Microsoft just announced its long-awaited move into the mobile phone hardware space: the software giant will acquire most of Nokia’s devices and services business for €3.79 billion ($5 billion), along with a license to Nokia’s patents for a further €1.65 billion ($2.2 billion), in a cash transaction expected to close in the first quarter of 2014. The €5.44 billion ($7.2 billion) deal is one of Microsoft’s largest to date, though, notably, it comes at a lower price than what Microsoft paid for Skype in 2011.

The move combines Windows Phone 8 with its most successful licensee and expands Microsoft’s first-party hardware efforts from Xbox, Surface, and accessories to mobile phones. 32,000 employees will make the jump from Nokia to Microsoft, including Nokia executives like CEO Stephen Elop, Jo Harlow, Juha Putkiranta, Timo Toikkanen, and Chris Weber.

For Nokia CEO Stephen Elop, the deal means a return to Microsoft, where he will lead an expanded Devices team, which, Microsoft CEO Steve Ballmer wrote in an email, “includes all of our current Devices and Studios work and most of the teams coming over from Nokia.” The acquisition follows Nokia’s strategic partnership with Microsoft in February 2011 and Microsoft’s new aim of becoming a “devices and services company.” It also feeds speculation that Elop may succeed Ballmer as CEO of Microsoft.

In February 2011, Nokia CEO Stephen Elop and Microsoft CEO Steve Ballmer announced a strategic partnership: Nokia would adopt the Windows Phone OS; now Elop will return to Microsoft to head its Devices business

Microsoft will acquire both Nokia’s Lumia smartphone business and its low-end lines, such as the S40-powered Asha phones, which Microsoft plans to use as an “on-ramp to Windows Phone” in developing markets. That means besides flagship Windows Phones like the 41-megapixel Lumia 1020, Microsoft will be selling a good number of phones at price points cheaper than that of an Xbox wireless controller and running non-Microsoft OSes– interesting and unfamiliar terrain for the company.

Microsoft’s slide deck on the strategic rationale for the deal (also embedded below) gives a sense of the company’s approach: by licensing the Windows Phone OS to OEMs, Microsoft only makes about $10 per phone (plus revenue from its app store and other services); as both the OS and phone manufacturer, it would make over $40 per unit. That’s more like the margins Apple enjoys, but Microsoft would ideally like a combination of its own devices and OEM licensees, to cover as many market segments as possible– and therein lies perhaps the biggest motive for acquiring Nokia: the risk that someone else could snap up the device maker and jeopardize Microsoft’s presence in the mobile industry:

We will continue to support iPhone and Android/Galaxy phones with our services, but we cannot risk having Google or Apple foreclose app innovation, integration, distribution or economics.

Like the Skype acquisition in 2011, this deal will be financed using Microsoft’s overseas cash reserves, which helps the company avoid paying taxes to repatriate the cash to the United States. Perhaps more interestingly, the slides reveal that Microsoft aims to triple its mobile market share by 2018, hitting 15 percent globally.

Announced in October 2011, the Lumia 800 was Nokia’s first Windows Phone

Nokia will refocus on its remaining businesses: network infrastructure and services, mapping and location services, and technology development. Microsoft will license Nokia’s portfolio of 30,000 patents for use across all its products, for 10 years, with an option to extend perpetually. It will also license Nokia’s HERE mapping services for 4 years, for use on its own products and for its business customers via syndication on the Windows Azure cloud platform.

Branding is a potentially interesting point– Microsoft will own the Lumia and Asha brands, and will gain a 10-year license to use the Nokia brand on non-smartphones, suggesting a transition over to the Microsoft brand for smartphones. Nokia is also rumored to be entering the tablet market with a 10″ Windows RT offering this fall, which would mean that come 2014, Microsoft would have two first-party tablet lines in the 10″ space– Surface and the Nokia tablets.

Nokia’s phones span the gamut from the $20 Nokia 105 to the flagship, 41-megapixel-camera-toting Lumia 1020

By acquiring Nokia’s devices business, Microsoft is taking a big leap into the cutthroat world of mobile phones, with a degree of end-to-end vertical device and service integration unseen beyond Apple and Google. A close parallel is perhaps Motorola, which sold its consumer devices division to Google to enable the latter’s entry into the first-party smartphone space, but Nokia is a much more significant global phone player than Motorola was, has a more valuable patent portfolio, and in spaces like mapping services, competes with Google in its own right.

In a blog post, Microsoft EVP, Operating Systems, Terry Myerson, wrote that Microsoft will continue to collaborate with its other OEM partners for Windows Phone, such as HTC, Huawei, and Samsung, treating them in the same way it treats its own hardware teams. Microsoft will likely integrate some of Nokia’s customization, like its HERE Maps suite, into the core Windows Phone OS to bolster all OEMs on its platform. Myerson even cited a song lyric to allay any concern its OEM partners might have: “I don’t shine if you don’t shine.”

Will the Nokia acquisition help Microsoft finally beat back iOS and Android domination of the global smartphone market? Only time can tell, but a great deal rests on Microsoft’s ability to integrate its vertical stack of services into high-quality device offerings. Rapid execution will be key– and that’s something Nokia’s done a much better job of than Microsoft over the last two years in the smartphone space.

Read on after the break for Microsoft’s strategic rationale presentation and press release.

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