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Why the Microsoft-Samsung Patent Dispute Could Ruin Windows Phone

Microsoft (NASDAQ: MSFT  ) recently sued Samsung (NASDAQOTH: SSNLF  ) over uncollected patent royalties related to Google (NASDAQ: GOOG  ) (NASDAQ: GOOGL  ) Android. The lawsuit highlights a strange fact -- that Android hardware makers actually pay Microsoft -- not Google -- patent royalties.

Those payments were used to cover some bits of Android that came from Microsoft technology, and gave Microsoft a price advantage when it dropped all license fees for Windows Phone in April. This was a sweet deal for Microsoft -- it would profit from every Android device sold, while promoting Windows Phone to device manufacturers as a free alternative to Android.

Source: Wikimedia Commons, Flickr.

Unfortunately, Samsung -- the largest Android handset maker in the world -- stopped paying Microsoft those royalties after the latter acquired Nokia's handset division earlier this year. Samsung claimed that the acquisition invalidated its 2011 contract with Microsoft.

Microsoft argued that Samsung used its clout to convince South Korean regulators to invalidate the contract. Microsoft also stated that regardless of the ruling in Korea, many of the disputed patents were granted in other countries, invalidating Samsung's appeal.

What's at stake for Microsoft
While the case is tangled in a mess of patents and international laws, a ruling against Microsoft could hurt the company in three ways:

  1. It would lose a revenue stream from Samsung.
  2. Other Android handset makers could follow Samsung's example.
  3. It could cause Windows Phone to lose its free license advantage.

Microsoft has never disclosed exactly how much it earns per Android handset sold, but Geoff Duncan at Digital Trends previously estimated that it earns $1 per Android device. Research firm Gartner recorded 759 million Android phone shipments in 2013 -- which translates to $759 million in revenue for Microsoft last year. That would be equivalent to about 0.9% of Microsoft's fiscal 2013 revenue. Samsung sold around 300 million of those phones. Losing royalties from Samsung, or even all Android handset makers, wouldn't hurt Microsoft very much financially.

Samsung's Galaxy S5. Source: Samsung.

But if Android becomes royalty-free, Windows Phone loses its only competitive advantage. Windows Phone only has a 3.2% global market share, compared to 78.4% for Android and 15.6% for Apple iOS. Windows Phone plays a key part in Microsoft's "One Windows" strategy -- the idea that mobile devices, PCs, and the Xbox One all belong in a single ecosystem.

Without Windows Phone, the "One Windows" ecosystem dies before reaching mobile users. That's why Microsoft paid top developers more than $100,000 to bring apps to Windows Phone, slashed its license fee of $25 per phone to $0, and paid $7.2 billion for Nokia's handset division.

Taking into account all of Microsoft's aggressive strategies in mobile, research firm IDC previously forecast that Windows Phone's market share would hit 7% by 2018. More important, it would gain market share as iOS and Android declined. But if Android shakes off its "Microsoft tax," Windows Phone could lose market share instead.

Why is Samsung refusing to pay Microsoft?
Samsung, on the other hand, simply gains $1 per device sold if it refuses to pay Microsoft, instantly gaining $300 million in extra revenue based on 2013 sales.

Samsung desperately needs to cut costs -- last quarter, the company's net profit plunged 20%, year over year, due to increased competition from lower-priced Chinese competitors and unfavorable currency impacts. One rapidly growing rival in China, Xiaomi, has launched comparable smartphones to Samsung's flagship Galaxy S handsets for half the price.

Samsung's strategy of entangling its agreement with Microsoft between Korean and U.S. courts practically guarantees that the case remains unresolved for months. Even if a court finds in Microsoft's favor, Samsung will inevitably appeal the case to further delay a final ruling.

The Foolish takeaway
The longer this battle drags out, the more Samsung will benefit. Every quarter that goes by with the case unresolved will net Samsung bigger savings and leave a gaping hole in Microsoft's Android royalties. But Samsung is only the tip of the iceberg. If other major Android manufacturers like Huawei, LG, Xiaomi, Sony, and HTC also decide to stop paying Microsoft, Microsoft could find itself backed into a corner.

Google certainly won't lend Microsoft a hand. In fact, Google would probably encourage Android handset makers to stop paying Microsoft altogether, since it would strip Windows Phone of its pricing advantage.

Microsoft may be the one suing Samsung, but Samsung clearly has the upper hand in this battle.

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Leo Sun

Leo has covered the crossroads of Wall Street and Silicon Valley since 2012. Follow him on Twitter for more updates!

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