Why Microsoft should buy RIM: to take on Apple

One of these days, if it hasn't happened already, Steve Ballmer, Mike Lazaridis and Jim Balsillie will gather for a quiet lunch or a pleasant stroll and discuss what seems inevitable: Microsoft buying Research In Motion

Both companies share an irksome problem called Apple . Both companies recently disappointed investors, in part because of this problem. Both companies are struggling because they can't innovate with the vitality of Steve Jobs and Co. And both companies are desperate for a solution. You could even argue that it's a matter of life or death.

Let's start with RIM. It pretty much invented the smart phone and had the market all to itself for almost a decade. But it didn't take Apple long to surpass our technological crown jewel in both sales and consumer appeal. RIM should have had a big lead; instead it's playing catch-up, with phones and tablets.

And that's a tough fight. RIM, with a market value of $24-billion (U.S.), is a bantamweight trying to avoid a knockout punch from heavyweight Apple, with its market cap of $320-billion. That's not a winning proposition, especially when the heavyweight is not only far bigger, but also faster and more nimble.

Apple's greatest strength is a long history of innovation. The company earns remarkable returns on equity because of what you might call a cultural asset: It attracts very bright and creative people and lets them thrive. The result is products that people not only want to buy, but for which they are willing to pay a premium. RIM also innovates and employs bright and creative people but, sadly, it can't touch Apple's ethos.

That disadvantage is visible in the numbers. I would estimate that Apple's gross profit from phones - what it earns from sales less the cost of manufacturing - is almost a third higher than RIM's.

Gross profits pay for research, development, sales and marketing and, ultimately, shareholders. Apple spent $580-million on R&D in the most recent quarter, compared with RIM's $380-million.

Two important points: Apple's R&D covers far more than just smart phones. It also pays for developing iPods, iPads, computers, iTunes, Apple TV and so on. RIM's R&D is mainly for phones and its tablet. Furthermore, as a proportion of gross profit, Apple's budget is roughly a third of RIM's.

Economies of scale are a huge advantage for Apple, whether in R&D or sales and marketing. It also appears to be getting a better return on its investment in research.

Microsoft's problem is similar to RIM's. It's not exactly a hotbed of innovation. When is the last time it invented anything? It spent billions on music players, smart phones, the Xbox and other things, with results ranging from complete failure (in most cases) to questionable success in others (notably Xbox).

None of this really mattered because Microsoft could always rely on its two cash cows - Windows and Office - to churn out profits.

But just as computing moved from the desktop to the laptop, which didn't hurt Microsoft, it's now moving from the computer to the smart phone and tablet, which will hurt because Mr. Ballmer's company has come up short in both areas. The race is over, and Microsoft was never really a contender.

Investors have an amazing knack for underestimating how quickly technological shifts can destroy what seem like unassailable franchises, but if you have any doubt, consider what innovation (or lack thereof) did to Eastman Kodak. Only 15 years ago, it was a $90 stock. It's about three bucks today.

Tablets will evolve - they already have come far - and it's not hard to foresee a future where many people never use a computer, just a tablet, leaving Microsoft out in the cold.

I am fairly sure the company is keenly aware of its predicament and that there is one way to help address it: buy RIM.

The BlackBerry is an excellent phone with a very valuable user base and, by all accounts, RIM is a viable contender in the tablet space.

Microsoft could buy RIM, including a premium, for cash in the bank. Why would RIM accept such an offer? Because the economics of its business are starting to deteriorate as competition - not just from Apple - crushes its profitability. That, in turn, makes it harder to be more innovative. Being part of a much bigger company would give RIM synergies and the financial security to concentrate on products.

While this union is no guaranteed win-win, doing nothing seems like a guaranteed lose-lose.

Fabrice Taylor writes the President's Club investment letter.

Email: Fabrice.taylor@gmail.com