Nokia-Microsoft's marriage: a marginal future

There is no conceivable end to the Microsoft Nokia deal other than a full merger of the companies.

If this deal had happened ten years ago, then that statement would be unarguably right. There are plenty of signs that it will happen, a probability only strengthened by Microsoft's Chris Weber taking over as head of Nokia US.

Bad as that might be for Nokia and its people, the reality could be far worse.

The two companies are almost inextricably bound together now, in something very like a shotgun marriage. Although polygamy is common in the relationships between software and hardware companies, few handset makers will fancy a role as deputy wife with Mrs Nokia in charge of the household's hardware. And while Nokia is technically free to see other people, Microsoft can be an enormously jealous husband, especially when it comes to seeing the missus wearing anything other than the family jewels.

So it is easy to say that in two years or sooner, Nokia will become Microsoft's portable hardware division. That would seem to give Redmond, at least in its own eyes, the ability to compete with Apple head-on – and Apple sets a very strong example of what you can do when one company has absolute control over everything in its product range. If Steve Jobs stays out of the picture, the equation seems even more compelling.

Let's look a year down the line at the companies as they celebrate their first anniversary. Nokia will have changed: some of its best people will have left for good, taking their expertise onto the market or into start-ups. Some senior software people will have moved to the US: it's that or move Microsoft's Windows Phone team to Finland. Both companies have plenty of experience of trying to run large R&D efforts across time zones, and thus plenty of reasons not to do it. There will be little or no work on software, let alone alternative platforms, within Nokia. Regardless of how sensible that would be, Elop's in charge and Ballmer wouldn't like it.

Nokia's fortunes are now those of Windows Phone 7.

Microsoft, however, will be much the same. All it needs from this deal is a compliant wife who can work miracles in the kitchen. Provided it can resist meddling, Microsoft will get some great handsets out of this, an unparalleled worldwide distribution network and a huge potential presence in the developing world that, at the moment, is hard to call. The talk of optimising Nokia's hardware design to run WP7 is misguided. There's not much to be done that wouldn't be expensively pointless, at least until Nokia can start to emulate Apple's notoriously effective and market-shaping deals with component suppliers.

Looks good for Microsoft, less so for Nokia, If this was all the game had to offer, the rapid assimilation of the plucky Finns would be a given. Yet there's another factor. The problem with that scenario is that it's got a major downside for Microsoft.

Assuming that the Nokified WP7 won't sweep all before it in the space of twelve months, the project still won't be turning in very much cash. Apple only works because it makes enormous margins — of the order of twice Nokia's — and can thus throw reality-bending amounts of cash at R&D, marketing and supply line management in maintaining the Apple brand. Nokia can't rebuild its brand on the back of someone else's software. Further, Nokia's margin will now be split with Redmond, whereas Apple keeps the lot.

That picture is painful for Nokia, as it spells the end of so much of the company's expensive R&D habits, but it's doubly so for Microsoft. All of Microsoft's money comes from the insanely profitable Windows and Office franchises — insanely profitable, but declining. They're roughly the same as Apple's, but heading in the wrong direction.

The game is played in the margins, and Microsoft is under huge pressure from investors to keep those up. (Investors including one Stephen A Elop, listed as seventh biggest individual Microsoft shareholder, although he demurs - see below). Absorbing a large hardware company dependent on the cut-throat mobile market will hit the books a lot harder than having a Arms-length relationship which just delivers software profits. Microsoft's recent and expensive experience with gaming underlines that logic: while the Xbox franchise may look healthy, that's purely on the Xbox Live billion-dollar, 60 percent margin business. The consoles themselves are basically break-even. Not a model that looks tempting from the other side of the Baltic.

If Windows Phone 7 doesn't deliver the numbers, then cutting loose the devastated hulk of Nokia will be much easier than having to soak up the pain internally. And if it does make money, it will be for Microsoft alone. The investment needed for Nokia to survive in anything like its current form will be unavailable; Microsoft remains free to discard the deal if Windows Phone 7 is a winner and pick up with a lower-cost, far Eastern partner.

The Microsoft-Nokia deal may indeed be a marriage, but it's one of praying mantises.

(note: edited to correct spelling, and to note Elop's disagreement with the shareholder listing)