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Why Microsoft’s Windows phone could succeed

Microsoft’s (NASDAQ: MSFT )  Windows Phone platform is pretty good, despite its relative lack of success. Much like Apple’s (NASDAQ: AAPL)  iOS, the platform is closed and controlled by a company whose expertise is in the development of high-performance, low-overhead operating systems.

This has several benefits, not the least of which is that the platform is typically snappier than its Google (NASDAQ: GOOG )  Android-based cousins on similar hardware. However, what Microsoft gains in efficiency, it loses in market share. Only Microsoft, via its acquisition of Nokia’s handset division, produces Windows Phone devices. Nevertheless, Microsoft still has a very real shot at being successful in the handset market — provided that investors temper their expectations.

A double-edged sword

The vast majority of Apple’s US$37 billion in net income from fiscal 2013 came from the sale of its iPhone products. Samsung (NASDAQOTH: SSNLF) , too, derives about two-thirds of its operating profits, which are looking to come in at about US$35 billion for the current year, from mobile devices. Microsoft is a world-class developer of operating systems that, quite frankly, are a league above what Google is doing with Android and many leagues above Samsung’s Tizen. So, it’s understandable that it would want to get into the hardware game.

This is a double-edged sword. On one hand, selling full devices is conducive to juicing the top line — after all, what generates more revenue: a US$449 tablet or a US$20-US$40 operating system license? That’s an easy choice, right?

Well, not quite. On one hand, the cost of goods sold for an OS license is next to zero, while a tablet may only have gross margins in the 20-30% range. Also, if the history of PCs is any guide, those margins will get much smaller over time.

On top of that, there is significant inventory risk, as Microsoft saw with the writedown it took on its first-generation Surface RT. Finally, being an ecosystem partner allows the company to mitigate the risk of banking its entire business on one set of devices and can instead benefit from the creativity and competition that happens among the more specialized device OEMs.

Why Windows Phone is the prime candidate for a devices play

While it looks as though an ecosystem-provider model is the way to go with tablets and above, handsets look like it’s a totally different ballgame. In this space, Android is ubiquitous, and it’s highly customisable by the handset vendors. This is in stark contrast to the closed OS model of Windows Phone.

That’s not necessarily bad. But differentiating on the software side while taking advantage of an absolutely monstrous application ecosystem is what will draw most non-Apple, non-Nokia/Microsoft handset vendors to Android. It also doesn’t hurt that handset vendors probably aren’t too keen to pay Microsoft’s OS tax — although many do pay royalties per device since Android utilises some key Microsoft patents.

The Foolish bottom line

Microsoft, indeed, has a strong brand, and thanks to all of the stores that it’s setting up and the image it’s building for itself, there’s little doubt that Microsoft could successfully develop the Nokia line of phones. After all, with control of the software platform, and with an excellent silicon partner — Qualcomm is currently the only supplier of Windows Phone chips — there’s no reason why these phones can’t be a profitable and growing business over time.

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