February 2008 Update and Company Reports
Qualcomm (QCOM 42) qualifies as a first class innovator by creating the CDMA/WCDMA broadband technology that underpins modern wireless communications worldwide. The company consists principally of two divisions. Qualcomm Technology Licensing, “QTL,” invents, develops, and owns intellectual property, documented as patents. It licenses this intellectual property to third parties on a royalty basis. Qualcomm CDMA Technology, “QCT,” produces and sells chipsets based on QTL’s intellectual property – 270 million chipsets projected in 2008. Legal actions related to royalty negotiations have disassociated the stock price from the worldwide success of the company’s technology. Essentially, Broadcom and Nokia are attacking QCT to “negotiate” lower royalty rates from QTL. The company should spin off QCT - NOW. This will defuse the legal leverage of Broadcom and Nokia while increasing the growth prospects of QCT. As detailed below, the parts are worth somewhat more than the price of the whole, so a spin-off should culminate in a realization of pent-up shareholder value.
The spin-off of QCT was actually planned in 2000, the previous time negotiating difficulties were experienced with Nokia. A prospectus was filed with the Securities and Exchange Commission on July 25 of that year for the tax-free distribution to shareholders of “Qualcomm Spinco, Inc.” The prospectus stated that Qualcomm would assign a portion of its patents to Spinco, without compromising its existing licensing and royalty business. Spinco would use these patents to negotiate the transfer from its parent of the existing cross-licenses necessary to access other licensee’s intellectual property rights. QTL would not need cross-licenses as it manufactures no products. The spin-off was tabled, because the threat alone was sufficient to bring Nokia scurrying to the negotiating table.
Broadcom has successfully asserted several patents against Qualcomm’s chipsets, giving it ammunition in its pursuit of an unusually favorable cross-licensing agreement with QTL. Broadcom essentially wants Qualcomm to change its business plan by giving Broadcom “pass-through rights” to its intellectual property. This means that when a handset manufacturer such as Samsung or Nokia incorporates a Broadcom WCDMA chipset into its handset, it also gets royalty-free access to all of Qualcomm’s patents. Broadcom’s chipsets have not sold well so far. Broadcom seeks the ability to sell its chipsets not only on their own merit, but also as a source of free access to Qualcomm’s IPR (intellectual property rights.) Were QCT no longer part of Qualcomm, Broadcom would lose the ability to bargain a handful of non-essential patents in trade for Qualcomm’s thousands of essential patents.
QTL, if separated from QCT, would present a daunting dilemma to Broadcom and Nokia. Broadcom, which has not yet licensed Qualcomm’s technology, would have to negotiate royalty rates for thousands of international patents. In view of a recent court decision ordering Qualcomm to pay Broadcom 6% for a single non-essential, patent, it is interesting to think what Broadcom might have to pay to license Qualcomm’s thousands of patents, many of which are essential to the operation of WCDMA. “Essential patent” may simply be defined as a patent without which the technology at issue, WCDMA in this case, does not work.
The Nokia litigation centers on royalty rates. Nokia
is in arrears on royalty payments it agreed to pay under a license that dates
to the last time Qualcomm broached the spin-off idea. Analysts estimate
the royalty rate is about 3.9%. Nokia has until the end of this year to
exercise an extension of the agreement, or it will expire. Nokia and
Qualcomm are presently arbitrating whether this contract is still valid, due to Nokia’s default. In view of the royalty rate
assigned to the Broadcom patents by the court, it is interesting to think what
a court might feel Nokia owes Qualcomm if the existing agreement is determined
to be null and void, necessitating that Nokia negotiate a new one. Here
again, QCT throws a wrench into the works. Part of the agreement consists
of a cross-license that gives QCT access to all of Nokia’s intellectual
property for use in making chipsets. Clearly, Nokia has ideas about what
its intellectual property is worth. In litigation with Vitelcom in
Anti-trust claims against Qualcomm in various venues are based on charges that the combination of Qualcomm’s large CDMA/WCDMA chipset market share and licensing business under the same roof is used to exclude chipset competitors. Clearly, such claims would be rendered invalid if the businesses were separated, and those bringing such claims would lose a major negotiating weapon against Qualcomm.
An additional consideration is the growth potential of QCT’s market share. QCT’s market share in CDMA chipsets is nearly 100%, but is only a little over 30% for WCDMA. QCT clearly has the superior cutting edge chipset product, notably in terms of power consumption for a given level of processor speed. QCT’s new Scorpion core uses 200 mW (milliwatts, a measure of energy consumption) at 600 MHz (megahertz, a measure of computational speed) and will operate at up to 1 GHz. Arm’s Cortex-A8 core used by Texas Instruments uses 350 mW at 600 MHz and Intel’s comparable core consumes nearly 1,000 mW. However, Nokia and Ericsson, despite the superiority of QCT’s chipset offerings, have avoided giving business to QCT. They, along with other customers, justifiably view the existing Qualcomm as a competitor. QCT would have a much greater chance of getting chipset orders from the two companies that dominate WCDMA handset market share if the association with Qualcomm faded into memory.
Qualcomm has two relatively new businesses that have tremendous potential. The first one is MediaFlow, which brings TV to the mobile handset. It recently won the “Best TV and Video Service” award from the European Mobile Entertainment Forum. MediaFlow features the world’s best entertainment brands and is currently available on the Verizon and AT&T Mobile networks. It offers mobile phone users the ability to watch networks such as ESPN anytime, anyplace, while offering networks a massive new opportunity to sell content. As mobile phone displays improve, watching TV and other sorts of data-intense video media will become a very large business.
The MEMS Technologies subsidiary has developed a display technology called “mirasol™” that is both easy to see in the brightest sunlight and has incredible clarity and resolution. It also consumes very little power, in contrast to the backlit screens we have on today’s mobile devices. Approximately half of the battery consumption of a handheld device is due to the display, so incorporation of a mirasol display should virtually double battery life. Available now for very small devices, such as pagers, mirasols should be available for handsets in a few years. Someday, one may hang on your wall. The market for such a display that consumes a fraction of the power needed to power LCD and plasma displays is huge. Competitors are working on a similar technology, but do not yet have a commercial product.
Valuing the pieces of Qualcomm
QCT will generate approximately $6.3 billion of revenues and $1.8 billion of operating earnings. The company will be debt-free and generate approximately $.80 in earnings per share. Slower growing Texas Instruments’ forward P/E is 15, so we assign an estimated P/E of 20 to Spinco. Value: $16.
QTL will generate approximately $3.5 billion in revenues, assuming Nokia will eventually have to pay its bills, and $2.9 billion of operating income. Earnings per share should approximate $1.32. This is a unique company, with an exceptional amount of cash flow production power, an outstanding return on invested capital, and a technological prominence paralleled only by Monsanto. A 30 multiple values it at $40.
We roughly estimate that MediaFlow, OmniTracs and MEMS are worth another $6, and there is $8 of cash on the balance sheet. This rough estimate of break-up value totals $70.
Technology steadily moves forward, as does Qualcomm’s
research and development work, necessitating more negotiation of licensing agreements
in the future. It is widely acknowledged that Qualcomm is the largest
owner of essential patents for OFDMA, the basic ingredient of WiMax and the “4G” alternatives being projected for the
future of wireless. It owns 1,400 OFDMA
Ownership of intellectual property and chipset manufacturing are two different businesses. QCT must be separated from Qualcomm, or the future potential of the company and its value to shareholders will suffer.
Steven L. Ré, CFA
February 15, 2008
This report contains the current opinions of the author and such opinions are subject to change without notice. It has been distributed for information purposes only and is not to be construed as a recommendation to purchase or sell securities. The information contained herein is from sources deemed reliable but is not guaranteed. It should not be assumed that investments in any of the above-mentioned securities will be profitable, and past performance is no guarantee of future results. Earnings projections often miss, and markets go up and down. The employees and families of Quality Growth Management, Inc. may own the above-mentioned securities in their own accounts, and may trade them at any time without notice.
[1] Expert
Report of Eric Stasik, 17 November 2004, page 7,
paragraph 44, expert report drafted at the request of Nokia for Nokia v. Vitelcom
patent litigation proceedings in