Breakthrough Ideas (continued, with [additions] in square brackets)
Profit Models.
I added License/Royalty Profit to Slywotzky and Morrison’s 22 profit zone models because licenses and royalties accounted for the majority of Qualcomm’s revenues, 59% in FY’01, at an operating margin around 88%. I believe the exceptional profitability of this model is evident.
De facto standard profit benefits from increasing returns to scale. In addition to royalties, the more OEMs, developers, operators, and end-user are drawn into using the 3G CDMA standards, the larger the network effect, usually generating a parallel increase in margins on MSMs in particular, which are currently about 29%. Whether cdma2000 or UMTS becomes the worldwide de facto standard (or how they divide market share) obviously impacts ASSP sales, but not licensing fees or royalties.
Installed base profit is dependent on growing a large installed base. Qualcomm benefits from installed base profit in the move from 2G to 3G. Each significant upgrade in performance or each expansion in features like BREW, position location, or multimedia help drive CSM-infrastructure or MSM-handset replacement sales. After-sales to carriers and end-users are a source of continuing profit.
[The Consumer Electronics Model creates cycles of rapid handset replacements in the 3G-installed base. These profits derive from any module interfacing with the platform that augments the CDMA offering. For example, predictions are that digital cameras will become a feature in 92% of handsets the next year or so. A module, like a camera, a camcorder, or an MP3 player, adds profits for Qualcomm that, aside from the connectivity and the integrating features in their interfaces, are not primarily based on improving normal trajectories of performance in CDMA RF or in QCT’s ASICS. Rather, the advance of these modules enabling digital media are following their own performance trajectories in, say, miniaturization, image capture, digital compression, or image presentation (e. g., color screens). As new dimensions of performance that benefit from connectivity, they augment the platform and drive replacement sales. This augmentation from modularity along their distinct but normal trajectories of performance include many features from the UI, connectivity, and applications that cannot yet be even imagined. Thus, we cannot estimate their market values. You cannot determine the net present value of the unimaginable, but you know from the history of innovations that unsuspected killer applications emerge. The handset is the “razor,” the augmenting hardware and software modules are the “razor blades” that accelerate profits.
Also, the MSM6300 (and other world phones) will begin to encroach on the GSM installed base because of their potential for roaming or for providing data alternatives to GPRS. The Qualcomm and Asian OEM first-mover advantage produces superior features, like position location, the Internet Launchpad, and BREW-distributed applications, that will drive both replacement sales and consumer desires, preferences, and ultimately needs. Thus, consumers will come to demand such advanced features that require spectral efficiency that can be satisfied only by Qualcomm’s UMTS or CDMA2000 set of complete standardized solutions. Not only will the pie grow ever larger, the appetite for more flavor in the slices of the connectivity pie waxes. Qualcomm’s royalty profits and de facto standards profits grow proportionately, until critical mass occurs, inflecting the dynamic offscale, creating disproportionate increasing returns to scale.]
Similar to the PC business, in mobile wireless, value chain profit concentrates itself in microprocessors and the software incorporated into ASSPs. If BREW is successful, it will profit from its position as a virtual marketplace, distributor, and service as the runtime environment for application software. There is a large potential upside here.
In the time profit model, using Intel as an example, the first mover advantage allows the innovator to generate excess returns before imitators begin to erode margin. The key is to maintain a two-year lead, according to Slywotzky and Morrison, because the majority of profits occur in the first few quarters (in the PC business). However, Qualcomm has proven to be more difficult to imitate, maintaining its uniqueness by holding about 90% share in the 2G CDMA market, and with 1X it is still increasing market share. The RF aspects of spread spectrum were not in, say, Intel’s learning base, and, over time, Motorola and Lucent used more CDMA chips. Along with Ericsson, they choose not to compete with QCT in designing 3G chipsets.
[Some of Qualcomm’s time-profit follows from first-mover advantages, some from its proprietary but openly licensed intellectual property, and some from it integrated learning base in spread spectrum and ASIC design. Asia leads the worldwide handset race to advanced data features, and Asia is taking market share].
QCT also benefits from experience curve profit. With its experience in designing and overseeing the outsourcing the manufacture of seven generations of spread spectrum chipsets, QCT profits from that experience. Each doubling of sales often produces a 20% reduction in costs. However, there may be as much as 30% reduction from the learning experience in the semiconductor industry. This control of the organizational learning of specialized capabilities required to integrate spread spectrum experience with chip design experience is a core competency that no competitor has yet equaled. And, the master of the game, Qualcomm, ensures that it owns this dynamic game by continually raising the stakes through tight integration of escalating complexity after achieving breakthrough ZIF-simplicity. If competitors could not catch up to 2G-spread spectrum in the form of competitive chipsets, how do you catch up today, or to next year’s 6xxx chips and to the road-mapped future generations?
I have included new product profit, which is a cyclic model of category niches in which new products grow rapidly, but profits fall as they mature. For example, the different cumulative adoption S-curves for, say, PCs, laptops, and servers shift profit dynamically to each newer wave as it inflects in the TALC. According to Slywotzky and Morrison (p. 68), “The key to winning is being prepared to shift investment to create undisputed leadership in the next-generation product, the one that most closely matches the customer’s current priorities.” I suggest that spread spectrum, 1X, 1xEV-DO, gpsOne, and radioOne demonstrate Qualcomm’s capacity to profit from innovative products from the leading edge of mobile wireless (and consumer electronics).
Both BREW and QChat have significant potentials whose excellence has yet to be demonstrated and documented by profits. In addition to the great intrinsic value in group-forming networks, QChat would enable the carriers to collect multiple access fees from groups of simultaneously connected users. BREW’s success would create a per transaction profit zone that potentially adds a 10% annuity stream from application revenues. This would be the third leg of the stool, joining licensing/royalties and ASIC sales. This profit potential staggers the mind.
Differentiation/Strategic Control.
Qualcomm’s continuous R&D, architectural innovation, platform expansion provide the strategic control of an increasingly differentiated set of ASICs that segment the market. When combined with BREW’s platform and business model for applications, this ever advancing roadmap of leading edge 3G wireless communication drives the market. The retained earnings and high margins from licensing and royalties of CDMA intellectual property alone can sustain this process of platform development and expansion. Moreover, Qualcomm continues to prove its capabilities as an innovator of new architectures that become a de facto standard. If its 1xEV-DO, gpsOne, BREW, and world phone succeed, it can modestly claim, not only to be the innovator and commercializer of CDMA, but also to be the standard-setter for 3G mobile communication. As it demonstrates and proves its excellence, its mindshare will rocket.
Qualcomm’s priority is meeting the priorities of its multiple layers of “customers” by providing complete standardized solutions. It has the competitive advantage of a superior integrated learning base in spread spectrum for voice and data that enables the harmonization of all modes and bands into a worldwide network of networks. Qualcomm broadens the scope of its platform to include position location, QChat, and a runtime environment for new applications. Qualcomm not only differentiates its CDMA2000 3G platform but also offers most of the same advantages in its CDMA2000/GSM/UMTS chipsets for world phones.
By innovating a spread spectrum RAN and commercializing CDMA as a 2G international standards, Qualcomm successfully became a 2G CDMA gorilla. According to RTW Report contributor Mike Buckley, in a three-year anniversary post, the 2G CDMA tornado began roughly in April 1998, lasting 27 months, until July 1999. Ericsson signing a license captured Mike’s attention. Mike used CDMA subscriber data as the best proxy for the onset and offset of the tornado.
Mike wrote, “At that time we could account for 23 million subscribers. Today [April 6 2002], there are nearly five times as many subscribers, representing a 70% average annual increase.”
The introduction of a lightweight business model had a salutary effect on Qualcomm’s cash flow. According to Mike, “Three years ago Qualcomm had $657 million in working capital. Today, it has $2.5 billion. …my rough calculations for the company’s free cash flow net of income tax adjustments generated in FY98 was a negative $328 million; for every dollar of revenue, the company generated about ten cents in negative cash flow. In FY01, utilizing a business model shed of the necessity to manufacture and market hardware, the company generated $547million in positive cash flow, about $.20 for ever dollar in revenue. Three years ago the company was almost debt-free, with only $3 million in long-term debt. Today there is none.”
Message 17295100
As a long-term buy and hold investor, Mike repeated a familiar theme, ‘things always take longer than we expect because we have a short-term time perspective’ by talking about waiting “impatiently” for the data tornado to begin, noting that it would be difficult to measure. Mike wrote, “We will have to wait a long time before the general financial health of Qualcomm’s direct customers improves. Ironically, it is the financial deterioration of the carrier world that might cause the first significant defection from the dark side, a defection that in the best possible scenario could be the first of many to fall.”
The issue today is whether, over the next dozen years, Qualcomm can leverage its CDMA leadership in developing and setting a de facto 2G spread spectrum standard into becoming the de facto spread spectrum standard for worldwide 3G mobile communication.
Scope.
Qualcomm includes within its scope the research, development, and design of spread spectrum ASICs for 3G 1X, 1xEV-DO, radioOne, gpsOne, Internet Launchpad, BREW platform and distribution system, and QChat’s push-to-talk. It outsources the manufacture of its ASICs to reduce asset intensity. The push to facilitate application development for its mobile wireless platform adds to its scope. Because it strives to offer complete standardized solution, its scope necessarily includes many technical and functional capabilities. However, a key-defining attribute of Qualcomm is its lean, focused, horizontal business scope.
The Harvard Business School’s Pulitzer Prize-winning historian of business, Dr. Alfred Chandler (2001, pp 2-5) introduced the concept of a business organization’s “integrated learning base” to describe the creation of organizational capabilities based on three types of knowledge: (a) technical, (b) functional, and (c) managerial. The process begins with the creation of a profit-making enterprise.
Chandler’s (p. 2) basic premise is: “In market economies the competitive strengths of industrial firms rest on learned organizational capabilities.” Such capabilities are product-specific [Here, Chandler uses “product-specific” in a general sense to refer, not to device-specific, but to product-category-specific capabilities.] to the technology used and the market served. The evolution of industries is a direct consequence of product-specific knowledge that is embedded in the organization itself as its creator and repository.
Technical capabilities are required for the R of R&D and are learned by applying new or existing scientific knowledge. On the one hand, technical capabilities are knowledge-related, drawing from science and the discipline of engineering. On the other hand, functional knowledge is product-specific, resulting in three kinds of organizational learning: how to develop, produce, and market products.
First, development capabilities are the D of R&D, created by learning the product-specific know-how required for transforming an innovation into a commercial product to be sold in national and international markets. Second, production capabilities come from learning how to build and operate large-volume production facilities, including how to train a labor force to run them efficiently. Third, marketing capabilities are acquired in learning the nature of the product’s market and in building extensive distribution systems. When development, production, and marketing are integrated, they position a powerful fusion of functional capabilities.
Finally, the third set of organizational capabilities, managerial, is essential to the creation and continued existence of a profit-making enterprise. Managerial capabilities are based on management knowledge and experience. Most essential are the learned capabilities of top management, whose critical decisions in allocating resources determine the fate of corporations and industries.
Chandler calls the first enterprises whose managers learn to commercialize, which means to develop, produce, and sell in national and then world markets, first-movers. This market-tested set of product-specific organizational capabilities serves as a learning base for improving existing products and developing new one. According to Chandler (2002, p. 4, his emphasis), “The creations of such an integrated learning base in a technologically new industry, together with the resulting continuing flow of funds [from retained earning], creates a powerful barrier to entry.”
Chandler (p. 5) continued, “The integrated learning bases of the first-movers become the primary engines for the continuing evolution of their industry through the commercialization of new technical knowledge. …The concentrated power of technical and functional knowledge embedded in the first-movers integrated learning bases is such that only a small number of enterprises defines the evolving paths of learning in which the products of new technical knowledge are commercialized for widespread public use.”
As the first-mover in mobile wireless spread spectrum, Qualcomm’s scope, which includes an integrated learning base of market-tested technical, functional, and managerial capabilities, shapes the evolution of its industry. Its learning base has a powerful momentum that is unlikely to be ever equaled within its domain. The fateful ITU IMT-2000 decision process that determined spread spectrum was to be the third-generation architecture for mobile wireless irrevocably acknowledged and increased its power. Qualcomm had done what others companies said could not be done, blazing the trail toward 3G’s future.
Not only does Qualcomm have a unique and proprietary integrated learning base, it also has a lightweight business model whose horizontal scope is focused on the key interfaces and technological drivers of its industry: the spread spectrum air interface, the CSM and MSM brains in the RAN, harmonizing networks, and BREW run-time environment for applications. Qualcomm is not only the first-mover in spread spectrum mobile wireless but also is the only pure-play horizontal 3G-knowledge company. |
