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Did Qualcomm Really Win?

LR Mobile Column
LR Mobile Column
LR Mobile Column
7/30/2008

You wouldn’t know it by the stock’s reaction last week (up 21 percent in two days), but after looking past the warm and fuzzy press releases, I’m not so certain Qualcomm Inc. (Nasdaq: QCOM) came away a winner in its settlement with Nokia Corp. (NYSE: NOK).

Qualcomm is a company built for the purposes of collecting fees for the use of its intellectual property. Nothing wrong with that from my perspective – it’s good old capitalism. However, when 31 percent of your revenue and 84 percent of your operating profits (fiscal year 2007) come from royalties, it’s incumbent upon management to protect the goose that lays the golden eggs with all its resources.

Qualcomm refers to this process as “business model defense” and has aggressively fought every challenge thrown in its direction for many years. It’s the only company I know that has a Legal Newsroom on its Website just so the fans can keep up with the activity (it can become quite confusing). What’s been rather humorous for the last year or so has been listening to management’s claims of being unfairly attacked by competitors. You would have thought they were the Mother Theresa of the wireless world. But, as predictable as the sunshine, President Steve Altman stated definitively that, “…we remain firmly convinced [of] the validity and strength of our positions and believe that we will ultimately prevail.”

So have they prevailed? I think not, but they’ve certainly lowered their legal bills somewhat.

For most of the last decade Qualcomm was essentially batting 1.000 in the courtroom, and I think most investors were expecting that to continue. It did until it didn’t, when the company lost a United States International Trade Commission (USITC) case with Broadcom Corp. (Nasdaq: BRCM) last year, which resulted in handsets that were using the offending technology being banned from entering the U.S. after a specific date. Achilles had a heel after all. (See Another Hole in the Good Ship Qualcomm.)

Qualcomm’s biggest domestic customer, Verizon Wireless , obviously wasn’t pleased with the outcome or the inability of Qualcomm to negotiate a settlement with Broadcom. Maybe more telling was the licensing agreement struck between Verizon Wireless and Broadcom that would allow Verizon Wireless to continue to import the offending handsets. Qualcomm implied on subsequent conference calls that it was planning to reimburse Verizon for the increased costs incurred in paying off Broadcom. However, this also indicates the degree of animosity between Qualcomm and Broadcom, that they were unable to negotiate anything.

Since that fiasco, Qualcomm has struck out in three more trips to the plate, and in each case it was against Nokia. Last December, an administrative law judge for the USITC announced that Nokia GSM/GPRS/EDGE-only handsets did not infringe three Qualcomm patents. About 90 days later, a U.K. High Court ruled that all of the GSM patents cited by Qualcomm in the complaint against Nokia were invalid. Lastly, the German Federal Patent Court ruled on July 23 that the GSM patent asserted in another complaint against Nokia was also invalid.

After going 0-for-3 against Nokia with its GSM patent assertions and the prospect of a trial with Nokia starting the next day in the Delaware Chancery Court, it’s difficult to conceive of a scenario in which Qualcomm was negotiating from a position of strength.

Ending this circus was certainly the humane thing to do, but the question remains of what impact it will have on the Qualcomm business model. The company has said for most of the past year that the lack of Nokia royalties in FY08 would cost it 25 to 30 cents per share. To put this into perspective, that’s about $500 million to $600 million at the operating line, or about 20 to 25 percent of Qualcomm Technology Licensing (QTL) operating income.

Obviously, the details of the new agreement are confidential, but we do know a couple of aspects of it along with estimates that Qualcomm management provided on its conference call. The agreement covers 15 years and includes a “substantial” up-front payment as well as an on-going royalty. The up-front payment will be amortized over the life of the agreement, commencing with the end of the last contract (4/9/07) and going forward. Given what Qualcomm management knows at this point, they estimate that the Nokia agreement will add anywhere from 7 to 10 cents to FQ4 EPS and in FY09 will add 20 to 28 cents. The FY09 contribution also includes a reduction in legal fees that had been originally forecasted to be “more than $300 million.”

Nokia was by far the biggest legal front for Qualcomm as the two waged battles across two continents. Consequently, it would appear that the Nokia settlement may have saved QCOM as much as 10 cents per share in reduced legal expenses. If that’s the case, it puts the “net” Nokia royalties for FY09 at 10 to 18 cents per share. That’s a far cry from the 25 to 30 cents the company had previously estimated Nokia would have contributed to FY09 in the past.

There’s another assumption that seems to be taken as a given with the settlement – that is, the complaint with the EU Competition Commission will go away. Hey, anything’s possible, but you have to ask, “Why?” Granted, Nokia was the biggest dog in the fight from the so-called Gang of Six: Nokia, Broadcom, Ericsson AB (Nasdaq: ERIC), NEC Corp. (Tokyo: 6701), Panasonic Mobile Communications Co. Ltd. , and Texas Instruments Inc. (NYSE: TXN). Aside from the financial impact, the remaining five have little incentive to fold their tents, given the success others have had at using the EU commission to harass competitors.

At this point, the big question for Qualcomm will be the reaction of existing licensees. With characteristic bravado, Qualcomm’s Altman said, “I would be very happy if those other licensees would accept the package of Nokia's terms and conditions…” That would seem to suggest that Nokia was paying royalties at a rate far higher than its competitors – or Qualcomm’s whistling past the graveyard.

Either way, it’s a dramatic change for Qualcomm. Certainly, they’ve at least opened the door to working more closely with Nokia, and that’s a plus. But the veneer of invincibility has been cracked. The telltale sign of who really won this battle may come in the September quarter. Remember that “significant” upfront payment from Nokia? It should wind up on Qualcomm’s balance sheet in the unearned revenue account. As of June 30, short- and long-term unearned revenue totaled $310 million. Let’s see just how much that changes.

— Bob Faulkner, Special to Unstrung

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