Yo, HTC — you got problems. And Dr. Dre can’t fix them

HTC today announced that it is buying a majority ownership in Beats Electronics, a company well known for making iconic headphones and its links to hip-hop impresario Jimmy Iovine and rap legend Dr. DreIt is paying $300 million for coolness and a brand, though it is not very clear how it allows the company to overcome problems that are much bigger than a few cool adverts can paper over.

I have been following HTC for almost seven years. The first time I got to know this white-label phone maker was back in the day when I worked for Business 2.0 magazine. My then colleague Matt Maier was the one who said that these guys are going to be a force to reckon with, so I started paying attention to the company. Remember, this was the golden era of Palm OS, Symbian-based Nokia(s nok) smartphones, web-hating Blackberry(s rimm) and Windows Mobile(s msft).

HTC at the time used to quietly make Windows Mobile phones for carriers, yet few knew it was HTC that build the handsets. It was an upstart, it had the hustle and it was on the right side of history. And when Windows Mobile stalled and Apple released the iPhone(s aapl), HTC caught the biggest break of its corporate life — Google(s goog) came up with Android.

Android co-founder Rich Miner had worked with HTC in 2002 when developing the Windows Mobile based SPV handset for Orange, the French mobile phone company. It was easy for HTC to later cosy up to Google and Android. It went on to develop Sense UI, come up with great marketing and manage to excite the early adopters. So what’s the problem, you must be asking?

Fast Start Doesn’t Mean Strong Finish

Well, a lot!

But let’s step back for a minute. During the early Android days, since it was the only game in town, the company saw its smartphone sales zoom as it got a lot of push from phone companies that were unable to offer the iPhone to their customers; like T-Mobile USA, for example. Smartphone sales for the Taiwanese company jumped — from 11.9 million units in 2009 to 24.7 million units in 2010 to an estimated 50.7 million units in 2011.

For much of 2010, its only real competition was Motorola(s mmi), a company beset with its own set of problems. And then came Samsung – a big gorilla with some natural advantages: a big brand name, the domestic South Korean market to prop-up its market share and more importantly, a vertically-integrated company. It makes screens, memory, storage, chips, radios and now even has its own software unit. And it has billions to burn in order to compete in a crowded market place, and deep pockets to fight any and all patent related battles.

In 2009, Samsung sold 5.5 million smartphones. In 2010 that number was up to 24.9 million phones and in 2011 they are going to sell 83.9 million phones, according to estimates from UBS Research. In three years they have gone from have 3.1 percent market share to 20.1 percent market share in smartphones. Sure, HTC has seen their market share double from 6.7 percent to 12.1 percent, but Samsung is making rapid strides.

Tomi Ahonen, a long time wireless industry insider writes, “HTC seems to be the perpetual bride’s maid in the smartphone bloodbath, they consistently report good results, but always someone else gets a spectacular result so HTC is always in the next-best category.” I think Tomi is being too kind.

The China Syndrome

Why? As if Samsung wasn’t enough, HTC now has to contend with two major competitors from China who have faint regard for profits – Huawei and ZTE, both with massive domestic market share to use as a springboard. The way I see it, HTC will hit a wall sooner rather than later.

HTC stock performance over past six months

But wait, there is one more thing — patents. HTC as a company will pay out nearly $1.1 billion in royalty payments to others, including $5 per phone it paid to Microsoft. That’s roughly 12 percent of their revenue pr over $40 per handset, according to estimates from Ashok Kumar, analyst with Rodman & Renshaw, a brokerage! And that is before Apple gets its pound of flesh. In a cut-throat business like Android smartphones, the average selling price of a device isn’t likely to go up, and HTC is going to be reduced to what it really is  — an aggregator of other people’s intellectual property with no real edge.

To me the first real sign of trouble was when HTC’s chief innovation officer, Howard Horace Luke — a man who I respect immensely — left. Since then, the company has made some muddling moves, buying companies and patent portfolios that are confounding at best. Over the past year or so the company has spent over a $760 million on stock buybacks, ill-advised patent acquisitions and now buying a headset maker.

From a financial standpoint, I do admit, Beats is not very expensive. Beats is likely to do sales of about $350 million this year, close to what Plantronics(s plt) is bringing in. But is it enough for HTC to become a lifestyle brand and compete in a market where margins are thin and getting thinner? Not likely, with all due respect to Dr. Dre.