Android Isn’t Free

How Google’s acquisition of Motorola Mobility will make it more like Apple.

Microsoft CEO Steve Ballmer has a knack for making completely boneheaded predictions about his competitors’ products, so when he took to blasting Google’s Android strategy last year, many observers—myself included—dismissed him. It was obvious back then that Android was eating Microsoft’s lunch and that it was beginning to nibble at Apple’s heels, too. (As of March of this year, Android had actually inched ahead of Apple in mobile OS market share.) Microsoft and Google play similar roles in the phone business—they make the software that runs on phones, but they don’t manufacture the phones themselves. In order to get their software out to the public, both companies must partner with handset manufacturers. But while Microsoft wanted phone makers to pay for the Windows Phone OS, Google was giving Android away. How could Ballmer ever compete with free? That’s simple, he explained in several interviews: “There’s nothing free about Android.”

Ballmer argued that Android infringed on several companies’ patents, and as a result, any firm that made Android phones would be forced to pay licensing fees to Microsoft and other patent holders. Patent-infringement cases aren’t unusual in the tech business; pretty much any complex new technology is sure to run afoul of lots and lots of patents. Tech giants often work these problems out by “cross-licensing“—firms trade rights to their patents in exchange for other people’s patents. But Google is a tech newbie, and it doesn’t have many patents to trade. In June, it tried to purchase a cache of telecom-related patents from Nortel, but it lost that effort to a coalition of rivals (including Apple, Microsoft, and Research in Motion). Google’s scrambling to get a load of patents with which to defend Android led to Monday’s surprise announcement that it’s spending $12.5 billion to purchase Motorola’s former phone division. Motorola Mobility makes many popular Android smartphones, but it doesn’t make much money doing so. (It has reported a net loss in recent quarters.) Consequently, its hardware business is an afterthought in this deal. What Google really wanted was Motorola’s 17,000 patents.

In other words—and I never thought I’d say this—Steve Ballmer was right. Android isn’t free. In fact, it’s not even cheap. As Daring Fireball’s John Gruber points out, the $12.5 billion that Google is spending for Motorola amounts to almost two years’ worth of the search company’s profits. No company—not even Google—can throw around that kind of cash without envisioning a direct return on its investment.

That’s why I’m betting that this deal will represent a turning point in how Google operates Android. Today, the platform is “open” but chaotic—because phone-makers get the software for free and can do whatever they want with it, Android is available on some good phones as well as lots and lots of cheap, bad ones. In the aftermath of this deal, Google will seek to exert greater influence over hardware companies. Eventually, the deal will help reduce the number of new Android devices that are released every year, and the few that are released will be of generally higher quality—and sell for higher prices—than what we see in the Android device market today.

This won’t happen overnight. Indeed, in a conference call announcing the deal, Google executives argued that the huge purchase won’t change anything about Android. The Motorola division will run as a separate entity within Google. This arrangement is meant to reduce Motorola’s ability to get preferential access to Android over other handset makers that use the OS. This is a signal that at Google, “openness” is still the ideal.

But that plan is untenable. To see why, it helps to understand how Google runs Android today. When you buy an Android phone, none of your money goes to the search company—remember, the phone manufacturer got the OS for free. Instead of taking a cut of the sale of phones, Google says, its main goal with Android is to keep a foothold for its websites in the emerging smartphone market. The theory is that every Android user will spend a lot of time using Google services and thus seeing Google ads.

It’s a circuitous path to revenue, something akin to an oil company offering carmakers free engines in order to stimulate demand for gas. Still, this strategy made sense as long as Google’s investment in Android remained small. The Motorola purchase changes that rationale; it’s as if Exxon Mobil bought General Motors. Now Google has to find a way to recoup at least $12.5 billion from Android (on top of whatever else it was investing to build the OS). That looks very difficult. Earlier this year, Gene Munster, an analyst at Piper Jaffray, estimated that Google makes just $6 in ad revenue per Android user per year. By 2012, that number could be $10 per Android user per year. Across all users, that would mean about $1 billion in annual revenue. Even if that figure grows over time, it will take a long time for Google to make back the money it spent on Motorola, let alone to turn a profit.

As it sits around waiting for Android-fueled ad revenue to pour in, Google would be stupid not to notice a much more direct way to extract money from the mobile device business—by selling the devices themselves at high margins. This, of course, is how Apple makes money; according to some estimates, it makes as much as $370 for every iPhone it sells. Apple is a singularly masterful company, and there are many reasons it can book such high revenues from its devices. But there are two main factors behind Apple’s mobile success, and the Motorola purchase gives Google a chance to match each one.

The first is tight integration between hardware and software: The iPhone’s operating system is designed for a very specific set of hardware components, and as a result, every iPhone brings an identical user experience. This means that customers don’t have to relearn how to use an Apple-branded phone each time they get a new one, and apps and hardware add-ons are compatible across all devices. Apple’s other secret is exclusivity: There’s only one iPhone every year, which guarantees waves of interest from the press and cultists. That translates into lots of free marketing.

Google can’t replicate this sort of success with its current Android strategy. All of those cheap Android devices are dissimilar and incompatible, creating a confused image for the OS. But the terrific Nexus line of Android phones that Google has built suggests that it knows how to make great phones. With the Motorola acquisition, it will have the opportunity to push out such high-end phones to the mainstream market. I suspect it will also begin to use Motorola as a way to block other Android manufacturers from releasing subpar phones—if they do, it could threaten to give its own phone division early access to Android code, for instance.

It’s true that cracking down on Android device makers could push some of them to flee (they could go with Windows instead). Also, pushing up the prices of Android phones will reduce Android’s market share growth. But it’s hard to imagine that Google will be able to resist the allure of making real money—$50, $100, maybe more—from the sale of each phone. After spending billions on Motorola’s patents, Google might not be able to afford to turn down that kind of cash.