Qualcomm's Quandary

Too-rosy financial forecasts? That's what analysts think

Qualcomm's ascent was the stuff of legend. Shares of the the wireless-technology pioneer soared an awe-inspiring 2,616% last year--by far the best showing of any major U.S. company. This mighty performance was powered by a simple yet seductive idea: Qualcomm's lock on key patents for digital-wireless technology would make it the Intel Corp. of the wireless world. It vowed to place its technology in virtually all wireless phones, just as Intel powered the world's PCs. That would allow it to extract a fat royalty fee from all the world's mobile-phone makers over the next decade. Investors were spellbound: The shares opened 1999 at 6 and closed the year at 200.

The spell appears to have been broken: Qualcomm shares have plunged 30% since the beginning of the year. Part of the reason is that the company warned in late January that phone-chip sales for its second quarter, which ends next month, will be disappointing. But what really has analysts spooked are growing fears that all the revenues and royalties they dreamed of last year will never materialize. Even bellwether brokers such as Merrill Lynch & Co. and Salomon Smith Barney have lowered their ratings on the stock. "The Qualcomm story is easy to swallow, but we simply don't believe it's true," says Hambrecht & Quist analyst Edward F. Snyder, who rates the stock "market perform"--the equivalent of a hold.

To understand the sudden change of heart, let's start with the rosy assumptions that drove Qualcomm's shares to dizzying heights. PaineWebber Inc. analyst Walter P. Piecyk, a prominent Qualcomm bull, predicted that royalty revenues from the company's code division multiple access (CDMA) wireless technology would mushroom to as much as $20 billion in 10 years. CDMA is one of three major wireless technologies competing with one another.

NEW MATH. Here's how Piecyk got to that number: He estimated that there will be 3 billion mobile phones and other wireless devices sold worldwide in 2010, and 85% of them would use technologies that Qualcomm has patented. After that, he projected that Qualcomm would get an average royalty rate of 4.5% on mobile phones and other wireless devices that cost an average $180. Crunch the numbers and--shazam!--Qualcomm is pulling in $20 billion in royalties at decade's end. When Piecyk put out his report on Dec. 29 and predicted the stock would hit 250 by the end of 2000, the stock soared. It rose 40% over the next four trading days before hitting a peak of 200 on Jan. 3.

Now for the new math. After taking a close look at the assumptions of Piecyk and other bulls, analysts are scratching their heads. First, some question whether there will be anything like 3 billion wireless phones and other devices sold in 2010. After all, that would mean nearly one phone or handheld sold that year for every two people in the world. To put that in context, mobile-phone sales totaled 222 million in 1999, and only 40 million were based on CDMA, Micrologic Research says. The research firm predicts that total sales will reach only 508 million in 2004, quite a ways short of 3 billion.

Even more suspect is the projection that Qualcomm will be entitled to royalties on 85% of those products. Companies such as Motorola and Ericsson are developing rival technologies and plan to neutralize Qualcomm's ability to leverage its patents to get high royalties. "The intellectual property will be so spread out that Qualcomm won't have the power it has now," says Yankee Research Inc. analyst Craig Ellingsworth. And Merrill estimates that Qualcomm's share of the CDMA chip market will drop from 90% last year to 50% in 2003.

That's not even the worst of it. The royalties Qualcomm collects for each mobile phone or other device are headed for a fall. For one thing, the average price of a cellular phone is sliding--Snyder says the average price for a handset will drop to $130 next year, down from $180 this year. What's more, Qualcomm almost certainly will have to lower the royalty rate it charges as competitors start to offer their own CDMA technology. While the company reaps about 5% of the price of a CDMA phone now, analysts such as Snyder believe that will fall to 1% to 2% in the future. Qualcomm's royalty rate could drop to as low as 3% in some cases by next year, says Gartner Group Inc. analyst Bob Egan. He argues that royalty rates could hit 2.5% soon thereafter and drop even lower within five years.

BOOM TIME? The bottom line is that Qualcomm's dreams of huge royalties are probably little more than that. "I think it's unlikely the world will organize itself in a way to pay some company, whoever it is, $20 billion in royalty income," says Dwight W. Decker, chairman and CEO of rival chipmaker Conexant Systems Inc. in Newport Beach, Calif. Ericsson says it has a strong CDMA patent portfolio, as do others. "Qualcomm will not get rich off of Ericsson," says Ericsson spokeswoman Kathy Egan. She derided the notion that Qualcomm would garner $20 billion in patent revenues as "pure fantasy."

Not to worry, says Qualcomm co-founder and CEO Irwin M. Jacobs. While he won't forecast specific royalty payments for Qualcomm, he predicts that the growth of the CDMA market will provide booming growth opportunities. "The [wireless] market will continue to grow significantly, and CDMA will maintain its position as the fastest-growing technology," he says. Even with competitors coming into the market, Jacobs thinks Qualcomm can stay ahead of the pack. It still holds rights to key technologies, including one known as "soft handoff" that allows cell phones to communicate smoothly even as they pass from one antenna to another. And he suggests that the company can use its still-powerful stock to buy other intellectual property that will expand its range of products and boost its leverage in royalty negotiations. Qualcomm could, for example, buy a company with rival GSM technology, the dominant wireless standard in Europe and Asia, so that it could build equipment for phones that handle both CDMA and GSM calls.

There's no question Qualcomm has proved critics wrong plenty of times in the past. Founded a decade ago, the San Diego company pioneered the commercial use of a military wireless technology that was extremely complex yet promised efficient use of scarce radio spectrum. Back then, the U.S. wireless industry was still using analog systems that carried one conversation on each radio channel. The Establishment laughed at Qualcomm's bold claim that it could cram 10 calls onto a channel by assigning a special digital code to each conversation--and many experts questioned whether the technology would work at all. But after Jacobs pushed the technology in Korea and demonstrated that it worked, U.S. carriers, including Sprint Corp. and Bell Atlantic Corp., agreed to use it. Now, CDMA, the least-used of the three major wireless technologies, is the fastest-growing in the world.

TRANSITION. So what are the prospects for Qualcomm in the years ahead? There's plenty of promise. Even people who say the stock got ahead of itself agree that Qualcomm will command billions of dollars in royalties as the wireless economy grows. The question is: How many billions? This year, unit sales of CDMA mobile phones will grow by more than 50%, to some 65 million units. That figure could reach 95 million in 2001 and as much as 200 million in 2004, analysts say. Skeptics such as Snyder put Qualcomm's annual royalty revenue at more than $1 billion by next year. That could double again by mid-decade if the use of mobile phones to tap the Web takes off.

Now, however, any optimism over Qualcomm's future needs to be tempered by a sober assessment of the facts. Piecyk stands behind his forecast despite this year's stock drop. With Qualcomm's Feb. 1 deal to deploy CDMA in China, Piecyk believes Qualcomm is "probably in a better position now than when I put out the report." Still, the company's shares won't have an easy trip back to 200. Analyst Gregory S. Geiling of J.P. Morgan & Co. says the company's investors are shifting their focus to earnings from momentum. In other words, the company is making the transition from myth to reality.

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