Nokia's plans to create a standalone software business, announced at its Capital Markets Day this week, have profound implications for the Finnish vendor's entire business model and modus operandi. (See Nokia to Create Standalone Software Biz, Target New Verticals.)

The move is a clear response to the arrival of cloud-based technologies that pose a huge threat to the traditional vendor approach of selling hardware and software together.

By taking advantage of technologies such as SDN and NFV, service providers expect to be able to run network functions as software programs on any cheap server in the future. Vendors that continue to produce expensive boxes supporting particular functions may quickly lose out.

Since acquiring Alcatel-Lucent (NYSE: ALU) earlier this year, Nokia Corp. (NYSE: NOK) has substantially beefed up its capabilities in the software field. But its applications and analytics division, which accounts for the bulk of the software expertise and currently forms part of the IP networks and applications division, made just €372 million ($399 million) in sales in the recent July-to-September quarter -- or about 6% of total network sales.

It also reported a disappointing 12% decline in revenues for that quarter, compared with the year-earlier period.

The aim, however, is to grow this business substantially in the next few years, ultimately spinning it out as a unit in its own right.

Nokia is currently being coy about the details. It will not say how big the software unit could be, or when it might eventually take shape outside the IP networks and applications division.

A few things are clear, however. First, the software business will cater both to existing service provider customers and to a range of new vertical sectors that together represent an addressable market worth about €18 billion ($19.3 billion) annually.

The verticals that make up this opportunity include energy, transportation, the public sector, so-called "technological extra-large enterprises" and the web-scale players.

While Nokia's mainstream addressable market -- worth about €113 billion ($121.3 billion) annually -- is expected to grow at a compound annual growth rate (CAGR) of just 1% over the next five years, this "adjacent" opportunity is expected to have a five-year CAGR of about 13%.

Perhaps more importantly, Nokia aims to make the software division responsible for transformation efforts throughout the entire business.

"It could be responsible for defining what we do around DevOps and open source," says Kathrin Buvac, Nokia's chief strategy officer, in a conversation with Light Reading. "That includes how we redesign the business model for those parts of the business that get virtualized and move from being on-premise to as-a-service type operations."

The software business is also expected to generate operating margins that are comparable to those of existing large software companies.

What does that mean, exactly? Again, Buvac would not shed further light on the specific targets, but a long-term objective for the overall networks business is to generate an operating margin of 10-15%, up from one of about 8% today.

In the short term, focus areas for the new business will include enterprise software and IoT platforms, Nokia has revealed.

"Enterprise software could include PBX replacement technologies -- Skype-type solutions," says Buvac. "In IoT, we already have a platform that gives us device management capabilities for things like telematics in the automotive sector, and we could think about transporting this to other verticals and growing that business."

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Nokia is not planning any kind of recruitment drive to gain more software expertise, arguing that it already has the engineering talent it needs to build software products.

However, it does intend to put more investment toward the development of new sales channels, Buvac revealed, without disclosing actual figures. "As you can imagine, selling an independent software business is different from selling hardware together with software," she says. "We have taken some measures this year but we'll put more focus into building the right channels for software selling."

Other vendors that have thrived on selling hardware and software together are coming under similar pressure to adapt.

During a recent event in China organized by Huawei Technologies Co. Ltd. , a number of big service providers told the Chinese vendor it needs to think about the role it wants to play in the future as hardware and software become "disaggregated." (See Virtualization Frustration Sees Telcos Rebel.)

Nevertheless, while Huawei has continued to report healthy growth in sales to service provider customers, Western rivals including Nokia have recently struggled amid tough operating conditions.

Nokia is not expecting those conditions to improve next year. Its main addressable market will decline by 2.2% in 2017, it told investors earlier today, and its own network revenues are forecast to fall at roughly the same rate.

The projection comes just days after Sweden's Ericsson AB (Nasdaq: ERIC) said the mobile infrastructure market -- in which it generates the bulk of its sales -- would decline by 2-6% in 2017, after shrinking 10-15% this year. (See Is Ekholm Ericsson's Savior or Seller?)

— Iain Morris, , News Editor, Light Reading