Microsoft (MSFT) is in a difficult position when it comes to the smartphone market. Its Windows Phone 8 operating system clawed its way into third place for global market share last year and was the fastest-growing mobile OS of 2013.
The “difficult” part of that position is that even at 104% growth on the year, it still only amounts to a paltry 4% of the market.
Plus, much of that was stolen from battered BlackBerry (BBRY), not to mention that almost all the Windows smartphones were from a single manufacturer: Nokia (NOK). Ergo, MSFT is going to have a very difficult time clawing out more significant smartphone share, especially when it charges hardware manufacturers for a Windows Phone license in a world in which Google (GOOG) gives Android away for free.
Windows Phone 8 Should Be Free for All
We’ve just seen the first cracks in Microsoft’s resolve to keep its smartphone operating system as a profit center with news MSFT has agreed to waive licensing fees for two Indian smartphone manufacturers. The company claims it’s doing so to help boost adoption in the country.
In essentially offering Windows Phone for free, Microsoft puts its operating system (for those two vendors) on a level playing field with Android — it costs the two companies nothing to release a smartphone running either OS.
Make no mistake, that license fee is a big deal. Smartphones are an extremely low-margin business for most manufacturers, and many actually lose money on every device they sell. Just two — Apple (AAPL) and Samsung (SSNLF) — have the industry profits literally locked up.
Apple’s iOS and BlackBerry’s BB10 are proprietary operating systems. So, as a smartphone manufacturer, you basically have two primary options:
- You can release an Android smartphone to a market clamoring for these devices, you don’t have to pay Google anything, and you’re still lucky to break even on the device — unless you’re Samsung, in which case you’re doing just fine.
- Or, you can choose to go with a Windows Phone 8 smartphone, try to sell it in a market with minuscule demand for such devices and fork over $20 or $30 to MSFT for each one you sell, effectively guaranteeing a loss on every smartphone while seeing your brand plummet in market share.
Which is why the only way Microsoft has a shot of goosing Windows Phone 8 adoption is if it just makes the operating system free for all manufacturers.
And yet … even that doesn’t solve the inertia problem.
With Android dominating smartphones, convincing consumers to risk their hard-earned cash on a Windows Phone 8 device next time instead of sticking with the familiarity of Android will be a tough sell. That sell is tougher still when you consider current Android phone owners might be invested in the ecosystem — they’ve paid for apps, and those apps won’t run on Windows Phone 8.
That’s where dual-boot smartphones come in.
Thanks to advances in chip technology, companies like Intel (INTC) are now offering mobile CPUs compatible with both operating systems. A dual-boot smartphone lets MSFT get Windows Phone 8 into the hands of consumers without forcing them to make the choice to kick Android cold turkey. The hope is, they’ll play around with Windows, decide they like it, begin to transition away from Android and next time, they’ll go all-in on a Windows Phone 8 smartphone.
Chinese manufacturer Huawei has announced it will release a dual-boot Android/Windows Phone 8 smartphone in the U.S. this year, so this isn’t a pipe dream — it’s happening.
Just to add another twist, MSFT collects patent royalties from the majority of Android smartphone makers. That’s right, Android isn’t really free, at least for the estimated 70% of smartphone vendors who signed agreements with Microsoft. That number has been pegged at $5 per handset and $2 billion in revenue for MSFT in 2013.
MSFT could sweeten the pot to convince manufacturers to offer the dual-boot option by waiving the Android royalty fee on such a device. On top of the Windows Phone free offer, suddenly manufacturers are saving money on razor-thin Android margins just by giving Microsoft a spot on the device.
Of course, making Windows Phone free and possibly waiving Android royalty fees means giving up revenue. But in the grand scheme of things, that isn’t much; call it roughly $3 billion between the two last year.
BlackBerry has few customers remaining, meaning the era of easy poaching for Windows Phone 8 is just about up. And rulings by European courts are beginning to chip away at those Android royalties. So in the status quo (charging instead of giving away Windows Phone free to manufacturers), MSFT faces the likelihood of slowing adoption and royalty fees from Android smartphones under siege.
Contrast $3 billion with little prospect for meaningful growth against the bigger game: the secondary revenue available to a mobile operating system vendor, primarily a mobile ad market that’s expected to top $38 billion by 2018.
There is other revenue that comes with mobile OS market share, including app sales and cloud storage. Meaningful numbers of Windows Phone 8 smartphones could help to popularize Microsoft’s Bing search engine on the desktop (more ad revenue) and combat the “halo effect” that’s seen PCs running Windows replaced at the enterprise level by Macs and Chromebooks.
Former CEO Steve Ballmer refused to play Google’s game, but new Microsoft CEO Satya Nadella is already showing signs of movement. Waiving the Windows Phone 8 license for a few Indian manufacturers is a start.
But if Windows Phone 8 is ever going to gain a meaningful smartphone market share and a bigger chunk of the mobile advertising dollars that are currently going mainly to Google, Microsoft needs to put a two-step plan into action:
Shove out Windows Phone for free and push dual-boot smartphones.
As of this writing, Brad Moon did not hold a position in any of the aforementioned securities.