Qualcomm's Royalty Revenue In Question

 Qualcomm's Royalty Revenue In Question
Lisa DiCarlo, 07.26.00, 1:40 PM ET

Qualcomm's spinoff of its chipset business yesterday leaves behind an intellectual property company almost completely dependent on the licensing of its cellular technology for revenue growth.

It's a strategy that's worked wonders so far, but without its market-leading chipset business to bolster sales, it's questionable whether Qualcomm's qcom (nasdaq: qcom - news - people) patents are broad and deep enough to continue extracting royalty and licensing fees from cellular handset companies.

Founded in 1985, Qualcomm was instrumental in developing CDMA (code division multiple access), now a standard for the delivery of digital cellular transmissions. If a company wants its cell phones to work in North America, it has to talk to Qualcomm. Giants Nokia nok (nyse: nok - news - people), Motorola mot (nyse: mot - news - people), Ericsson ericy (nasdaq: ericy - news - people) and others have done just that, paying Qualcomm a fee on every phone they sell.

The company won't disclose royalties, but Prudential Securities telecom analyst Pete Peterson estimates that Qualcomm collects about 4% of the price of every cell phone sold.

Qualcomm collected royalties and licensing fees because it claimed ownership of very broad first- and second-generation CDMA patents. "Qualcomm was unusually successful in collecting royalties on narrowband CDMA because everyone needed to agree to pay [to speed up] their time to market for CDMA phones," says Charles DiSanza of Gerard Klauer & Mattison.

"PacTel and Bell Atlantic, for example, were very much in favor of it because they had congestion problems with TDMA," an earlier standard, he says.

Now the third generation of cellular infrastructure, known as 3G, is being developed and Qualcomm's lock is not as solid. Dubbed W-CDMA, it will eventually replace CDMA and GSM, the European standard. Dozens of companies have contributed intellectual property (IP) to W-CDMA, which could easily dilute the revenue stream Qualcomm collects from CDMA royalties. Qualcomm disputes this and says its CDMA patents are broad enough to cover crucial pieces of W-CDMA.

The stakes are enormous, especially when one considers that the standard will be used not only for cell phones but also for the tons of forthcoming gadgets that will offer wireless Web access.

Qualcomm has already signed up Hitachi, Toshiba and Sanyo to license IP related to W-CDMA. But big players like Nokia and Motorola have not licensed Qualcomm's W-CDMA. In fact, Nokia suggests that it will not capitulate.

"It remains to be seen what the intellectual property really is and how it applies," says Nokia spokeswoman Megan Matthews. "There are dozens of companies that hold W-CDMA patents. The future can play out a lot differently than existing CDMA" royalty agreements.

Ericsson, which settled a two-year legal battle with Qualcomm by cross-licensing patents, hints that it is not completely beholden to Qualcomm.

"They don't have a monopoly at all on CDMA patents," says Kathy Egan, a spokeswoman for Ericsson.

Maybe not, but Nokia, Ericsson and NTT DoCoMo have already challenged the validity and breadth of Qualcomm's CDMA patents. Last week, Japanese and European IP courts upheld all Qualcomm's patents. Motorola challenged Qualcomm's patents in Korea, where the vast majority of the patents were also upheld.

"We have broad patents for any type of CDMA," says Don Schrock, who will become president and chief operating officer of the Qualcomm chip spinoff, temporarily called Spinco. He says they'll collect the same royalties for W-CDMA patents as CDMA.

But that logic seems fuzzy. How can Qualcomm collect the same royalties and fees when so many companies have developed pieces of W-CDMA?

Prudential's Peterson says that perhaps a pooling of IP will occur. Under this scenario, a European organization would collect all the IP that makes up W-CDMA and based on each company's contributions, divvy up the royalty structure.

Whether that happens is still up in the air. What is clear is that W-CDMA deployment is coming fast. NTT DoCoMo is intent on having 100,000 W-CDMA phones in use in Japan by the end of 2001. With deployment closing in, Peterson says that companies will have no choice but to pay Qualcomm.

"We're starting to see the timing of the market put pressure on [cellular handset] players to cut deals with Qualcomm," he says. "If you want to play there, you have to get a license. That's why it's such a high profile stock."

Indeed, Qualcomm was one of the best performing stocks last year, bringing investors a return of over 2,400%. It's since come back to earth--down to $67 off a high of $200--on concerns about worldwide adoption of CDMA. While executives insist the company has just as lucrative an opportunity with 3G, some analysts aren't convinced.

"Qualcomm is overvalued with respect to what they can collect on W-CDMA," says DiSanza.

The greater opportunity may be in Spinco, which will sell chipsets for cellular handsets. Peterson says Spinco has sold about 100 million chipsets, ten times as many as all its competitors combined. Qualcomm Chief Executive Irwin Jacobs says that the chip division had sales in 1999 of just under $1.1 billion and earnings of $360 million.

Qualcomm Classic--that is, the licensing company--has a very similar financial picture, with just over $1.1 billion in sales and $660 million in earnings.

As long as Qualcomm is in the position of collecting royalties and licensing fees, revenue will continue to grow with the demand for cellular communications. But if, as some expect, Qualcomm's broad CDMA patents are not adopted globally and upheld by IP courts, royalty and licensing revenue will be harder to come by in the long run.