Third Quarter
2006 Update On QUALCOMM Intellectual Property Defense and Royalty Negotiations
QUALCOMM (QCOM 39) is slowly and gradually winning the 2006 battle over its royalty rates. Long-term QUALCOMM shareholders remember a similar battle in the late 1990’s. The stock performed poorly over that period as the company’s royalty income was threatened and disparaging statements were made about the growth prospects of CDMA. It took a couple years, but QUALCOMM won a complete victory enforcing its ownership of CDMA and its right to receive royalties. Negative statements made then about the growth of CDMA proved false. The pressure on the stock price released like a spring in March of 1999 when Ericsson capitulated, and the stock made up for years of underperformance. In ways, this scenario is simply being repeated. However, this time, the ownership of CDMA technology is not in question. Instead, several licensees, led by Nokia and Broadcom, are seeking a special deal on the rate they pay QUALCOMM, so that they have an advantage over the other 135+ licensees. I believe the stock has now entered a several-year period of steady appreciation, based on 1) the massive growth of the CDMA/WCDMA market and 2) the gradual resolution, in QUALCOMM’s favor, of numerous challenges to its royalty rates.
On September 1, Broadcom’s antitrust complaint against
QUALCOMM in U.S. District Court of New Jersey was dismissed in its entirety,
rejecting all purported antitrust violations.
Essentially, QUALCOMM’s concurrent sale of chipsets and collection of
royalties was upheld, along with its right to choose the rate of royalties
charged to licensees. In another venue,
on October 10, 2006, International Trade Commission Administrative Law Judge
Charles E. Bullock made an initial determination that QUALCOMM had infringed Broadcom
patent number ‘983, but did not penalize QUALCOMM for it. In fact, he recommended against an exclusion
order on handsets imported into the
Nokia
(NOK 20) owns a 35% market share in worldwide cellular handset
sales. Over the past fifteen years, it
built itself into the world’s leading handset manufacturer on the GSM cellular
technology standard, a notable accomplishment.
It is a ruthless competitor that does not shy away from any maneuver to
gain advantage over rivals. Nokia’s
direct competitors include Motorola, Sony-Ericsson, LG, Samsung, ZTE, and
Huawei. Due to very slim profit margins,
handset manufacturers must tightly control costs of manufacturing, the largest
of which consists of components sourced from various suppliers, such as
chipsets and displays. An additional and
relatively modest cost is royalties on enabling technologies invented by others
and incorporated into the phone. Nokia’s
CDMA/WCDMA license from QUALCOMM expires in April of 2007, and the companies
are locked in a divisive royalty rate negotiation on CDMA technology. A significant cost advantage would be gained
by any handset competitor that could negotiate a lower royalty than its peers.
Nokia announced its exit from manufacturing CDMA2000 handsets on June 22, 2006. Nokia structured the announcement as an affront to CDMA and swipe at QUALCOMM, saying, “In addition to an already financially prohibitive CDMA ecosystem in general, recent developments may indicate that the CDMA emerging markets business case is looking more challenging.” Nokia blamed the “financially prohibitive ecosystem” on the cost of QUALCOMM’s chipsets and royalties. Less informed investors and the press reacted as though this was bad news for QUALCOMM. The truth is that Nokia has not succeeded in CDMA2000 due to its own failure to develop competitive chipsets, despite spending billions of dollars and ten years trying. It has proudly refused to buy chipsets directly from QUALCOMM. Meanwhile Samsung, LG, Huawei, and others have emerged from making zero handsets to being formidable competitors, courtesy of QUALCOMM technology and chipsets. Rather than exiting the CDMA market, Nokia is having its CDMA2000 handsets manufactured by a contract manufacturer.
At the same time, a large cellular system operator in
The actions of Nokia and Reliance contradict their words. On September 6, 2006, Nokia announced, with
great fanfare, an agreement to supply 2 million of its very low priced Model
1255 handsets to Reliance (pictured.) This
handset is 20% less expensive than
the least expensive GSM phone it sells in
From looking at this huge order, the claims by Nokia and Reliance about the “financially prohibitive CDMA ecosystem” look fallacious. If anything, it appears that Nokia’s lowest-cost Indian handset was enabled by QUALCOMM’s patented technology and chipsets.
The reason that Nokia is fighting so hard for a lower royalty than its fellow handset makers is to gain competitive advantage in a burgeoning market. Technology consultants have prepared numerous projections of handset demand, all agreeing that the GSM markets are rapidly transitioning to WCDMA (currently 123 operators in 55 countries.) The typical projection is that the addressable market for WCDMA handsets is expected to grow to over one billion in 2010. Nokia must retain its entire current market share of 33% to grow revenues at a high single digit rate over this period. Insurgents using chipsets from QUALCOMM have proven to be price cutters in Nokia’s markets, thus creating the problem Nokia fears most.
At the same time, it is interesting to analyze the implications of these projections to QUALCOMM. QUALCOMM’s addressable market up until late 2005 was limited to CDMA2000, with total handset unit sales last year of about 190 million. The rapid growth of WCDMA into the GSM space gives QUALCOMM entrée into the 1 billion units projected for 2010, a five to one increase. Clearly, the growth opportunity for QUALCOMM is enormous.
Subtle, but Important
QUALCOMM brought some of these problems on itself. Since QUALCOMM charges all licensees about the same royalty, Broadcom and Nokia feel they have nothing to lose by negotiating. They assume that even if they lose the fight, QUALCOMM will still agree to the old rate, akin to the return of the prodigal son. However, QUALCOMM’s litigation strategy reveals that it is raising the stakes. Some of the patents over which QUALCOMM is suing Broadcom and Nokia are not limited to CDMA/WCDMA hardware and software, but apply to other communications systems as well. These patents address what one could call the “application layer,” concerning not just the devices, but how the devices work. Specifically, these patents cover the encoding and decoding of data over any communications network and the compression and decompression of video in general. Furthermore, QUALCOMM believes its inventions were copied to fix the problems encountered when GSM was upgraded to transmit data, in particular pictures. If these patents are upheld, GSM companies like Nokia could end up not just paying royalties on CDMA/WCDMA, but also on GSM, GPRS, EDGE, WiFi, Bluetooth, WiMAX, etc. QUALCOMM’s pursuit of such broad patents radically escalates the risk of fighting over royalty rates.
Steven L. Ré, CFA October 17, 2006
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