Qualcomm’s China Challenge Greets Incoming CEO: Tech

(Corrects to remove erroneous reference to carriers paying royalties in sixth paragraph.)

Qualcomm (QCOM) Inc.’s Steve Mollenkopf helped get the company’s chips into the world’s top-selling phones. His challenge now is making deeper inroads in the world’s biggest market.

Cracking China’s phone system is the most critical task facing Mollenkopf, who will become Qualcomm’s chief executive officer in March, as the company’s growth slows elsewhere. Qualcomm, whose chips and technology are key parts of Apple Inc. (AAPL)’s iPhone and Samsung Electronics Co.’s Galaxy family, is largely absent from devices on China Mobile Ltd.’s network, because the state-owned carrier deployed a related system it said was developed locally.

As China’s carriers upgrade to a higher-speed network called long term evolution, or LTE, Qualcomm needs to gain a wider foothold in the market, particularly with China Mobile, which has twice as many subscribers as the U.S. has people. Mollenkopf, a 20-year company veteran, also is grappling with an antitrust probe by a Chinese government agency, which hasn’t made public why it’s investigating Qualcomm.

“China is the single biggest swing factor right now,” said Alex Gauna, an analyst at JMP Securities in San Francisco who has the equivalent of a buy rating on the shares. “It’s such an enormous untapped addressable market.”

Underscoring the challenges that other U.S. companies have with China Mobile, it took Apple six years to come to an agreement with the carrier, before announcing a deal in December.

Royalty Fees

Qualcomm, based in San Diego, gets the majority of its profit from royalty fees paid by handset and phone system manufacturers to use its technology. In fiscal 2013, while 67 percent of sales came from chips -- processors and basebands that connect handsets to cellular networks -- more than two-thirds of its pre-tax profit came from licensing.

On China Mobile’s current third-generation, or 3G, network, Chinese handset makers don’t pay Qualcomm royalties, because the government claims it’s using a different homegrown standard. In the move to LTE, Qualcomm is telling China that embracing the company’s technology would give domestic manufacturers like Xiaomi Corp. and ZTE Corp. a better shot at competing with Apple and Samsung overseas.

The Korean government took that approach in the upgrade to 3G starting in the 1990s, helping Samsung and LG Electronics Inc. (066570) expand globally with Qualcomm’s assistance, which outweighed the licensing fees.

Qualcomm’s Benefits

“We spend a lot of time talking to people about what they get from Qualcomm,” said Mollenkopf, 45, in an interview. Mollenkopf, who has been chief operating officer since 2011, was a candidate to become CEO at Microsoft Corp. before Qualcomm promoted him, people with knowledge of the matter said.

Under current CEO Paul Jacobs, who is moving to the role of executive chairman, Qualcomm’s sales more than tripled and profit more than doubled since he took the helm in 2005. While Qualcomm’s annual revenue has increased on average by 31 percent the past three years, the company predicts growth will slow to about 8 percent next year as a shift to less-expensive handsets curbs chip prices.

More than 55 companies have signed up to use Qualcomm’s technology on China’s LTE network as handset makers aim to reach the growing base of consumers. Twice that many have licenses when including older technologies.

Troubled History

In dealing with China Mobile, Mollenkopf is trying to reverse one of the few setbacks Qualcomm suffered when phone systems were upgraded to 3G, a process that saw the company’s code division multiple access, or CDMA, technology become central to all modern networks and phones.

While the Korean government chose CDMA as the basis for that country’s digital phone networks, starting a string of wins for Qualcomm, China Mobile went with an alternative technology called TD-SCDMA. The Chinese government declared the standard indigenous, letting China-based handset makers avoid royalty payments to Qualcomm.

TD-SCDMA shares many characteristics of CDMA, Qualcomm has said. China claimed the technology is different enough that its companies don’t need to pay royalties.

CDMA proved to be the best technology for delivering data to phones, helping it win adoption by carriers such as Verizon Wireless in the U.S. and Japan’s KDDI Corp. Qualcomm now needs China to follow Korea’s lead as carriers upgrade to LTE.

“It is an opportunity for us both on the chip side and on the licensing side,” said Qualcomm Executive Vice President Derek Aberle, who heads the company’s technology licensing arm.

Rainie Lei, a Hong-Kong based spokeswoman for China Mobile, declined to comment on the carrier’s relationship with Qualcomm or whether it would pay any licensing fees for LTE technology.

Patent Protection

Chinese companies should view Qualcomm’s patents as an asset instead of a cost, because of the legal protection they provide to exporters, Aberle said.

“Many have aspirations to go outside China,” he said. “They worry about the intellectual property. They have to play by the rules internationally.”

To help its efforts in China, Qualcomm has produced a new lower-cost version of its Snapdragon chipset with integrated connections to LTE and compatible with all networks across the world. The company also meets regularly with carriers, phone makers and government officials to educate them about the benefits of its technology, said Aberle.

Whether that will be enough to help Qualcomm succeed in claiming royalties on its LTE patents in China is still an open question, according to Gus Richard, an analyst at Piper Jaffray & Co. who has the equivalent of a hold rating on the stock.

Investigation Overhang

In November, Qualcomm’s struggle in China became even more acute. The company disclosed that China’s National Development and Reform Commission had begun an investigation related to an anti-monopoly law. The NDRC said details of the probe are confidential, according to Qualcomm, which said it knows of no charge by the agency that it violated the law.

“Is it -- we’re not going to pay you, what are you going to do about it?” said Richard. “I don’t see why they pay Qualcomm.”

China’s quest to foster a domestic chip industry that competes with outside suppliers may encourage the government to stand in the way of Qualcomm’s expansion, he said.

Mark McKechnie, an analyst at Evercore Partners, said that if Chinese leaders are considering what’s best for its handset industry, they’ll go along with Qualcomm.

‘Innovation Engine’

“If you want to do a global launch of a 4G handset that goes from no units to tens of millions of units in the first quarter, no one can do it like Qualcomm,” said McKechnie, who has the equivalent of a buy rating on the stock. “If you slowed down the innovation engine in San Diego, it’s not going to be good for the Chinese handset makers.”

Lenovo Group Ltd., the world’s largest computer maker, is already China’s No. 2 phone maker and plans to expand smartphone sales to 20 more countries using Qualcomm, CEO Yang Yuanqing said in November.

“Qualcomm has a big advantage on the LTE side,” said Wayne Chen, general manager of Lenovo’s mobile business unit. “When we go outside of China, they have a very good image in mature markets.”

Qualcomm controls more than 90 percent of the market for smartphone processors with built-in baseband chips that supply the fastest data download speeds. It’s been offering baseband processors for LTE for more than two years while Intel Corp. and other chipmakers are just starting to introduce rival products.

“We’re probably the best positioned supplier because our solution is global,” said Cristiano Amon, executive vice president of Qualcomm’s chip business, in an interview in Hong Kong. Some Chinese handset makers such as Huawei Technologies Co., ZTE and Xiaomi “are now investing in their brands. Some of their brands are now becoming global.”

To contact the reporter on this story: Ian King in San Francisco at ianking@bloomberg.net

To contact the editor responsible for this story: Pui-Wing Tam at ptam13@bloomberg.net

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