where once a dominant player is established, it usually enjoys market leadership for a few years (think Apple vs. Samsung, 2010-present). Although the phone hardware segment is a paltry 11% of Microsoft’s entire business (using 1st quarter fiscal 2015 numbers), I expect this number to steadily increase going into 2015.

Source