You Can't Lose on This Bet

Mohsin is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Handheld ecosystems have become a big thing in the technology sector.

Apple and Google control the two biggest ecosystems in the entire technology sector. They have created the concepts of ‘apps’ and OS-exclusive online service, building themselves a unique competitive advantage. This revolution has, to some extent, reduced the emphasis on the features and hardware of smartphone devices.

Google’s Android has allowed a number of device manufacturers to use their platform. Manufacturers such as Sony, Samsung etc. do not have to worry about OS or an ecosystem which is provided for free by Google. This not only reduces their development costs but also gives them access to loyal Android customers.

Nokia (NYSE: NOK) and Microsoft (NASDAQ: MSFT) are trying to challenge the domination of Android and iOS. These partners are trying to bring customer focus back on OS quality and device capability. This is because Windows 8/WP8 platform is still quite young and does not have the depth its rivals can offer. The WP8 Lumia series is gaining traction solely based on quality of its devices and beauty of WP8. Nokia is still one of the best manufacturers of handheld devices, and the company remains highly undervalued due to the reasons discussed below.

Acquisition prospects

Nokia acquisition rumors have been circling the Wall Street grapevine for months now. Just this week, there were rumors that the Chinese technology giant Huawei is interested in buying Nokia. The shares jumped above $4 but came under soon after Huawei denied any such plans. There have also been rumors that the Chinese PC giant Lenovo is negotiating to acquire Nokia. Lenovo is emerging as the largest PC manufacturer in the world and is flourishing in an industry many are calling dead.

With a market capitalization around $14 billion, Nokia is a solid acquisition target. The real trouble is finding the best fit for a company that is struggling with feature phone sales and is still slowly developing a smartphone presence. Although Lenovo and Huawei are both good fits for Nokia and can certainly afford it, the best fit is none other than Microsoft.

Microsoft is looking to establish itself in a handheld industry dominated by two companies operating under quite different models. Apple controls its own hardware and software while Google freely lends out its OS to a diverse range of manufacturers. The Android manufacturer has also dabbled a bit into hardware with its Nexus series, but Google partners handled manufacturing of these devices.

It is highly unlikely that Microsoft can manufacture smartphones itself because the company lacks the patents or manufacturing capability to do so. The other option is partnering with companies like LG, Sony etc. on the same lines as Google Nexus. This strategy will not give Microsoft the control it would want over the manufacturing of its first smartphone.

It can also go for any unknown Chinese smartphone manufacturer which it can totally control. This strategy would raise serious question marks on the quality of devices and the ability of these devices to compete with the likes of Apple and Samsung.

The last and the only reasonable option is to acquire the highly undervalued Nokia which has over 10,000 patents and a history of making top class devices. The two companies have already worked together on the Lumia WP8 rollout, and more importantly Lumia is already a flagship device for Windows 8. Therefore, it is evident that if Microsoft ever plans to enter the smartphone hardware arena, it has already shown a flair for hardware with Surface tablets and Xbox, its only logical choice is to acquire Nokia.

Valuations

Nokia traded below $2 last year, but after its resurgence the shares have been oscillating around the $4 mark. The company generates sales of around 5.9 billion euros ($7.8 billion) with Nokia Siemens Networking (NSN), the network equipment unit, generating 2.8 billion euros ($3.7 billion). The progress made by smartphone segment was outdone by the decline in feature phone segment, so its sales continue their downward trend. We can calculate a 'safe' value for Nokia by totally ignoring the phone segment.

NSN generates annualized revenues of around $15 billion, a per share value of $4.7. The company also has approximately $6 billion in net cash i.e. $1.6 per share. Ericsson is currently trading at a P/S of 1.12x which gives us an approximate value of $5.2 for NSN. This gives a $6.8 target price even without the entire phone segment.

Bottom line

Nokia is an attractive acquisition target due to its cheap valuations, rich patent portfolio and NSN division. Microsoft has already shown a flair for hardware manufacturing with the highly acclaimed Xbox and Surface. However, if the company plans to enter the smartphone manufacturing business it will need to acquire or develop/buy the necessary patents and manufacturing capability. This makes Nokia the best fit for a cash rich Microsoft which is already a partner in Lumia. 

Feature phone revenues are declining, but the Lumia series is gaining traction in both high and low-end markets. If we ignore the troubled phone segment entirely, Nokia is still worth $6.80 per share. This is why the troubled Finnish smartphone giant is an excellent investment. 


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