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Qualcomm's Profit Driver Under Pressure

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Updated April 13, 2015 7:36 p.m. ETOne Saturday night in February, Qualcomm Inc. QCOM -0.62 % arra...

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Qualcomm's Profit Driver Under Pressure

  1. 1. Qualcomm's Profit Driver Under Pressure Updated April 13, 2015 7:36 p.m. ET One Saturday night in February, Qualcomm Inc. QCOM -0.62 % arranged for documents to be slipped under the doors of a select group of guests at the New Orleans Hyatt Regency. The spiral- bound folders, according to one recipient, contained articles aimed at swaying an influential industry group in a hard-fought debate over technology patents. The chip maker's last-ditch maneuver, the culmination of a lobbying campaign that included ads, op- eds and a website, failed. Directors of the Institute of Electrical and Electronics Engineers, which establishes standards governing communications products like Wi-Fi routers, voted the following day for policy changes that could weaken the ability of Qualcomm and other big holders of technology patents to set lucrative royalty rates. Decisions by groups like the IEEE have played a key role in the fortunes of Qualcomm, whose unusual business model was thrust into the spotlight this week by the actions of an activist investor. Qualcomm, founded in 1985, is the biggest maker of chips used in smartphones. But the San Diego- based company has also parlayed its pioneering role in cellular technology into a patent-licensing business that generates most of its profits. Qualcomm charges a royalty on nearly every smartphone made, whether or not the device uses its chips. As a result, Qualcomm has reaped more than $50 billion in licensing revenues since 2000. But investors like Jana Partners LLC aren't satisfied with Qualcomm's $114 billion valuation. The hedge fund has invested $2 billion in Qualcomm's shares, and on Monday suggested options such as a spinning off the chip business to unlock more shareholder value. Some investors see more trouble ahead from owning both patent and chip businesses, a combination that helped fuel a series of antitrust investigations and played into the unusually intense debate at the IEEE last February. The organization's decision didn't affect Qualcomm's current licensing business. But its new policies run against the core principles of the revenue engine that Jana sees as the source of Qualcomm's future value. Arrayed against Qualcomm in the IEEE vote was a cadre of competitors and customers including Intel Corp. INTC -0.63 % , Apple Inc., AAPL -0.20 % Microsoft Corp. MSFT 0.10 % Samsung Electronics, 005930 -0.34 % and Cisco Systems Inc. CSCO -0.21 % They hope to convince other standards groups to change their policies in ways that could reduce royalty fees on technologies essential to ubiquitous consumer products like smartphones. The outcome of IEEE's February vote left Qualcomm executives feeling stung. They say opposing forces hijacked the group's deliberations. "A small, exclusive group of companies stacked each of the different rungs in the decision-making process," Sean Murphy, Qualcomm's vice president and counsel for international government affairs, said in an interview shortly before the final IEEE vote.
  2. 2. Qualcomm's opponents denied the accusation. "The implication that somehow we gamed this system is incorrect," said Chuck Mulloy, an Intel spokesman. "We worked through the process." Qualcomm's royalty stream is attributable largely to its success in working with standard-setting organizations like the IEEE. The company pioneered an innovation chosen in 1999 by the International Telecommunication Union as part of third-generation, or 3G, cellular networks. Qualcomm typically charges makers of 3G devices--and 3G-compatible 4G models--up to 5% of their products' wholesale price; say, $20 on a $400 phone. Steve Mollenkopf, Qualcomm's chief executive officer, defended the formula, noting that Qualcomm often spends billions developing technology before standards are set and royalty payments start rolling in. "It's actually a screaming good deal," he said in a recent interview. But Qualcomm's practices have prompted harsh scrutiny, including a 15-month investigation in China for antitrust violations. The day after the IEEE decision, the company announced a settlement that would trim its royalty formula there and agreed to pay a fine of nearly $1 billion. Mr. Mollenkopf looks forward to a new period of stability in China. But the company still faces government probes in the U.S., Europe and South Korea. The formula's opponents say the royalties on feature-laden mobile devices can combine into a crushing burden. Apple and others have objected to calculating royalties as a percentage of handset prices. Smartphones, they argue, derive much of their value from features other than cellular connections. Big licensees want industry groups to press patent holders to limit potential royalty rates before their technologies are chosen as standards--rather than wait until the choice increases the value of their patents. "This should be uniform across the industry," said Mark Chandler, Cisco's general counsel. "It really is a matter of simple fairness." The IEEE studied such issues during a debate that stretched over nearly two years, ending in a closed-door board vote at the New Orleans hotel on Feb. 8. Long-standing IEEE rules encourage companies to promise to license their patents on a "fair, reasonable, and non-discriminatory basis." Such voluntary pledges can affect whether standard- setting committees choose a particular technology. But the IEEE didn't define what reasonable meant, leaving companies to set terms through negotiations. WSJ.D WSJ.D is the Journal's home for tech news, analysis and product reviews. The new IEEE policies for the first time link "reasonable" rates to the "smallest saleable implementation" of a technology. That phrase points to applying royalty percentages to the price of chips that carry out a particular function--components that may cost a 10th as much as an entire
  3. 3. handset. Another change discourages patent holders from seeking court injunctions against companies that implement inventions adopted as standards, limiting a tactic patent holders have used to pressure companies that refuse to pay royalties. Patent-rich companies such as Qualcomm, Ericsson, Nokia Corp. NOK 2.98 % , Alcatel-Lucent SA ALU 7.67 % and InterDigital Inc. IDCC -1.01 % bitterly opposed the IEEE's new policies. They assert that Intel and others conspired to manipulate the group's processes and ignored hundreds of their suggestions. "We were taken by surprise," said Gustav Brismark, Ericsson's vice president of patent strategy. IEEE officials say the process was fair. "There was plenty of opportunity for discussion and dialogue," said John Kulick, who chairs the IEEE standards board. IEEE officials also note that members of the group are expected to vote according to their own opinions, not those of their employers. Intel and other proponents link the changes in part to ideas voiced by a Justice Department official in 2012. Patent holders, in turn, are quick to point out that an IEEE member who worked for Intel brought those ideas to a key committee that oversaw the policy changes. At a meeting in June 2014, the Intel employee voted with members affiliated with Apple and Microsoft to approve the policy changes, outvoting members employed by Ericsson and Alcatel-Lucent. Qualcomm wasn't immediately affected by the latest IEEE changes. That is because its royalties flow from standards set by other groups. Those bodies haven't changed their policies, despite lobbying by the likes of Intel and Cisco. But the changes could affect Qualcomm's future licensing royalties. The IEEE is extending Wi-Fi, evaluating technology from Qualcomm and others. The group may also help define upcoming 5G cellular services. And its new policies may influence similar organizations to follow suit. For now, Qualcomm doesn't plan to comply with the IEEE's revised rules, which remain voluntary, says Qualcomm President Derek Aberle. He foresees no negative consequences. But Mr. Aberle worries that litigation might ensue if the IEEE were to reject technology submissions from companies that didn't comply. "There will be a number of companies that would be very concerned about that," Mr. Aberle said. Write to Don Clark at don.clark@wsj.com http://www.wsj.com/articles/qualcomms-main-profit-driver-is-under-pressure-1428967051?mod=rss_ markets_main

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