Why Microsoft's Decision to Buy Nokia Is Bad (Update 1)

Updated from 8:48 a.m. to include comments regarding ValueAct being aware of the deal in the seventh paragraph.

NEW YORK ( TheStreet) -- Microsoft's ( MSFT) decision to purchase Nokia's ( NOK) devices and services division has broader implications for the company than just additional revenue, operating expenses and how the company will look in the future. It's about the next CEO as well.

Former Nokia CEO Stephon Elop, who had previously been a part of Microsoft, as head of Microsoft's Business Division, responsible for Microsoft's Office business, will now be head of Microsoft's Devices team. Elop is now clearly the front runner for the horse race to replace Steve Ballmer, and that's not a good thing for Microsoft, or its shareholders.

In the press release announcing Ballmer's retirement, the company clearly hinted that a hardware CEO would be forthcoming, judging by the wording of the statement. "My original thoughts on timing would have had my retirement happen in the middle of our company's transformation to a devices and services company," Ballmer wrote in the press release. "We need a CEO who will be here longer term for this new direction."

It's abundantly clear that with this purchase, and bringing Elop back to the fold, Microsoft is trying to take on Apple ( AAPL), and to a lesser extent Google ( GOOG) by becoming a complete end-to-end corporation for both hardware, software and services. However, one of Microsoft's largest shareholders, ValueAct Capital, has repeatedly talked about Microsoft becoming the largest cloud computing company in the world.

Microsoft and ValueAct recently reached a cooperation agreement that will allow for regular meetings between Mason Morfit, president of ValueAct Capital, and selected Microsoft directors and management to discuss a range of significant business issues. The agreement also gives ValueAct Capital the option of having Morfit join the Microsoft board of directors beginning at the first quarterly board meeting after the 2013 annual shareholders meeting.

Perhaps going in the direction ValueAct has stated would be best for Microsoft, for a variety of reasons. Not only do software companies get higher multiples from the market, but it would continue to focus on Microsoft's software business (the transition of Office to Office 365, SkyDrive, etc.) as an annuity stream, as so many cloud computing companies are. The subscription and services revenue of companies such as salesforce.com ( CRM), while significantly smaller than Microsoft, affords salesforce a higher multiple from the market, due to higher margins and visibility. That's something Microsoft has struggled with for years. Based on forward estimates, Microsoft's earnings multiple is just over 11 times earnings, and with additional hardware revenue, that may come down in the future, especially if execution risk becomes a factor.

On this morning's conference call to discuss the deal, Microsoft said that ValueAct was not made aware of the deal.

While companies don't have to disclose every purchase to shareholders, it does seem like it would've been a good start to the relationship between the two parties, especially seeing as Morfit will likely join Microsoft's board later this year.

Citigroup analyst Walter Pritchard, who rates Microsoft shares "buy" with a $35 price target, notes that with Microsoft "entering the phone business in a major way," it will try to improve its market share in smartphones. Elop may help achieve this at Microsoft, but the smartphone and tablet market are becoming increasingly competitive, with margins being pressured for almost all, including to some extent, Apple. Any potential for Microsoft to focus on its enterprise business, which Pritchard calls "profit-driving," is now unlikely, as Microsoft doubles down on its devices strategy, with Elop presumably taking over the helm once Ballmer steps down.

Oppenheimer analyst Shaul Eyal, who rates shares "Outperform" with a $37 price target, notes that Microsoft "is placing a final bet on its mobile opportunity."

With shares sliding some 4% in early Tuesday trading, investors appear to be saying that this strategy by Microsoft, while relatively inexpensive for a company with over $77 billion in cash on its balance sheet, is the wrong one.

MSFT Chart MSFT data by YCharts

With Stephen Elop coming back to the helm, and presumable the odds-on front runner to take over for Ballmer, investors, who have been patient with Microsoft for years with a stagnant share price, may finally just walk away.

-- Written by Chris Ciaccia in New York

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