Qualcomm Inc (QCOM)

[khemara_qc]

The Next Monopoly
As the 3G revolution picks up steam, wireless pioneer Qualcomm may be poised for market dominance that even Bill Gates would envy.

By Om Malik, February 16, 2005

The professor couldn't sleep. Again. For six months he had been traveling tirelessly from his home in San Diego to Kansas, pitching a radical new cell-phone technology to telecom giant Sprint. Sprint executives at first told the professor he was nuts. But they humored him, and he kept visiting, each time a little more desperate. On the eve of yet another flight to Kansas, the professor awoke, shaking. He slipped on a bathrobe and began to pace the living room floor in the dark.

He has slept better since -- and now may be about to pull off a business coup that few could dream of. The professor was Irwin Jacobs, co-founder and chief executive of Qualcomm (QCOM). The immediate result of that 1993 trip was that Sprint decided to gamble on Jacobs's technology, a move that, over the next several years, converted Qualcomm from an unknown upstart into a major telecom player. But only now is the more dramatic impact coming into focus. Sprint recently announced a $36 billion merger with Nextel (NXTL). And, largely as a result of Jacobs's decade-plus association with Sprint, the biggest winner in that deal may well be Qualcomm.

Here's how: The Sprint-Nextel merger will speed up the combined company's rollout of a 3G (third-generation) network that will allow people to do wondrous things with cell phones, from downloading TV-quality video to hearing Green Day's American Idiot loud and clear. Qualcomm chips and other technologies will be at the heart of the phones people will use on Sprint's 3G network. Nextel hasn't used any Qualcomm technology to date; when the merger is done, any of the 15.3 million current Nextel customers who want to go 3G will have to buy new phones with Qualcomm technology in them. There's no way around it -- and it will mean tens of millions of dollars for Qualcomm in just the first year after the merger.


More broadly, the deal fortifies a market position that could give Qualcomm an incredibly lucrative -- perhaps dominant -- role in the coming world of souped-up wireless communications. The 3G revolution has been hyped forever, but this year, analysts say, it is finally starting to arrive. By year's end there will be an estimated 52 million 3G phones, double today's figure. By the end of 2008, there will be an estimated 352 million, and explosive growth is expected for years thereafter. Qualcomm doesn't manufacture phones, yet it will make money on every single 3G handset sold. That's because Qualcomm controls patents that make its chips, software, or other technologies vital in the functioning of 3G -- no matter which of the competing standards or technical approaches phone makers and carriers adopt for their new networks. Every time a customer of Sprint, or any other carrier that has fully embraced Qualcomm technology, buys a 3G phone, Qualcomm will get roughly $20. Every time giants like Nokia and others in its camp, which don't particularly like Jacobs and Qualcomm, sell a phone, they have to pay Qualcomm at least nine bucks. Do the math. "Qualcomm squeezes money at every pressure point in the 3G food chain," one competitor says.


COLLECT $2 BILLION
Qualcomm is poised to rake in enormous profits during the next phase of the wireless revolution.


BIG TODAY
Qualcomm technology already underpins many cell phones.



BIGGER TOMORROW
The number of advanced 3G phones is expected to surge.



It is a sweet arrangement, and it's testimony to Jacobs's unusual combination of sheer perseverance, business savvy, and technical brilliance -- he taught electrical engineering at MIT before becoming an entrepreneur, and he holds 12 patents in his own name. Once dismissed as something of a crackpot, Jacobs increasingly is seen as one of the great innovators of his time. As a businessman, his record speaks for itself: Qualcomm had a 2004 profit of $1.7 billion, more than double the 2003 figure -- even without the big boost from 3G that seems imminent. The company's 2004 net profit margin was a staggering 36 percent, richer than that of almost any other public company its size or bigger. By comparison, Microsoft's (MSFT) net margin last year was 18 percent.


Qualcomm could still face plenty of static. Its rivals, including most of the telecom giants, are all trying to figure out new high-speed technologies that might loosen its grip. And the company's stock was blasted recently when its first-quarter earnings growth of 25 percent fell shy of some analysts' 3G-fueled expectations. But if just a few things break its way, Qualcomm has a chance to become something truly special -- and perhaps a bit frightening to some people. "The wireless Wintel" is how some telecom insiders put it.

No one, not even Jacobs, could've imagined such a thing at Qualcomm's birth. Jacobs started the company in his den in 1985 to pursue his interest in an obscure technology called code division multiple access, or CDMA. At the time, its best-known characteristic might have been that Hedy Lamarr -- yes, that Hedy Lamarr -- held an early patent on the approach. Put simply, CDMA is a way to split a radio signal into packets of information, shoot them into the ether, and reassemble them when they reach their destination. When Qualcomm was launched, the telecom industry was already planning its initial switch from analog to digital -- but almost no one other than Jacobs thought CDMA could play a role. The big telecoms were betting almost exclusively on a different technological standard.


As Qualcomm engineers built on CDMA, Jacobs became its traveling evangelist. It was a tough sell, and not just in Kansas. In 1989, Jacobs invited executives of all the big wireless players to his office, hoping to demonstrate the glories of CDMA. To this day, few outside Jacobs's inner circle realize how close to total disaster he came at that meeting.


PATENTLY OBVIOUS
Qualcomm's patents mean it makes money on every 3G handset, regardless of which technical standard it uses.
TECHNOLOGY CDMA
(controlled by Qualcomm) W-CDMA
(partially controlled by Qualcomm)
MAJOR BACKERS SK Telecom (Korea), Sprint, Verizon Cingular, Ericsson, Nokia, Vodafone
QUALCOMM PROFIT PER PHONE $20 $9-$20


Jacobs was scheduled to give a 30-minute talk, capped by a live CDMA phone call. But just before the big moment, a lieutenant signaled Jacobs to keep talking -- the system, an almost comically jury-rigged thing, wasn't working. It turned out that making the call depended on connecting with a satellite; Qualcomm engineers could not make that happen. As the frantic engineers drove around San Diego County in a van with a satellite dish on top in search of a signal, Jacobs played for time. "Luckily, being an old college professor, I was able to keep blabbing for an hour and 15 minutes," he recalls. At last the call got through -- and Qualcomm had made another narrow escape.


MONEY MACHINE
The lucrative position is already bolstering Qualcomm's profits.



SHARING THE WEALTH
Qualcomm stock has surged since bottoming out in 2002.



Sources: CDMA Development Group; First Global; Harris Nesbitt; In-Stat/MDR; Qualcomm
Over time Jacobs and his engineers came up with patent after patent on CDMA. Buoyed by the Sprint win of the early '90s, Jacobs traveled the world in search of customers. Big carriers like Verizon (VZ) and Alltel, which has 10 million customers mostly in rural America, signed on. But Jacobs's greatest scores came overseas: CDMA went live in South Korea in 1996 and China in 2002. In 2003 he landed a deal with Reliance Infocomm, India's largest wireless operator. By the end of the decade, analysts figure there'll be 70 million people on CDMA networks in India. Jacobs still works the territory: On a recent trip to Rajasthan in northern India, he saw a disabled man pulling a ricksha and carrying a mobile handset, stopping outside shanties to ask people if they wanted to make a call. It was a CDMA phone. "That to me was a telecom success story," Jacobs says.


If it did nothing more than develop technologies for the current generation of CDMA -- call it 2G -- Qualcomm would be in an enviable position. There are more than 240 million phones for CDMA networks now, and not all of the users will swiftly move to new high-speed networks. Indeed, places like China and Russia are still building out 2G CDMA networks; analysts expect roughly 500 million 2G CDMA phones to be in use by 2010. That will mean billions of dollars for Qualcomm going forward, much of it from selling chips to phone makers like Samsung, the global leader in CDMA phones. It bought more than $500 million of Qualcomm chips last year.

But the real game is 3G -- a contest in which there are now two competitors. One is a turbocharged version of the current CDMA and is controlled almost entirely by Qualcomm; the company makes the chips and operating systems for all phones whose networks will use it. About 12 million of the world's phones employ 3G CDMA, and the number is rising smartly. SK Telecom, Korea's largest carrier with 18 million customers, uses Qualcomm's 3G standard. So does Japan's KDDI, which has 18.9 million customers. Alltel, Sprint, and Verizon -- three of the five largest U.S. wireless networks -- are likely to use Qualcomm 3G technology almost exclusively. All told, they're expected to have more than 90 million customers by year's end.


The bigger pool of potential 3G callers will use another alphabet soup of a wireless standard: W-CDMA. (The W stands for "wideband.") It's backed by most of the world's telecom elite, including Nokia (NOK), Ericsson (ERICY), Cingular (America's biggest mobile carrier), and Vodafone (VOD) (the world's biggest). That camp has 1.2 billion 2G customers, more than four times as many as Qualcomm's 2G. Bad news for Qualcomm? Hardly. Qualcomm controls key patents on some of the technologies behind W-CDMA. As that giant herd of customers migrates to 3G, Qualcomm stands to rake in money -- not as much per customer as on its own 3G standard but, given the hundreds of millions of potential customers, a big pile nonetheless.


FIGHTING BACK
How competitors are trying to thwart Qualcomm.
Qualcomm's stranglehold on 3G has made it plenty of enemies; one rival executive calls the company the John Gotti of telecom. Competitors are scrambling to undermine Qualcomm -- and to make sure it doesn't grab a similar lock on future wireless technologies.

Qualcomm controls patents on about 15 percent of the technology for W-CDMA, which is backed by rivals like Cingular, Ericsson, and Nokia and has a huge potential market. Qualcomm hopes to own half of that market by selling chips to phone makers, but Nokia is building its own chips with help from Texas Instruments.

Sweden's Ericsson has already grabbed 30 percent of the W-CDMA chip market. Sony and 13 other handset makers use the Ericsson chip; so far Qualcomm has five big customers. Ericsson's chip is about 25 percent cheaper than Qualcomm's.

Other competitors, however, have essentially given up on making a stand against Qualcomm in 3G. They're mapping out plans for the next big wireless shift, to 4G. Flarion Technologies, a startup founded by a former Bell Labs researcher, is working on a technology that could be five times faster than current 3G. Fujitsu, Intel, wireless pioneer Craig McCaw, and others are experimenting with a high-speed technology called Wi-Max. It, too, remains largely theoretical, but the goal is concrete: "Nobody," one executive says, "wants to see Qualcomm in control again."

Getting a piece of that W-CDMA standard was the finishing touch on Qualcomm's heads-I-win, tails-I-win coup. How Jacobs pulled it off underscores his wiliness -- and toughness. Many of the big telecom players, particularly Nokia, had hoped to create Qualcomm-free 3G. But Jacobs, armed with his patent portfolio, threatened a legal siege. He called on his platoon of lobbyists -- he employs several full-time and uses three outside firms -- and, if the stories are to be believed, got politicians and the U.S. government to pressure Qualcomm's rivals. Many in telecom have called that period Jacobs's "holy war" phase. He won't talk about the details of the combat, but when W-CDMA equipment hit the market in 2001, Qualcomm had its slice.


One thing about owning the catbird seat: You can't just sit there. Qualcomm is trying to press its advantage through Brew, its cell-phone operating system. Brew (binary runtime environment for wireless, if you must know) rolled out in 2001 and was aimed at soothing a long-standing peeve of the carriers: that handset makers, by controlling the OS, define user interfaces and what content can be accessed by phone. Carriers want to control that themselves -- largely so they can charge customers every time they, say, use their phones to buy something off the Web. Qualcomm tailors Brew to carriers' specifications and typically takes only a percentage of the fees that carriers charge customers for Web transactions. Nokia's operating systems are still by far the biggest in the industry, but Brew is gaining ground. Phones that carry the Verizon brand, for instance, run on Brew. Qualcomm sold roughly 26 million copies of Brew last year, twice the 2003 figure. "Carriers love Brew because it allows them to create a walled garden and lock out everyone who doesn't pay," says one telecom executive

Brew also exemplifies Qualcomm's most exalted corporate principle: Love thy carrier. "We never forget that the carrier owns the customer," says Qualcomm president Paul Jacobs, one of Irwin's two sons who are at the company. The carriers, of course, determine which standard will be used in their 3G networks; they can also lean on phone makers to use Qualcomm chips. Thus Qualcomm goes out of its way to romance carriers. For instance, carriers want to pump video to 3G phones but worry that the huge files could gum up even high-capacity networks. Qualcomm's solution? It's spending $800 million to build a parallel network, called MediaFlo, for streaming video to phones that contain a special Qualcomm chip. The carriers will charge their customers for the service, but Qualcomm mainly makes money by selling the specialized chip to phone makers.


The potential payoff from these initiatives is eye-popping. Through all the royalties, chip sales, and payments for other technology -- at current prices and under today's licensing deals -- Qualcomm earns about $20 for each 3G CDMA phone sold that uses Qualcomm's standard. On sales of 3G phones that use the competing standard, analysts estimate that the very least Qualcomm can make is about $9. Some industry experts believe that the company could control more than half of the CDMA market. That's why analysts project that Qualcomm's revenue in 2006 will hit $7.1 billion -- 45 percent higher than in 2004 -- and that profit will surge 47 percent to $2.53 billion.


THE 3G ECONOMY
By the end of 2007, there will be 200 million 3G phones worldwide, creating rich new opportunities for startups and established players alike. Here are four potentially hot sectors.
Apps
OPPORTUNITY: Web surfing, instant messaging, and other tasks will migrate to high-speed phones, requiring scads of new software.
PLAYER TO WATCH: Norway's Opera Software leads the cell-phone browser market, thanks to deals with handset makers like Nokia and Sony Ericsson.
CONTENDERS: Agile, Profimail
ESTIMATED MARKET SIZE, 2007: $1 billion

Games
OPPORTUNITY: Millions of people will use phones with high-speed connections and 3-D graphics as game consoles.
PLAYER TO WATCH: Mforma, based in Kirkland, Wash., already provides games and content to more than 100 carriers worldwide and has attracted $63 million in venture capital to fund its expansion.
CONTENDERS: Digital Chocolate, Jamdat, Sorrent
ESTIMATED MARKET SIZE, 2007: $7.4 billion

Music
OPPORTUNITY: High-speed 3G connections will spur consumers to download and listen to music on cell phones rather than iPods, radios, or other portable devices.
PLAYER TO WATCH: Musiwave, a French startup, delivers tunes from publishers EMI and SonyBMG; through carriers like Vodafone, Musiwave allows users to download full songs with hi-fi sound quality.
CONTENDERS: Melodeo, Sony StreamMan
ESTIMATED MARKET SIZE, 2007: $1.7 billion

Video
OPPORTUNITY: Mobile video is a potential killer app for 3G networks. In Japan, mobile video is now widespread; the rest of the world won't be far behind.
PLAYER TO WATCH: Mobliss, based in Seattle, just launched Thumbdance, a wireless video channel that broadcasts animated shorts and other content.
CONTENDERS: Idetic, Qualcomm MediaFlo
ESTIMATED MARKET SIZE, 2007: $800 million

Sources: ARC Group; Strategy Analytics; ThinkEquity
It's also why, on a recent day at Qualcomm, Paul Jacobs is talking a little smack. "Everybody used to say, 'You're the Betamax of cellular,'" Jacobs says, harking back to the days when many predicted that CDMA would be crushed by other technologies. "Guess what: It didn't turn out that way. Now the question we hear is, 'How much of the value chain can you occupy?'" When you factor in 3G, the answer is simple: virtually all of it.


The wireless industry has a history of surprise twists and sudden reversals -- remember when Motorola's (MOT) Iridium was going to rule mobile communications? Any number of things could slow down Qualcomm: a sluggish move to 3G phones, breakout technology that leapfrogs Qualcomm (see "Fighting Back"), management blunders. In the near term, some observers have suggested that Qualcomm markets like India and China are losing steam. That's one reason Qualcomm stock -- one of 2004's hottest performers, up 60 percent for the year -- tumbled nearly 10 percent in one day in mid-January and has hovered at about $35 a share since. Some analysts, recalling that Qualcomm shares collapsed from $180 to $15 after the Internet bubble burst, think Wall Street may still be overvaluing the company. "The good news about 3G is already reflected in the stock," says Sachin Salgaonkar, an analyst at research firm First Global.


Jacobs, of course, has heard the skeptics before. In 1994, esteemed Stanford professors were writing papers proving conclusively that Qualcomm's vision of CDMA was, given the laws of physics, "impossible." Today, equally esteemed people marvel at what Jacobs has done. "He'll go down as one of the great business innovators of his era," says Martin Cooper, who invented the cell phone as a Motorola engineer.


Jacobs says he's too busy to be thinking much about legacies. He still spends a quarter of his time on the road, and his mind is constantly working on technical puzzles. At age 71, he says he has no plans to retire. He even still has a sleepless night from time to time. Recently, just back from talks with telecoms about new chip designs, he bolted upright in bed before dawn, wondering how in the world he'd get that chip delivered on time.


Somehow, you get the feeling the professor will figure it out -- and his competitors will be the ones losing sleep.

http://www.business2.com/b2/web/articles/0,17863,1026579,00.html?promoid=yahoo