Tero's Column>
Risk - the Qualcomm conundrum
By Tero Kuittinen, Guest Columnist
Last Update: 11:00 AM MT Dec 14, 1998
HELSINKI, Finland - Trade-offs
That's what we buy when we buy stocks - we buy risk. We are willing to share some of
the risks the company will face and in return we get to share the rewards the company
reaps. If any. The choice between a big, steady company and a small, hungry upstart
can be an excruciating one. When you buy shares in a company that has a market cap
between 50-100 billion dollars you basically kiss off any chance of seeing the worth of
your investment climb tenfold. When you invest in a smaller company you get that
chance of finding the next Dell - or the next Wong Computer. In mobile telecom, the Big
Three have now grown past the point where you could call them genuine discoveries any
more. Nokia stands 70 times higher than in 1992. I'm going to go out on a limb here and
predict that it won't repeat that performance during the next six years. So is it smart to
try to find a company that can, conceivably, soar ten or fifty times higher? Or does it
make more sense trust the Big Three and assume that these juggernauts will flatten their
smaller rivals? Let's look at one of the hottest smaller mobile telecom companies around
to try to get a handle on the problem.
Playing the standard game
It's the best racket around the high tech block. You create an industry standard,
leverage your position as its creator, and then you rake in more money than Exxon.
Microsoft did it. Intel did it. And, of course, that is what every company in the mobile
telecom industry wants to do. Problem is, this industry fragmented among competing
digital mobile telephony standards years ago. So being the top dog or even the creator
of one standard is not enough to make you a Microsoft - you have to compete against
different standards as well as other manufacturers within your standard. Different
companies are reacting to this challenge in different ways. Ericsson is refusing to
manufacture any CDMA equipment in trying to protect the global market shares of
GSM and TDMA. Nokia is making CDMA, GSM and TDMA phones to make sure
they keep their number one slot among phone makers, but is focusing on GSM in the
infrastructure side to ensure that it is the leading network manufacturer in at least one
sector (GSM-1800). Motorola is making GSM, TDMA and CDMA phones - and
iDEN and Iridium phones. It is also making both CDMA and GSM network gear.
Meanwhile, Qualcomm is placing all its eggs in the CDMA basket - as they well may,
since they created the modern CDMA standard (IS-95).
The score
How are the strategies developing? Motorola spread itself too thin. By attempting to
simultaneously bring to market during 1998 in USA alone new GSM, TDMA, CDMA,
iDEN and Iridium phones, the company fumbled most of the product introductions and
was forced to push back some models by up to one year. By its hard-line anti-CDMA
stance Ericsson has been able to slow down the spread of CDMA in Asia, perhaps
even keep it out altogether from China. This would be a major strategic victory - but it
comes at the price of a steep loss of US handset market share, to which the lack of
Ericsson CDMA phones is contributing. Nokia hit the sweet spot during 1998 - they
had genuinely impressive GSM and TDMA phones at the market, supported by
tolerable CDMA phones. The combination seems to have boosted them to 40% US
market share during the first nine months of 1998. On the network side, Nokia's narrow
focus has worked within the limits of the plan - they now pretty much own the
GSM-1800 market. The idea is that it's better to be number one in one network market
than a laggard in several - and Motorola's disastrous performance in trying to straddle
both CDMA and GSM markets seems to bear this out. It looks like in handsets,
partaking in several (though not necessary all) standards is a bright idea - but in
infrastructure manufacturing, getting entangled in too many webs allows narrow-focus
companies to gain an advantage. In mobile phones, you can share a lot of design work
and components among different standards - but in infrastructure manufacturing the
synergy benefits seem elusive.
Qualcomm's dismal digital handset market share performance during 1998 is a textbook
illustration of the problems small company faces when competing in a crowded high tech
field. Since they are exclusively CDMA they have to bet that A) CDMA will do as well
against other digital standards as expected and B) Qualcomm can hold its own among
companies manufacturing CDMA equipment. The initial 1998 market share information
from USA would seem to indicate that both bets are looking iffy. Qualcomm's plunge
from 17% share in 1997 to 8% in 1998 tells us that being the creator of a standard does
not automatically translate into solid performance. Problem is compounded by the fact
that USA is the only major handset market for Qualcomm. Dataquest's contention that
TDMA has so far actually grown faster than CDMA in 1998 is highly surprising and
spells trouble for the entire CDMA phone market. Many companies piled into making
CDMA phones, because they anticipated an imminent break-through in China and
superior performance in USA. Now that both projections are suspect, suddenly the
TDMA market in USA and the GSM market in China look much bigger than was
previously thought. Companies that crowded into CDMA phone field are fighting over a
suddenly shrunken pie, while companies specializing in GSM and TDMA face less
competition and a bigger pie, thanks to the big bets Sony, Samsung, LG and other Asian
companies have placed on CDMA phone manufacturing.
Size and age matters
Qualcomm's handset problems can be traced to both problems associated with CDMA
as a standard and the small size of the company. Creating a new standard may be a
license to print money - but only if the standard takes over. CDMA is competing with
two much more mature digital standards in USA and many other countries - TDMA and
GSM. GSM was launched in 1992 and as a result can now pack more features into
phones than the newly hatched CDMA. Nokia's GSM phones are pushing 250 hour
stand-by times - CDMA phone is extraordinary if it can hit even 100 hours. The weights
of GSM models tend to be lower than in equivalent CDMA models. All that money
poured into GSM R&D is now creating models with distinct, novel design solutions - a
variety of shapes, colours, user interfaces, electric games, easy text messaging, etc.
During 1998 the development of the CDMA phone field was curiously sluggish.
Motorola kept pushing back its CDMA Startac (which is highly derivative to start with),
Nokia pushed back the introduction of its 61xx CDMA phone into 1999, Qualcomm
had troubles getting its new Q-phone into Christmas market in volume - the phone was
initially slated for late summer. None of these phones is truly groundbreaking, even when
they finally arrive in shops. The enormous R&D advantage of GSM and even TDMA is
slowly but surely grinding down CDMA's image among consumers.
Last Chance Saloon
A special reason for concern for Qualcomm is the aging model line-up the company is
now stuck with. Qualcomm's first small model, the Q-phone, flopped due to various
pricing, quality and engineering issues. The next generation Q-phone is now arriving in
shops and probably presents the last chance for this company to make its mark as a
handset manufacturer. While the company concentrated on Q-phone development, it
allowed its other models to age. This is a small company dilemma: when so much
attention is focused on creating one hit product, the rest of the product line can become
obsolete and then everything rests on one bet. Qualcomm's double headache of other
CDMA manufacturers and the sizzling growth of GSM and TDMA leaves it in a
precarious position. I think it was a big risk to pattern the Q-phone so closely after
Motorola's far better known Startac. Qualcomm took the battle into Motorola's
backyard and invited consumers to make direct comparisons. This is not a smart move,
when the technical specs of your product are inferior. The vastly better stand-by time of
CDMA Startac alone will pose an immediate problem for Qualcomm. Nokia's imminent
launch of CDMA 61xx is pretty scary as well - this model is the hottest-selling digital
phone in US history in its GSM and TDMA incarnations. The consumer awareness for
the model-line is good and there is already a built-in market formed of people waiting for
a CDMA 61xx. Meanwhile, Asians keep charging in.
So what?
About half of the readers are asking this by now. So what if Qualcomm hits a wall in its
attempts to become a digital phone manufacturer? It still gets licensing revenue from
every single CDMA phone sold in the world. It still sells infrastructure and does plenty
of other interesting things. Here's what: you have no idea how expensive handset
manufacturing is. Very few people do. That is why it was such a shock when Philips
announced that its handset division will rack up half a billion dollar loss in 1998. This
industry is a maelstrom that sucks in hopeful companies and spits out wrecked profit
growth projections. Making mobile phones was just a small part of Philips - it just
happened to be a hideously expensive, small part of Philips. Qualcomm is steaming
ahead with some of the most ambitious, costly projects around - like their new
smart-phone. This company has sold itself to investors as a handset manufacturers and
its growth projections rest on the assumption that it can ride a 100%-plus growth of
CDMA handset market. If all this does not jell, rest assured that the stock price will
suffer. Managing growth in handset production is a high-wire act that can easily plunge a
company with sudden, massive losses if the inventories pile up. Halving your market
share during the breakthrough year of American digital phone market is not a good early
sign.
Nokia is selling close to 40 million phones this year - the giant competitors of Qualcomm
have reached such economies of scale that it will be close to impossible for this company
to match them in pricing and make a good profit. It has to do more than that - it has to
match them in pricing, create additional value that will win over consumers and
simultaneously close the quality gap that now leaves Qualcomm with some of the worst
weight/standby time ratios in the civilized world. Tall order, when their R&D budget is a
fraction of Ericsson/Motorola/Nokia triumvirate average.
El Dorado
This is why people who invest in small companies deserve the 50-fold returns they
sometimes get. Because most of the time, the small companies facing steep odds simply
crumble. The reason why Nokia and Ericsson beat those odds back in 1990-1995 was
that they arrived in a new industry just as it was taking off - at the time big companies
simply did not want to risk making mobile phones, because there were no guarantees
that anyone would buy them. Arriving at the phone scene now is infinitely riskier. This is
the time when everyone wants to make phones - and the competition includes
companies that have a ten-year head start.
I would argue that for people wanting to make huge financial killings the future is now
somewhere very few of us realize. Just like back in 1990 everybody thought that the PC
industry was the best place to invest in and mobile phones were seen as yuppie oddities.
For people willing to accept 30-50% annual returns Ericsson, Nokia and Motorola are
intriguing possibilities. For people wanting much, much more, the mobile phone industry
is yesterday's news. You missed the gold rush by a decade. So did I, but I'm not
whining. I'm no conquistador and for me, a fair likelihood of 40% annual returns during
next 3-5 years are plenty enough. If you need more excitement than that, perhaps the
stock market is not the right place to look.
The case for Qualcomm
Just to make things that much more interesting, there *is* a joker in the pack.
Qualcomm is claiming that it has the blocking patents with which it can derail the launch
of the third generation digital standard for mobile telephony that is being developed to be
the successor standard for GSM. Nokia, Ericsson, NTT-Docomo and several Japanese
companies have spent hundreds of millions of dollars to develop W-CDMA. It is
scheduled to be launched in Japan during the spring of 2001 and in Finland soon after.
Massive implementation in Europe, China and other GSM strongholds is expected after
that. This is the standard that is supposed to finally unite Europe, China, Japan, Korea
and other major mobile telecom markets.
Apparently Qualcomm does have a case when it says that this standard may need
Qualcomm's IPR. Ericsson claims that the Qualcomm patents are not necessarily needed
- but nobody is sure whether to believe Ericsson on this point. The fact that Ericsson has
been forced to offer a compromise solution for W-CDMA chiprate would seem to
indicate that Qualcomm may hold the upper hand here. Qualcomm is demanding that
W-CDMA is to be made compatible with IS-95 - so that both GSM and IS-95 would
have an easy upgrade path to W-CDMA. Plus substantial licensing fees.
Frankly - I'm out of my depth here. Nobody seems to know what will happen if
Ericsson and other W-CDMA creators try to get W-CDMA implemented without
Qualcomm's consent. Can Qualcomm block the whole project, costing the companies
involved huge sums of money? Can they demand high licensing fees from every single
company producing W-CDMA equipment or cn the international bodies force
Qualcomm to accept licensing fees in line with those received by Nokia and Ericsson for
developing W-CDMA.
The experts seem to disagree on this. It is possible that this single issue may redeem
Qualcomm for all its manufacturing sins and shortcomings. If Qualcomm can get its way,
the stock may skyrocket practically overnight as investors suddenly realize that
Qualcomm will become the gatekeeper of the next generation mobile telephony standard
intellectual property rights. I will try to address this issue in greater detail in the upcoming
W-CDMA column.
As an investor, I'm betting that whatever happens with the W-CDMA debacle, the
companies capable of profitably manufacturing complex, highly sophisticated mobile
handsets now will also benefit most in the W-CDMA competition. Packing live video in
a handset will tax the technological prowess of any company to its limits. But it is just
possible that even though Qualcomm may not succeed in the handset business, it can
leverage its patent portfolio into a formidable money machine. If it can exit the phone
business cleanly or carve itself a niche as a specialty company it could the just lay back
and watch the licensing fees pour in. It's a highly unusual strategy. But just because
nobody has made it work in the mobile telecom business before does not mean it is
impossible to implement.
This is a matter of faith for investors - do they find Qualcomm more credible than
Ericsson? A couple of months ago I would have said this is a no-brainer, but the recent
developments have made this a rather thorny question <TK>.
I appreciate any feedback and try to address issues you raise on the Q&A
page.
Tero Kuittinen
Tpkuitti@operoni.helsinki.fi
Tero Kuittinen's next column will discuss the Chinese mobile telecom market.
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