Apple: The Real Cost Of Patent Wars

Maxwell is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Apple (NASDAQ: AAPL) has reported strong results in the third quarter. On strong iPad, iPhone, and Mac sales, the company has reported record quarterly revenue while expanding its profit margins. In protecting the intellectual property behind these stellar sales, however, Apple's performance has been less than stellar this year. Apple has lost some major battles in patent court recently. In the fervor over record iPhone sales, the impact of increased patent risk in the smartphone industry on profitability is being ignored.

According to the folklore, Steve Jobs once declared that it has cost him more money to defend iTunes' proprietary rights than he would have lost if he had left the music and app store contents open to thievery. By the amount of money Apple spends on patent suits these days, Apple may still share this sentiment. Apple is a staunch defender of its technology rights, but are the growing number of patent disputes and losses becoming too costly?

Apple continues to wage patent wars with the most powerful technology companies in the world. Yet in the media, the glare on the iPad's high resolution screen is getting more attention. Tallying the costs of Apple's recent patent skirmishes, it is clear they are getting expensive.

Patent disputes are becoming an increasing and expected cost of being a smartphone maker. The costs and risks of patent litigation are rapidly climbing, though, and they are not insignificant. Accusing Samsung (SSNLF) of infringing on iPhone and iPad designs and functionality, Apple won a $1 billion lawsuit against the Korean technology giant in August.

For now, Apple and Samsung, sharing half of global smartphone sales, can afford the costs of patent battles. Both Apple and Samsung reported record revenues and profits in the third quarter. On quarterly revenue of $35 billion, Apple has turned a net profit of $8.8 billion, up from $7.3 billion in the year-ago period, while stretching its gross margin 1.1% to 42.8%. iPhone, iPad and MAC sales were all up, 28%, 84%, and 2%, respectively. While the smartphone giants can afford to absorb some losses in patent court today, they are likely to face more competition ahead. Apple, Samsung and HTC all expect profit margins to narrow in the fourth quarter.

Samsung's Q3 profits were $7.3 billion, a 91% jump from the year-ago period. The telecom unit saw an 80% increase in operating profits to $4.2 billion, with mobile communications generating $23 billion in revenue. Apple maintains a higher operating profit than Samsung. In the third quarter, Apple's operating profit to sales ratio of 30.4% was almost double that of Samsung at 15.5%. Samsung has 31% of the global smartphone market and Apple 17.5%, according to IDC. With the sale of 21 million Galaxy S III phones, Samsung sold a total of 56.3 million smartphones in the quarter while 29 million iPhones sold.

Following the Samsung win in patent court, Apple has had a slew of losses. Apple recently lost a patent case against Motorola Mobility launched in 2011. Apple argued that Motorola was seeking to charge Apple excessive royalty fees to use its Wi-Fi and video technologies in its iPhones. For using its industry standard patents, Apple is to pay 2.25% of all net sales to Motorola. Since the suit was launched Motorola has been acquired by Google (NASDAQ: GOOG). Steve Jobs has publicly vetted his angst toward Google for copying technology related to the iPhone and iPad.

On November 6, a Texas court ordered Apple to pay $368.2 million to VirnetX (VHC) for using its network patents in FaceTime and other products. VirnetX had asked the court for a $900 million award. VirnetX has previously won a $200 million settlement against Microsoft (MSFT) and is now suing Avaya and Cisco (CSCO). In a separate suit, the US International Trade Commission launched a suit against Apple looking into the company's use of a patent governing the secure connection between two computers.

Strong smartphone sales have helped to shield Apple and Samsung from the practice of the market discounting stocks with patent losses and rewarding wins. Upon its Samsung win, Apple wasted no time reminding investors of the billions of dollars it was losing before the patent ruling. To reduce increasing patent risk and its potential costs, firms are being proactive. Notably, a group of businesses have formed Bridge Crossings LLC to gain rights to MIPS Technologies' (MIPS) portfolio of 498 patents. MIPS retained rights to 82 technologies directly related to its core technology. ARM Holdings (ARMH), a member of the patent consortium and a supplier to Apple, expects the consortium to reduce litigation risk.

In what may be a response to its losses in the patent wars, Apple is strengthening its R&D by $1 billion, with plans to spend $3.4 billion in 2012. A greater risk than Apple's growing patent defense costs is its paltry research and development expenditures relative to its peers. Apple spends about 2% to 3% of revenues on R&D, or $2.4 billion. In contrast, Samsung spends 10% of revenues on R&D, which will reach close to $14 billion in 2012. Samsung, of course, is a more diversified technology maker. It is hard to separate out for example benefits from semiconductor research across its entire technology platform. Nokia (NYSE: NOK), which has the strongest mobile technology patent portfolio, also spends the most on R&D. In a 2011 report, Bernstein separated out mobile technology R&D and estimated that Nokia spends close to $4 billion, or five times more than Apple on smartphone innovation.

The positive correlation between patent portfolio strength and profitability has not necessarily held for the smartphone industry, or Apple. Apple's 3Q profit margin is 22%, Samsung's 12.6% and Motorola Solutions' (MSI) 9.5%. Nokia's 2Q profit margin was a negative 18%, despite its strong patent war chest. As the cost of defending patents increases for the iPhone maker, however, they could have a more discernible impact on future profitability.

Samsung and Apple face more patent risk in the fourth quarter. Samsung is seeking to reverse the $1.05 billion jury verdict Apple won against it in August. The verdict could go either way, resulting in an increase or decrease of the penalty. While Apple may still reel in $1 billion from Samsung's patent wars, the legal costs for these large patent suits can top $100 million. A hotspot to watch is the potential for Nokia to become more litigious in defending its strong 4G/LTE patents. In 2011, Apple settled its two-year patent litigation over Nokia's wireless technology, agreeing to pay royalties for an undisclosed amount. As the major smartphone makers follow the iPhone and roll out LTE-enabled phones, some patent disputes are bound to emerge.

If Apple's revenues fall off iPad highs, it will be harder to overlook the legal expenses incurred from the patent wars. Apple and Samsung are rumored to have incurred $400 million in legal fees before they even went to court. Apple doled out another $32 million on the Motorola patent case. As patent risks and associated costs increase, we should expect Apple to be more aggressive on R&D spending going forward.

StockCroc1 has no positions in the stocks mentioned above. The Motley Fool owns shares of Apple. Motley Fool newsletter services recommend Apple. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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