Apple's iPhone and the Future of Qualcomm: Part II

Sramana Mitra submits: Last week I wrote "Apple's iPhone and the Future of Qualcomm" (NasdaqGS: QCOM) and it generated a huge amount of controversy. My main point in the iPhone series is that if iPhone succeeds in becoming the industry galvanizing event that I think it will be (even if the product itself is a limited success for Apple), it will impact a lot of players in the eco-system.
One such player is Qualcomm, who owns most of the IP around CDMA, one of the two alternate network standards. The other one, ofcourse, is GSM. I suggested that if the world unites under one standard, and if that standard is GSM, then Qualcomm has trouble ahead. [There are 2 IFs here, folks …]
Readers pointed out that I have not taken into consideration the fact that Qualcomm owns a lot of the WCDMA patents as well.
In your recent blog, you state that the iPhone going with GSM(Cinglar) is bad news for Qualcomm. What you fail to mention is that Cingular/ATT is now rapidly upgrading their network to WCDMA to get faster data rates. Qualcomm is a leader in WCDMA and does sell chips and receive royalties. So, if Apple never plans to upgrade the iPhone to WCDMA, then your arguement would be correct. But, given that the iPhone could greatly benefit from a high speed data connection, logic might say that they would, at some time, move towards WCDMA, as this is what the Cingular network is doing. This would seem to be a benefit to Qualcomm.
(This reader requested anonymity, but was thoughtful and data-driven, unlike many others who suggested I stop blogging altogether because they disliked so much my analysis!)
I agree, that there is a very strong likelihood that Apple’s 3G strategy could include WCDMA, given that they would likely need to work with Verizon to win market share in the foreseeable future. My question, however, remains: Does Qualcomm’s WCDMA royalties compare with what they have in CDMA? Will it be a meaningful substitute financially? And will WCDMA win over and / or be an essential component of 3G/4G GSM in the long run?
It is precisely on this question that the opinion differs. Some say, “Yes, in fact, this is what made Qualcomm a hot stock. The fact that 80% of the world is GSM, but is migrating towards WCDMA, for which Qualcomm has chips and gets the same royalties as CDMA, because the essential patents are the same. Nokia (NYSE: NOK - News) is fighting this hard, but I think some agreement will happen.” Key question to ask: How fast will the GSM to WCDMA transition be? Will it be global? Are Qualcomm’s projections realistic? And will WCDMA be as big a building block of 3G/4G GSM / UMTS?
Morningstar says:
Nokia is trying to obtain a lower royalty rate for the next generation of mobile phones (or 3G WCDMA) by arguing that Qualcomm’s share of the intellectual property (NYSE: IP - News) behind the 3G WCDMA standard is much lower than its share of the IP behind the CDMA standard. In addition, Nokia’s share of the IP behind the WCDMA is second only to Qualcomm and much larger than it was in the CDMA standard. Nokia therefore argues it should be allowed to pay a lower royalty rate on WCDMA handsets. Qualcomm currently receives a royalty rate of between 4% and 5% on the sale of every CDMA- or WCDMA-based handset, with the royalty rate being the same regardless of whether it is CDMA or WCDMA technology.
Qualcomm’s future, therefore, relies on two things: WCDMA winning over GSM (UMTS/HSDPA) as the 3G standard, and CDMA sustaining itself, especially in the emerging markets, continuing to provide a strong royalty stream. (Note: Low-end phones on CDMA will also suffer from lower royalty revenue due to dropping handset prices, but that’s a totally different issue.)
Well, I am a huge fan of IP-Licensing business models. In fact, Qualcomm’s IP Licensing business QTL has an operating margin of 87%, and even if it drops a few points, it is unlikely to drop below 80%. QTL posted revenue of $759 million (34% of total). Whether this business will continue to thrive at the same growth levels or not depends on how the standards war fares in the upcoming years and whether a universal standard emerges in the next 5-7 years.
So what’s iPhone’s role in all this? As another reader points out:
If rumors are to be believed, then Apple tried to pitch the iPhone to Verizon first (which would have been a CDMA product). Only after Verizon walked away, did Apple pursue Cingular with a GSM variant. GSM, of course, also makes the most sense from a global perspective for Apple because it can then leverage the product throughout LTA, APAC and Europe (whereas the vast majority of CDMA subscribers are isolated in North America, Japan, Korea and India). And if Cingular’s exclusive on the iPhone expires, Apple would gladly create a CDMA version if Verizon is willing to commit to volume levels that create a sound business case.
All of the above is true. Apple is not YET in the position to call the shots on standards. If the iPhone becomes a huge success, then they COULD take the position that they would only support one standard, but this won’t be for 3-5 years. Meanwhile, the iPhone needs to establish itself as a Product success first, not just a PR success. Again, lots of IFs.
To end, I believe, that in the 5-7 year window, an opportunity for the market to converge on one standard would arise. If the iPhone does become successful, they would be in a position to drive this standardization, and if the Nokia-Qualcomm situation is any indicator, they would have allies in the market. Those include, at least, Nokia, Eriksson, Motorola, and possibly also Alcatel, Philips and others.
Why? Because, these are the companies who are the owners of the GSM patents, and those amongst them who manufacture handsets, negotiate cross-licensing agreements with each other, and don’t have to shell out the 5% royalty that they do to Qualcomm, if CDMA or WCDMA became the standard.
You can read more of the discussion around the previous article, under comments. And if you participate in the discussion, please refrain from using rude language, and stick to data and logic, but by all means, do feel free to disagree with me.