How the Chinese Government’s Android Patent Move Threatens Xbox

The Chinese Government just divulged Microsoft's (MSFT -2.45%) long-held secret--the 310 patents within its Android patent portfolio as part of its review of Microsoft's $7.2 billion purchase of Nokia's (NOK -0.27%) handset division. The move potentially gives Android smartphone vendors a big head start when Microsoft decides to take them to court in the future. It might also mean that the Nokia acquisition could unfortunately end up costing Microsoft more than it bargained for.

Although Microsoft does not usually reveal how much it earns on its Android patents, a Nomura analysts provided an estimate of $2 billion per year, about five times the revenue Microsoft makes from Windows phones.

Microsoft has been using proceeds from the highly lucrative Android patents to support its loss-making divisions, especially Xbox. The company loses more than $1 billion from Xbox sales each year.

How real is the threat?
Microsoft has signed 20 patent deals with Android device manufacturers to-date. The company inked a patent deal with Samsung back in 2011 that licensed Samsung to use certain undisclosed Microsoft Android patents on its smartphones and tablets. It's estimated that Microsoft makes about $5-$16 per Android device sold.

That might not seem like much, but when you consider that profit margins on many Android devices are slim-to-not existent, it's not hard to see why Android vendors might be an unhappy lot. Android smartphones and tablets sport the lowest ASP (Average Selling Price) for all major device OSs. Only Samsung makes any meaningful profit selling Android smartphones among all major vendors.

Source:GeoActive Group

So far, only Motorola Mobility has ever dared challenge Microsoft in court over its demands on patent licensing. All other companies have usually elected to pay up whatever Microsoft was demanding, due to the heavy cost of litigation. Patent trolls cost the U.S. economy $30 billion every year.

Interestingly, Motorola had field day with Microsoft Android patent lawsuits against the company. Microsoft had filed 17 patent suits before the German Federal Patent Court against Motorola Mobility. Motorola won 16 of these. Microsoft's solo win was U.S. Patent No. 6,370,566 for ActiveSync back in 2011.

It's extremely likely that other Android smartphone vendors will now be more willing to take on Microsoft in court whenever Microsoft demands patent fees from them, instead of simply paying up. With the Android Patent information in the public domain, these vendors and their army of lawyers will no doubt take time to scrutinize the patents for any cracks they might use to evade paying up. Motorola's unprecedented success will no doubt spur them along too.

Judging by Motorola's success, these recalcitrant companies might also enjoy a high success rate if they decide to challenge Microsoft in court, and end up toppling the company's Android gravy train.

But why not lose Surface Tablets instead?
Microsoft loses quite a lot of money on its Surface Tablet sales. Surface tablets generated $1.8 billion in revenue for Microsoft in the first three quarters of the current fiscal year, while the cost of revenue ran into $2.1 billion, thus losing $300 million for the company.

The Surface tablet generated $1.8 billion in revenue in the first 9 months of the current fiscal year, while its cost of revenue ran into $2.1 billion, thus losing $300 million for the company.

Data: Microsoft, SEC Filings

Source: Computer World

It therefore came as a real surprise when Microsoft announced in early June that it was going to make huge price cuts for 7-inch, 8-inch and 10-inch Windows devices. Microsoft vice president of OEM partners, Nick Parker, made the announcement saying that devices which sported price points in the $300-$500 range would now sport lower price points in the $100-$300 range.

Microsoft does not usually reveal the number of Surface tablets it sells each quarter. But we can try and get an estimate. Surface tablets sport price points in the $299 to more than $1,000 range. We can therefore use $600 as the ASP for Surface tablets. That would in turn mean that Microsoft sold roughly 830,000 Surface tablets in the third quarter, with an annual run rate of 3 million units to 3.5 million units. Cutting the ASP of Surface tablet by $100 would therefore mean an extra $350 million or so in Surface losses for Microsoft, or about $650 million for the full year. That's considerably less than the $1 billion-plus it loses on Xbox.

Microsoft seems to be a lot more willing to stomach Surface tablet losses because the devices help users to connect to Microsoft's cloud, and other Microsoft experiences such as Bing Search and Skype. Surface users can also subscribe for Office 365 and makes Microsoft extra revenue.

The Xbox gaming console is capable of doing other things as well, thanks to Microsoft's efforts at convergence. But people buy the devices primarily for gaming purposes. If push came to shove, it would perhaps make more sense, both from an economic and strategic viewpoint, for Microsoft to lose the Xbox and keep the Surface tablet.

Foolish bottom line
The Chinese Government revealed details of Microsoft Android patents as part of its review of Microsoft's purchase of Nokia's handset division. The move could, however, have far-reaching consequences for the company and its lucrative Android patent portfolio.