The Long War: What's At Stake for Microsoft in Smartphones

Google's already won. Why bother?

That is the point of view expressed by many strategists who believe Microsoft is wasting time and resources on a battle for market share and profitability it can never win.

Google's Android, in partnership - so far - with Samsung, dominates globally. Apple owns the upper end of the market as well as the income and stock price that go with it.

So, the question goes, why would Microsoft throw good money after bad in a vain attempt to stay relevant, more out of pride than possibility?

The answer, as the following article explains, may be, that it is fighting an entirely different war. And smartphones are but one front. This really is about sustainability, in the sense that the health of technological ecosystems will determine the survival of the species. Yes, the outcome is in doubt. JL

James Stewart comments in the New York Times:

Microsoft is in a different war — one that isn’t over handsets or even the operating systems embedded in them, but the ecosystem of applications and services that sit on top of them

When Microsoft announced in September that it was buying Nokia’s struggling handset business and would meld its Windows operating system with the devices, it offered two major reasons for the $7.2 billion deal:

■ Apple and Google were already combining their software and hardware.

■ The deal would ensure the survival of Microsoft’s Windows operating system in a mobile universe.

That was then. Last month, Google threw in the towel on its foray into handsets, selling its Motorola Mobility division to Lenovo of China for $2.91 billion.

And this week, The Wall Street Journal reported that Nokia would offer a version of Android, Google’s operating system, on a line of smartphones aimed at emerging markets.

So much for Microsoft’s rationale. Satya Nadella, Microsoft’s incoming chief executive, faces some urgent questions: Does the Nokia deal still make sense? And how does Microsoft expect to survive, let alone prosper, in a cutthroat hardware market where Google is giving up?

The basic problem for Microsoft is that most consumers have already chosen an operating system.

Changed Landscape

Every smartphone operating system has lost ground to Google’s, which has all but completely replaced Symbian, once widely used by makers like Ericsson, Motorola and Nokia.

Smartphone operating

system share of sales

100

%

Others

Symbian

80

iOS

(Apple)

60

BlackBerry

40

Android

(Google)

20

Microsoft

’08

’09

’10

’11

’12

’13

Source: Gartner

2013 data is for the first three quarters.

“Google has won,” said Nicholas Economides, an economics professor at the Stern School of Business of New York University, and currently a visiting professor at the University of California, Berkeley who specializes in network economics and electronic commerce. “We’re in a world where the biggest market share by far is Android. And the second-biggest is Apple. Then, way behind, is Microsoft. What’s in this game for Microsoft?”

From Microsoft’s perspective, the answer may be that it is in a different war — one that isn’t over handsets or even the operating systems embedded in them, but the ecosystem of applications and services that sit on top of them. And if that’s the case, Microsoft had little choice but to double down on Nokia and its handsets, since the alternative would be worse.

In an email to Microsoft employees on Feb. 4, his first day as chief executive, Mr. Nadella said, “Our job is to ensure that Microsoft thrives in a mobile and cloud-first world.”

It’s hard to imagine how Microsoft could be “mobile and cloud-first” without mobile.

Microsoft’s “objective is to get to the point where Windows phones would be able to use Microsoft software and applications for PCs and tablets,” Professor Economides said. “If they can get there, that would be a huge win. They could leverage all their applications and be a formidable competitor. But they’re not there. Saying that’s the objective doesn’t mean it will happen.”

Kirk Materne, an analyst at Evercore Partners who covers Microsoft, agreed that the company had little choice. “It was a fairly low-risk way for Microsoft to dip its toe into the market and try to extend Windows’ relevance,” he said. “It’s not going to be pretty. They’re already running uphill. But investors have very low expectations. If Microsoft can regain any momentum, it’s all upside for them.”

With $83 billion in cash on its balance sheet, Microsoft’s investment in Nokia is relatively modest.

Still, for Microsoft or Lenovo or any other hardware maker trying to grab market share, the trends are ominous: In a global market once dominated by Nokia and BlackBerry, both are struggling for survival. Nokia’s market share in 2013 dropped 25 percent, to 13.8 percent, and BlackBerry’s was just 1.9 percent, according to the research firm IDC.

So far, the marriage of the Microsoft Windows operating system with Nokia’s handsets under the Lumia brand has done little to upend the global smartphone market. Although Lumia’s fourth-quarter sales doubled to 8.2 million from the year earlier, they still represented a drop from the previous quarter. And Lumia fell even further behind Samsung, which sold 10 times as many that quarter (86 million), and Apple (51 million). It was also behind both Huawei (16.6 million) and Lenovo (13.6 million).

In its last earnings report as a handset manufacturer, Nokia said last month that the handset division it was selling to Microsoft lost 201 million euros in the fourth quarter and sales fell 29 percent. Microsoft has said it needs to sell 50 million Lumia units a year to break even, and it is nowhere near that yet.

Google seems to have made only a halfhearted effort in its foray into handsets, but its numbers were also grim. Under Google, Motorola had operating losses of $1.1 billion in 2012 and $645 million for the first nine months of 2013.

But analysts I interviewed said Microsoft may not have the luxury that Google did of abandoning a money-losing handset operation. “Microsoft doesn’t have the same hand to play as Google,” said Ken Sena, the Evercore analyst who covers Google. Unlike Microsoft, Google does not have to worry about its ecosystem since Android is the largest handset operating system by far. Android ensures access for Google’s search engine, which is where Google earns the bulk of its profit. Selling Motorola to Lenovo will strengthen a growing competitor to Samsung, even as it gets Google out of a business that put it in the awkward position of competing with some of its largest customers.

Without Nokia’s commitment to Windows, Microsoft was in danger of extinction on handsets. And Microsoft does not really have to worry about competing with partners who use Windows in their handsets, since there are so few.

And at least, the deal buys Microsoft some time. “Microsoft needs to see how Windows works on a handset,” Professor Economides said. “Having a division that does it for you is very useful. Otherwise you have to beg or persuade Samsung or someone else to make a Windows device. But Samsung already sells millions of Android phones, and it doesn’t care about Windows.” (Samsung does offer Windows on some phones and computers.)

Then, there is Apple, which has succeeded in wringing high margins from its handset business. While Google may have given up, those margins are an attractive target for any competitor. Carlo Besenius, chief executive of the independent research firm Creative Global Investments and a persistent skeptic when it comes to Apple, said that Apple was especially vulnerable in price-sensitive emerging markets.

Microsoft’s strategy “is much more suited for emerging economies, where there is limited consumer buying power and where smartphones are sold contract-free,” Mr. Besenius said. “We see Microsoft’s mobile strategy clearly to be more successful than Apple’s” because “it focuses on the low-end to medium-priced segment.” Although starting from a small base, Microsoft has made some progress. According to IDC, Windows Phone was the No. 2 smartphone operating system in nine markets, and shipped more units than Apple in 10 markets in 2013.

Although Nokia hasn’t formally announced that it will embrace Android for a line of entry-level handsets aimed at emerging markets, and Microsoft may well reverse that decision once it completes the acquisition, even that strategy may not be as crazy as it sounds. Microsoft would presumably be using a version of Android that places its own apps on top of the operating system, much as Amazon has done with its Kindle. “Placing Windows services on top of Android for low-end devices is as sensible as doing so for smart devices, " said Horace Dediu, who worked at Nokia and is the founder of the consulting firm Asymco. “Android without Google is just commodity plumbing.”

Then, if Microsoft can get entry-level customers to use its apps and services (like its Bing search engine and maps), they’ll eventually move up to Windows smartphones. At least, that’s the theory.

“Microsoft has to learn to operate in a more heterogeneous operating system world,” said Mr. Materne of Evercore, who has an overweight rating on Microsoft. “I think the new chief executive understands that. It’s the apps on top of the device that really matter. The margins on the devices aren’t going to be what moves the needle for Microsoft.”

Whatever the outcome for Microsoft, some analysts predict that today’s handset wars may some day be irrelevant. “Consumer wearables are going to make mobile phones and tablets obsolete, and will dominate the entire personal communications market,” Mr. Besenius predicted.

One reason Google abandoned handsets may have been to focus on the growing but still nascent field of wearable technology, including Google Glass and other as-yet-undisclosed products. There’s avid speculation that Apple, Samsung and Microsoft are all working on smart wristwatches (Microsoft made a failed effort 10 years ago) and other wearable products.

So is Nokia — a part of the company it isn’t selling to Microsoft.