How Is the Phone Business Going for Microsoft Corporation?

By Markets Fool.com

A year and a half ago, Microsoft shocked investors by announcing its intentions to acquire theNokia handset business in a $7.2 billion deal that would make Microsoft one of the largest handset vendors in the world by volume. At the time, Microsoft had high hopes for the acquisition, including some optimistic projections for where it could take the business.

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Let's check in on this major deal and see how much progress the software giant has made.

Where Microsoft is coming from
To set the stage, the first quarter of 2014 was the last full quarter that the handset business was still part of Nokia. During thatperiod, it generated $2.2 billion in revenue (down 30% year-over-year), while posting a negative 17% operating margin.

Nokia had been struggling for years, suffering declines in both unit volumes and prices. Its other business segments, mapping and networking equipment, were still healthy, but handsets had long been a financial drag. Clearly, it would be a major challenge for Microsoft to turn this business around.

As a much larger company, Microsoft had the resources to potentially make that happen. It also had a vested interest in vertical integration, since most third-party OEMs had shunned the Windows Phone platform in favor of Android.

The deal officially closed in April of last year, halfway through the second quarter. The company wasted no time in cutting costs, just months later announcing a breathtaking round of layoffs that would send 18,000 employees looking for work. Microsoft said the restructuring plan would simplify its organizational structure and "align" its devices strategy.

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Where Microsoft is now
After acquiring a business operating at negative 17% margins, how has Microsoft improved the division? Those layoffs sure helped, but Microsoft has indeed been able to improve profitability.

Source: SEC filings. *Nokia devices business acquired during quarter; only partial results and restructuring expenses included.

On a percentage basis, the phone hardware business enjoyed a 14% gross margin last quarter.

Quarter

Q2'14*

Q3'14

Q4'14

Gross Margin

3%

18%

14%

Source: SEC filings. *Nokia devices business acquired during quarter; only partial results and restructuring expenses included.

While Microsoft continues to make progress improving profitability on a gross basis, operating profitability is the next step. The official goal is to get the phone hardware business to operate at break-even by fiscal 2016.

Where Microsoft is going
In apresentation to investors, Microsoft predicted that it would be able to win a 15% share of the global smartphone market by 2018. It would be a 1.7 billion unit market by then, according to company projections. Microsoft figured that it could enjoy approximately $45 billion in revenue at that point. Reading between the lines, those estimates imply 255 million units at an average selling price of $176.

Source: Microsoft

Furthermore, Microsoft will need to dramatically streamline operations in order to improve profitability. At a 5% operating margin, the net present value of the Nokia deal was $15 billion at the time. Boost that to a 10% operating margin, and the deal looks even sweeter.

In order to get to operating break-even (and ideally a positive 5% to 10% operating margin thereafter), Microsoft has been shifting the product portfolio toward its Lumia devices that run Windows Phone. Cheap non-Lumia devices are hurting profitability and do nothing to strengthen the Windows platform.

Last quarter, just 21% of Microsoft handset volumes were Lumia devices, and investors can expect that figure to rise in the long-term as the company rallies behind Lumia sales. Still, Microsoft is a long ways away from 255 million units and operating profits in its phone business.

What is at risk?
Considering how poorly the handset business was doing at the time of the deal, there were not a whole lot of tangible assets that Microsoft acquired, relative to the purchase price. As a result, Microsoft allocated $4.5 billion of the total purchase price to intangible assets and another $5.4 billion to goodwill. That goodwill was attributed to expected synergies after Microsoft fully integrated the device business.

Microsoft has already successfully reduced its phone operating cost base by $1 billion, but it will still need to realize additional synergies to justify the premium that it paid for a struggling business. If it falls short, the company could suffer impairment charges in addition to continued operating losses.

Adding insult to injury, Apple and Google would continue to enjoy their bragging rights for dominating the era of mobile computing.

The article How Is the Phone Business Going for Microsoft Corporation? originally appeared on Fool.com.

Evan Niu, CFA owns shares of Apple. The Motley Fool recommends Apple, Google (A shares), and Google (C shares). The Motley Fool owns shares of Apple, Google (A shares), Google (C shares), and Microsoft. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.