Qualcomm Inc (QCOM): from today's S2N - Brian Modoff of Deuts...

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Monday, 10/31/2005 11:28:44 AM

Monday, October 31, 2005 11:28:44 AM

from today's S2N - Brian Modoff of Deutsche Bank chimes in

We sue what we fear
Several Qualcomm competitors announced today that they had filed suit against the
company with the European Competition authority. These companies, which include Nokia
and Ericsson among others, allege that Qualcomm’s licensing of its intellectual property is
anti-competitive.

Who is anti competitive? History matters
It may seem arcane, but we feel a quick trip through history is relevant to today’s events.

When Qualcomm was first developing CDMA it faced a significant challenge from incumbent
GSM vendors in promoting its new technology. To this day there are no large-scale CDMA
networks in Europe. In more competitive markets, however, CDMA gained a foothold as
operators came to realize the benefits it offered over TDMA and GSM.

Eventually, the rest of the industry realized this too and as the leading participants began
designing 3G standards they looked to incorporate the benefits of spread spectrum and code
division into its news plans. According to Qualcomm and other industry sources, however,
they tried to design the new standard to avoid Qualcomm’s patents. You’ll notice that to this
day many industry participants refer to the 3G standard as UMTS while Qualcomm always
refers to it WCDMA. There are technical differences between the two, but in this case we
think there is also some linguistic propaganda taking place.

The 2G incumbents tried to avoid the Qualcomm patents by introducing subtle variations to
the standard in areas such as chip rates, the allocation of bandwidth and the introduction of
asynchronous handoff. Then the tech meltdown happened. As the fortunes of Nokia,
Ericsson and others turned sour in the early years of the new millennium, cost-cutting efforts
slowed WCDMA development efforts. Qualcomm, however, forged ahead contributing
significantly to not only the standards process, but also to helping wireless carriers such as
Vodafone prepare for new networks. Ultimately Qualcomm contributed significant amounts
of intellectual property (IP) to the process.

At the same time, Qualcomm was also investing in developing a 3G standard for its core
CDMA technologies as well. Remember that there is already a significant overlap between
CDMA and WCDMA. Qualcomm has claimed that much of the work it did for CDMA EV-DO
and EV-DO Rev. A can be directly applied to the WCDMA camp. In particular, Qualcomm
highlights contributing its work in commercializing HSDPA, the next upgrade to WCDMA. We
believe this is what ultimately led to last week’s lawsuit. (More on this below.)

What was inessential, shall be essential again
Ironically, until very recently (i.e., three months ago) Nokia and Ericsson had been claiming
that Qualcomm’s patents in WCDMA were less significant to the technology. Nokia widely
circulated an academic study on the topic. As recently as July we even fielded questions
from some in the investment community about whether or not Qualcomm would compete in
3G at all. Now, imagine everyone’s surprise when Nokia and Ericsson have come out and
claimed the exact opposite. Apparently, Qualcomm’s IP are essential after all. We made this
point in Signals to Noise #159 in May 2005, that while some were claiming the patents were
less essential, Broadcomm was simultaneously suing Qualcomm saying the opposite. While
we have not seen the actual claim, and as of this writing neither had Qualcomm, the center
of the claims seem to lay in Qualcomm applying the same royalty for WCDMA as it does for
CDMA. Qualcomm’s response to this claim (in the past as well as in its latest press release)
has been that the market has not seen this practice as unfair. In fact, many of the parties to
the suit are among the 130 licensees of Qualcomm technology
(http://www.qualcomm.com/technology/licensing).

You sue what you fear
As we mentioned above the heart of the matter is how the proceeds from WCDMA are
shared. On the chip side, Qualcomm has built a significant lead over its competitors in
developing 3G chips. Qualcomm announced late last week that it had completed the first
road test call using its HSDPA chip, and they remain the only company with an actual HSDPA
product sampling with handset vendors. This is important because wireless carriers are
anxious that HSDPA become a commercial reality as soon as possible to fend off their
numerous competitors – not least EV-DO Rev. A. We estimate that Qualcomm has almost a
year lead in commercializing HSDPA chips. Moving further along the upgrade cycle,
Qualcomm plans to have an HSUPA chip sampling as early as 1Q06 before most of its
competitors. So within six months Qualcomm will be into its fourth wave of 3G chip
technology, while many of it competitors are still struggling with their first wave.

An example may help illustrate the matter. Texas Instruments is a party to the latest suit
claiming that Qualcomm stifles competition. In TI’s recent earnings conferences, however,
they have actually claimed to have a leading market share in WCDMA. This incongruity is
underscored by the fact that TI does not yet have its own WCDMA baseband.

All of this lends credence to Qualcomm’s claim, as noted in its press release late Friday, that
the motivation for the suit has nothing to do with anti-competitive practices, but is instead an
extreme negotiating tactic used by its competitors. At stake are the royalty payments other
WCDMA IP contributors seek to earn for their IP contributions. If handset makers pay
Qualcomm a 4.5% royalty, that does not leave much on the table for others and still keep
handsets affordable. As we noted, however, many of the handset makers do not see it that
way and have been willing to sign up with Qualcomm’s licensing program.

Conclusion
So where does this leave us?
First, we are not taking our QCOM estimates down, we are maintaining our Buy rating and
$50 price target. As responsible analysts, however, we think it is important to understand the
potential outcomes ahead.

First, the suit was not filed with a judicial body. Instead, the 2G incumbents petitioned the
EU’s Competition Authority. Many people have asked us how that body will likely respond.
We read the Economist like everyone else, and this is about the extent of our knowledge of
how they will respond. We are not going to attempt to predict the outcome of the suit,
especially since no one else, including Qualcomm, has actually seen the complaint.

Worst case scenario, we have prepared a sensitivity analysis which appears on the following
page. This table shows the impact on Qualcomm’s FY06 earnings estimates of a decline in
the royalty rate it charges for WCDMA licensing.
Our current estimate is $1.56. We have estimated the impact on this number from both a
decline in global WCDMA royalty rates and from a decline on royalties for devices sold in
Europe. In theory, any EU Authority action could be held to only affect devices sold under its
jurisdiction. We do not think anyone knows what possible outcomes could transpire, but as
the table below indicates, the worst case is far short of catastrophic.

Global
Royalty
Rate

   FY06 European Royalty rate 
      1.5% 2.0% 2.5% 3.0% 3.5% 4.0% 4.5% 5.0% 
 1.5% 1.31 1.33 1.35 1.37 1.39 1.41 1.43 1.45 
 2.0% 1.33 1.35 1.37 1.39 1.41 1.43 1.45 1.47 
 2.5% 1.36 1.38 1.40 1.42 1.44 1.45 1.47 1.49 
 3.0% 1.38 1.40 1.42 1.44 1.46 1.48 1.50 1.52 
 3.5% 1.40 1.42 1.44 1.46 1.48 1.50 1.52 1.54 
 4.0% 1.42 1.44 1.46 1.48 1.50 1.52 1.54 1.56 
 4.5% 1.44 1.46 1.48 1.50 1.52 1.54 1.56 1.58 
 5.0% 1.46 1.48 1.50 1.52 1.54 1.56 1.58 1.60

---------TABLE______

By our estimates, in 2006 Qualcomm will generate 37% of revenue from its QTL licensing
business, of which about 40% will come from WCDMA licenses. The entire licensing
business (CDMA and WCDMA) should also contribute 65% of operating income. We find it
highly unlikely that Qualcomm’s WCDMA royalty rate will fall to zero, and we also think there
is a distinct possibility that Qualcomm may be able to hold onto the roughly 4.5% royalty rate
that it currently enjoys.

Finally, the 2G incumbents claim that Qualcomm’s practices will stifle the WCDMA market.
We think this will be disproven in the coming months as WCDMA volumes accelerate sharply
during the Christmas shopping season. This will likely become even more apparent in coming
quarters as an ever wide range of WCDMA handsets come to market.
So while this issue may cast a slight shadow over Qualcomm’s share price until the matter is
disposed, we think the company’s fundamentals will continue to demonstrate the strength of
its abilities. We encourage readers to examine the company’s comments responding to the
suit, as it is one of the more straightforward, and strongly-worded press releases we can
recall.

Valuation
We maintain our $50 price target and Buy rating. We have established our price target for
QCOM using two methods. Under a comparable company analysis, at our target price
QCOM would trade at a 38x multiple of CY05E EPS and 28x multiple of CY06E EPS. This is a
premium to our coverage universe multiples of 25x and 21x, respectively, justified based on
QCOM lead position in the market and industry leading profitability. We have also established
the target price using a discounted cash flow analysis with a discount rate of 11.0% and a
growth rate of 5.0%, which equates to our $50 target price.

Risks
Risks to our QCOM price target include slower-than-expected industry growth rates,
particularly for the adoption and growth of 3G networks and consumer demand, a slower
than expected expansion of CDMA and WCDMA in emerging markets such as China and
India. The company could also experience greater-than-anticipated competition in several of
its markets especially in WCDMA. Upside risks include the company gaining greater-thananticipated
market gains in WCDMA, improved macro-economic conditions, higher-thanexpected
adoption and growth in emerging markets such as China and India, faster-thananticipated
subscriber adoption of 3G.