Qualcomm Investors Survive Telecom Bust, Bank on Cellular Boom
By Anthony Effinger
San Diego, Aug. 24 (Bloomberg) -- Finding a good investment in telecommunications
equipment these days is like unearthing an undamaged part on a wrecked Porsche Boxster
at the junkyard.
The once-hot industry has hit the wall. Makers of fiber- optic components, cellular phones and
networking gear have plunged from record highs set last year.
JDS Uniphase Corp., the biggest manufacturer of optical parts for communications networks,
immortalized the crash in July, when it reported the largest full-year loss in U.S. history: $50.6
billion. The San Jose, California-based company and its competitors have announced plans
to shed more than 100,000 jobs.
Investors may find that Qualcomm Inc. is one remnant of telecom's joyride that's worth
scavenging. The San Diego company makes semiconductors for cell phones and develops
patents on the radio wave technology that runs them. It hasn't fired a single one of its 6,500
employees this year. And its stock, which closed at $62.95 yesterday, has risen 12 percent in
the past year. Compared with a 79 percent plunge in the Standard & Poor's
Communication-Equipment Manufacturers Index, that's a rally.
``This is the only technology stock I own that's up in the last 12 months,'' says Howard Ward,
manager of the $3.5 billion Gabelli Growth Fund, which holds 1.2 million Qualcomm shares.
Patent Power
What sets Qualcomm apart? Its patents. The company collects a royalty from manufacturers
on about 12 percent of all cellular phones made worldwide, and some analysts expect that
figure to climb much higher.
``We are believers in this company,'' says Dominic Vignola, an analyst at the Merrill Lynch
Global Technology Fund, which has 2 percent of its $1.5 billion invested in Qualcomm stock.
Vignola says that by 2004, Qualcomm could be collecting a royalty on every cell phone sold.
Other investors say it's no sure bet that cell phone operators will adopt Qualcomm technology
or that the company will shed its habit of making overoptimistic projections about its position
in the marketplace. ``Management's guidance is almost useless,'' says Ed Snyder, an analyst
at J.P. Morgan Securities Inc.
Qualcomm receives a fee every time a manufacturer ships a phone that uses code-division
multiple access, or CDMA, a World War II technology that Chief Executive Irwin Jacobs
patented for cellular phone systems in 1990. CDMA systems carry more calls than others
because CDMA dices up voice signals and pumps them over a bigger piece of radio
spectrum. CDMA royalties have a profit margin of about 90 percent before taxes and
account for a third of Qualcomm's $2.8 billion in annual revenue.
``Our patents are very strong,'' says Jacobs, 67, a 6-foot, 2-inch engineer with a passion for
contemporary art.
Coming to Terms
In July, after two years of negotiations, Nokia Oyj, the biggest cell phone maker, said it
agreed to pay Qualcomm royalties on two new versions of CDMA called WCDMA and
CDMA2000. AT&T Wireless Services Inc. in the U.S. and Vodafone Group Plc in the U.K.
are among the carriers that plan to use one version or the other for networks they say will
provide videoconferencing, Internet access and better voice quality.
Nokia was one of the last phone makers holding out on paying Qualcomm for the new
technologies. The question is how soon Vodafone and the other carriers will build the new
systems, says Snyder. He says the networks will be late -- if they're built at all -- because of
high costs and technical hurdles. Snyder calls WCDMA ``Iridium light,'' referring to the
wireless company that went bankrupt after spending $7 billion and launching some 72
satellites.
Today's Laggard
These days, CDMA is an also-ran to GSM -- Global System for Mobile Communications -- a
standard that's used by about 66 percent of mobile phone owners, according to EMC, a
researcher in Walton-on-Thames, England. If carriers decide on less costly updates to their
existing GSM networks and never embark on WCDMA, Qualcomm will remain a laggard.
First Union Securities Inc. analyst Mark Roberts estimates that Qualcomm collects royalties
that amount to 5 percent of the wholesale price of a CDMA phone. If Samsung Electronics
Co. sells a CDMA phone to Sprint Corp. for $200, Qualcomm gets $10, at least in theory.
Qualcomm spokesman Richard Tinkler says the company won't disclose its royalty rates, nor
will anyone say why they are secret. By not revealing the rates, Qualcomm is able to keep
customers for its patents in the dark when negotiating new contracts.
About half of Qualcomm's revenue comes from semiconductors, whose pretax profit margins
are a more mundane 23 percent. The beauty of Qualcomm's business is that customers pay
the licensing fees for CDMA regardless of whose chips they use -- Qualcomm's or someone
else's. The rest of Qualcomm's sales come from a satellite-based long-haul-truck-tracking
system called OmniTracs.
Qualcomm reported a loss of $274.7 million in the quarter ended July 1. The loss included
charges of $241 million for investments in a Brazilian phone company that Qualcomm deems
to be at risk. Sales fell 10 percent to $640 million. Jacobs said in the earnings statement that
he expects sales and earnings to rise in fiscal 2002, which starts on Oct. 1.
Prone to Surprises
Gabelli's Ward says Qualcomm is prone to surprises in part because its future hinges on
contracts in such unpredictable markets as China and South Korea.
Qualcomm's stock, which rose 27-fold in 1999 to make it the Standard & Poor's 500 Index's
best performer, lost a quarter of its value in two days in June 2000. The shares tumbled after
Bear, Stearns & Co. analyst Wojtek Uzdelewicz cut profit forecasts by 3 cents to $1.05 a
share for the year ending that September. Uzdelewicz acted because South Korea, one of
Qualcomm's largest markets, had banned cellular carriers from subsidizing phones.
Qualcomm's beta -- a measure of how much a stock fluctuates compared with the S&P 500
-- was 1.73 yesterday, meaning that its shares are almost twice as volatile as the index.
That's higher than even the struggling Lucent Technologies Inc. at 1.58 and Tellabs Inc.,
another equipment maker, at 1.31.
``To be comfortable with this stock, you have to trade it every day or put it away and look at it
twice a year,'' says Gabelli's Ward. ``It's so volatile, you'll drive yourself crazy.''
Tight-Lipped
Getting information from the company can be difficult, says Snyder at J. P. Morgan.
Qualcomm doesn't make public its chip prices like Intel Corp. and others do. Nor has Jacobs
said who will succeed him as CEO. His son, Paul, 38, is heir apparent after a promotion in
July to president of a unit that includes the licensing business. Don Schrock, 56, who came to
Qualcomm from Hughes Electronics Corp., will continue managing the chip business, his job
since 1996.
Jacobs is prone to unpredictable actions that require patience to understand, First Union's
Roberts says. The patent negotiations with Nokia are a case in point. The two companies
signed an agreement in 1992 giving Nokia the right to patents for cdmaOne, the version of
CDMA that's in use today. Then, in 1999, negotiators began discussing WCDMA and
CDMA2000, the technologies for new networks.
Qualcomm Executive Vice President Steve Altman met with Heikki Huttunen, Nokia's vice
president of licensing -- mostly in San Diego, New York and Helsinki. The sticking point, says
Nokia spokeswoman Megan Matthews, was figuring out which Qualcomm patents applied to
WCDMA. Nokia and other companies also had patents on WCDMA.
Nokia had some leverage on the patent front: Qualcomm's chip unit needed Nokia's patents
to make chips for phones that work in today's GSM systems. ``Nokia was trying to bend
Qualcomm over a barrel,'' Roberts says.
Spinoff Strategy
Jacobs devised a way out. On July 25, 2000, he said he planned to spin off Qualcomm's chip
unit. He said he would give the new company enough of Qualcomm's almost 600 patents to
horse- trade with Nokia for the technology the chip business needed to make GSM-based
phones. Most of the patents would stay with Qualcomm, and Jacobs would keep exacting
payment for them.
As the talks progressed, analyst Tim Long at Credit Suisse First Boston and others figured
Qualcomm would never get the same royalty rate for WCDMA as it got for cdmaOne, the
version of CDMA that Nokia licensed in 1992. ``It could be in the 2 percent to 3 percent
range for WCDMA,'' Long said in June, down from the 5 percent he figured Qualcomm got
for cdmaOne.
Then, on July 3, Qualcomm and Nokia announced they had extended their 1992 agreement
and that Nokia would pay Qualcomm royalties at the same rate it had been paying.
Qualcomm also got the right to use Nokia's GSM patents. Few people know what was in the
1992 agreement, so saying the new rate was the same disclosed nothing.
The 10 percent gain in Qualcomm's stock that day, compared with a drop in Nokia's, shows
that many investors believe Qualcomm did well. ``Nokia totally capitulated,'' says Roberts.
Three weeks after the agreement was announced, Jacobs withdrew plans for the chip
spinoff, saying he had secured the patent rights the unit needs.
Roberts says the threat of the spinoff worked as planned because the move was designed to
bring Nokia and others to heel. They gave in because they realized that dealing with one
Qualcomm was better than dealing with two, he says. ``Qualcomm upped the ante, and
everybody folded.''
The question now is what Qualcomm has won. Potential customers, slated to build
high-speed cellular networks, are $650 billion in debt, according to Merrill Lynch & Co. It will
cost another $250 billion to put up WCDMA networks in Europe alone. John Brewer, a
Portland, Oregon, consultant to wireless equipment companies, predicts Europe will stop
short of WCDMA and stick with the lower-cost upgrades once viewed as stopgaps.
``Qualcomm better not bet the mortgage on this one,'' he says.
Jacobs agrees that WCDMA isn't likely to arrive until 2004 or 2005. He's pushing
CDMA2000, the variant that Qualcomm developed in-house and that carriers are installing
today. Sprint's PCS Group, the No. 4 U.S. mobile phone carrier, says it will spend $800
million to update to CDMA2000 before the end of next year.
Too Confident?
CDMA2000 doesn't solve all of Jacobs's problems. So far, the only carriers committed to it
are existing CDMA customers, such as Sprint. Almost every GSM carrier, including
Vodafone, has chosen WCDMA. Jacobs says he'll win no matter which variant customers
pick. ``The whole world is going to CDMA,'' he says.
Such confidence has gotten Jacobs in trouble before. Some companies say he promised
technology on deadlines he couldn't meet. ``What bothers us is the routine overpromising,''
says Jim Grams, a vice president at AT&T Wireless. He considered CDMA for McCaw
Cellular Communications, which AT&T Corp. bought in 1994. When he asked for delivery
dates for equipment, Qualcomm hemmed and hawed, he says.
Jacobs says CDMA has done everything he said it would. The former engineering professor
from the University of California, San Diego, started Qualcomm in his house in 1985. He
dusted off CDMA after realizing that the features that made the technology secure during
wartime could make radio waves carry more calls.
In 1989, Jacobs claimed that CDMA could provide 40 times the capacity of analog systems
then in use. Later, he reduced the forecast to 10 or 20 times. It took three years to sign his
first client, U S West Inc. in Denver. Another customer, AirTouch Communications Inc., had a
year of delays putting CDMA in Los Angeles. It went live in May 1996.
Delays aside, Jacobs has managed to make CDMA a contender. Now, he may have one of
the most profitable niches in telecommunications, thanks to strong patents and a willingness
to go to the brink to protect his royalties. With that reward come new risks, says First Union's
Roberts. Jacobs's victory in the Nokia talks makes Qualcomm a standard-bearer for the
wireless industry.
``If [the new networks] don't take off, Qualcomm stock will suffer,'' says Roberts. For investors,
that would mean another trip to the junkyard.
bloomberg.com
ROC
(Voluntary Disclosure: Position- Long; ST Rating- Strong Buy; LT Rating- Strong Buy)
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