Microsoft Jettisons Windows Playbook With Nokia Devices

Photographer: Chris Ratcliffe/Bloomberg

A Nokia Lumia 800 smartphone is seen in this arranged photograph in London, U.K., on Thursday, Jan. 5, 2012. Close

A Nokia Lumia 800 smartphone is seen in this arranged photograph in London, U.K., on... Read More

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Photographer: Chris Ratcliffe/Bloomberg

A Nokia Lumia 800 smartphone is seen in this arranged photograph in London, U.K., on Thursday, Jan. 5, 2012.

Microsoft Corp. (MSFT) Chief Executive Officer Steve Ballmer isn’t letting his departure plans stand in the way of a complete overhaul of the software-centric strategy he spent decades putting in place.

Even after saying last month he will retire from Microsoft within the next year, Ballmer is accelerating the company’s move into hardware with a $7.2 billion deal to buy Nokia Oyj (NOK1V)’s handset unit yesterday. That’s an area the Redmond, Washington-based company waded into in the past 18 months, including last year’s introduction of the Surface tablet.

Now the company, which built a dominant position in personal-computing operating systems by focusing on software and relying on multiple partners to offer hardware, is diving into its own smartphone line, a low-end handset business and manufacturing operations. With rivals like Apple Inc. (AAPL) and Google Inc. (GOOG) leading in mobile, Microsoft executives said the company had few options except to break from its software past.

“We were in software exclusively and that was a logical thing to do for a long period of time, but the reality today is that’s no longer possible,” Microsoft Chief Financial Officer Amy Hood said in an interview.

Ballmer had no choice, said Carolina Milanesi, an analyst at Gartner Inc. Even combined with Nokia, Microsoft has less than a 4 percent share in smartphones and is running out of time to carve out a piece of a market ruled by Google’s Android and Apple’s iOS.

Urgent Change

“There must be a sense of urgency that Microsoft feels about how much longer it will take them to make it in mobile and they need to make it in mobile,” Milanesi said. “There is a sense that they have to move faster than they have been and the only way they can do that is by integrating the hardware and software.”

Within Microsoft’s headquarters, Ballmer realized last year that the company needed to dump its traditional playbook and make its own phones, said a person familiar with the matter.

At the time, Microsoft’s Windows Phones were still at a percentage in the low single digits. It became clear that the company couldn’t gain on competitors or turn phones into a significant moneymaker if Microsoft only made the operating system, said the person, who asked not to be identified because the talks were private.

Six Weeks

Soon Ballmer was on the phone with Nokia Chairman Risto Siilasmaa, resulting in a meeting in February at the Mobile World Congress show, said the person. Various forms of a deal were rejected by both boards and talks seemed dead in June before being revived about six weeks ago, the person said.

Peter Wootton, a spokesman for Microsoft, declined to comment on specifics of the talks.

With the deal, Microsoft becomes the last major developer of smartphone operating systems to get into phone hardware. Apple makes its own handsets that use its iOS operating system. Google acquired Motorola Mobility last year for about $12.4 billion, giving the company its own lineup of phones.

“Phones are the most personal of the personal devices people use today and success in phones is important for success in tablets and PCs,” Brad Smith, Microsoft’s general counsel, said in an interview. “We need to move faster.”

Ballmer helped Microsoft co-founder Bill Gates formulate much of the strategy that led the company to dominate PC operating systems in the 1990s. As Microsoft’s first business manager, Ballmer negotiated some of the company’s initial deals to put its software on partners’ computers.

Strategy Shift

The formula: focus on software that supports a multitude of devices, give customers choice, hone in on the part of the market that has very high margins and leave the low-margin hardware to others.

Microsoft has developed Xbox game consoles since 2001 and took that on because partners weren’t interested. Elsewhere it hewed to the strategy -- it avoided making its own music player, for example, until it was too late to catch Apple’s iPod.

Microsoft has increasingly deviated from the formula in recent months. In October 2012, it started selling the Surface tablet. That same month, Ballmer wrote a shareholder letter announcing a new strategy focused on devices and services. In July, he instituted the biggest reorganization in more than a decade to align divisions around his vision.

“It’s a big transformation, but that’s kind of what you need to do in the technology world to move forward,” Ballmer told Tom Keene on Bloomberg Television’s “The Pulse.”

Trickier Partnerships

Microsoft isn’t completely changing its stripes, and it will still license its Windows Phone software to other handset makers. Yet that will be trickier because Microsoft now has to reassure hardware partners that it isn’t putting Nokia devices ahead of their products.

Terry Myerson, head of Microsoft’s operating systems, this week authored a blog post claiming the deal would benefit all Windows Phone partners. He ended with a lyric from the rock band The Killers: “I don’t shine if you don’t shine.”

The move to devices and services means a change for Microsoft’s margins. Internet-based services and hardware are costlier to deliver than software, and margins will decline, Hood said. Microsoft will still be able to increase revenue and profit by selling more, even at a lower margin, she said.

Shareholder Reaction

For phones specifically, Microsoft’s traditional strategy of working with equipment manufacturers wasn’t very profitable, Hood said. The phone unit had to fork over more than $1 billion to Nokia as part of a 2011 deal that got the Finnish phone maker to use the software. Hood said the Windows Phone business will end up with higher operating income once Nokia is integrated than it had without the hardware business.

Neither the prospective margins nor Microsoft’s further entrenchment in consumer hardware thrilled shareholders, some of whom favor a focus on business software. The company’s shares fell 4.6 percent yesterday to close at $31.88.

This is “not good for investors that were hoping the company would narrow their focus to the enterprise,” said Pat Becker Jr., a fund manager at Portland, Oregon-based Becker Capital Management Inc., which oversees $2.6 billion including Microsoft shares. “Why not let the next CEO make this call?”

The deal is also serving to jolt investors who read Ballmer’s retirement as a sign Microsoft would reverse course on its devices strategy.

“Anyone who thought that would be put on hold while a new CEO was sought has to accept that now,” said Tony Ursillo, an analyst at Loomis Sayles & Co. in Boston.

To contact the reporters on this story: Dina Bass in Seattle at dbass2@bloomberg.net;

To contact the editors responsible for this story: Pui-Wing Tam at ptam13@bloomberg.net

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