Apple and Qualcomm’s Billion-Dollar War Over an $18 Part
Illustration: Jack Sachs for Bloomberg Businessweek
IPhone season, that extravaganza of novelty and surprise, began in mid-September with a two-hour-long presentation at Apple Inc.’s brand-new, spaceshiplike campus. Amid oohs, ahs, and an embarrassing number of standing ovations, Chief Executive Officer Tim Cook introduced two phones. The iPhone 8, an updated version of the current model, is already out in the wild. True Apple devotees are holding out for the iPhone X, the 10th anniversary edition, which will cost $1,000 and go on sale in early November. “This really is the future,” Cook said.
The iPhone X—which will boast a full-screen display and facial recognition capabilities and is made out of a “special Apple-designed alloy that’s both durable and more pure,” according to marketing materials—is almost certain to be a hit. There will be block-length lines in front of Apple Stores, moody TV spots, and ecstatic unboxing videos. By Christmas, 75 million or so people will have bought new versions of a device that, before any of this pomp and circumstance, was already the most successful consumer product of all time.
But Apple can be as coldly calculating as it is dazzling. There will be lots of romantic stories about 10 years’ worth of iPhones published in the coming weeks. This is not one of those stories. This is a story about the power dynamics in one of the world’s largest industries.
It’s based in part on court documents filed as part of a dispute over one of the most expensive and, arguably, most important parts of the phone: the wireless modem. The story starts two summers ago, at a conference in Idaho, where a senior Apple executive, probably Cook, and a senior Samsung Electronics Co. executive, most likely Vice Chairman Jay Y. Lee, shared a quiet word.
Samsung is Apple’s biggest rival. The two companies have spent almost a decade in a bitter patent infringement dispute stemming from Apple’s claim that Samsung copied aspects of the iPhone. On the other hand, Samsung is also a top iPhone supplier and an ally in another contentious patent fight, against Qualcomm Inc., one of the world’s largest semiconductor companies.
Most people, save for electrical engineers and Los Angeles Chargers fans (Qualcomm’s name was on the NFL team’s old stadium in San Diego before the Chargers moved), don’t know much about Qualcomm, which has more than tripled its revenue over the past decade, thanks in part to an unusual business model. In addition to selling modems and other chips, Qualcomm has amassed a portfolio of more than 130,000 patents covering, among other things, the key technologies that allow phones to send and receive data. If you want to sell a phone capable of connecting to the internet at high speeds, you need a license from Qualcomm. The company charges a royalty of as much as 5 percent of the average selling price of the phone, which can come to more than $30 per device.
Qualcomm says its pricing scheme is fair, and, seen from a certain angle, it is. Thirty bucks, after all, is a small price to pay for the ability to pull data straight out of the sky. Cell phone manufacturers refer to it as “the Qualcomm tax,” and the practice has been investigated by regulators in China, Taiwan, South Korea, Japan, the European Union, and the U.S. A few phone makers, including Nokia OYJ and Ericsson AB, have unsuccessfully taken Qualcomm to court. The rest have simply tried to negotiate volume discounts.
Apple, the biggest smartphone manufacturer by revenue, was well-positioned to negotiate, and it persuaded Qualcomm to agree to rebates that brought the price of Qualcomm’s license down to about $10 per phone, according to analyst estimates. To get that price, Apple promised not to challenge Qualcomm’s patents. Crucially, though the agreement prevented Apple from encouraging regulators to crack down on Qualcomm, it allowed Apple to truthfully answer questions in any investigation already under way.
At the conference in Idaho, according to documents Qualcomm filed earlier this year, Apple saw an opportunity to put itself in front of investigators. Qualcomm claims that at the event—almost certainly the Allen & Co. conference in Sun Valley, which both Cook and Lee attended—the Apple executive urged Samsung to pressure South Korean antitrust regulators to intensify an investigation into Qualcomm that had been open since 2014. “Get aggressive,” the Apple executive said, according to Qualcomm’s filing, adding that this would be the “best chance” to get Qualcomm to lower its prices.
Qualcomm’s allegation—that Apple got Samsung to use its influence with the Korean government to push regulators to go after Qualcomm as part of a global conspiracy to pressure it to reduce prices—is explosive, particularly given that Lee was later convicted of bribing the country’s former president, Park Geun-hye, in an anticorruption crackdown in Korea. The crackdown also led to the resignation of the vice chairman of the Korea Fair Trade Commission, which brought the case against Qualcomm. Apple says nothing improper happened. “I don’t know what conversation they are talking about,” says Bruce Sewell, the company’s general counsel, in an interview at headquarters in Cupertino, Calif. “For Apple to have said to Samsung, ‘You guys are in Korea and you should be watching this case carefully,’ doesn’t seem to me to be anything beyond simply the kind of conversation two CEOs might have.” Samsung declined to comment on the allegation. A KFTC official, Yoo Young-wook, says the agency began the investigation on its own and that Samsung was “only one of the companies we enlisted for reference.”
Whatever the impetus, the KFTC did get aggressive with Qualcomm, fining the company $850 million at the end of 2016 “for abuse of market dominance” and announcing that it would order Qualcomm to change its pricing scheme. Three weeks later, the U.S. Federal Trade Commission accused Qualcomm of anticompetitive tactics. Qualcomm denies all wrongdoing in both cases. The FTC complaint, the company says, “seeks to advance the interests and bargaining power of companies that have generated billions in profit from sales of products made possible by the fundamental 3G and 4G cellular technology developed by innovators like Qualcomm.”
Just three days after the FTC filed its complaint, Apple sued. It’s asking a California court to order Qualcomm to pay $1 billion in damages and to offer technology licenses at a much-reduced price. Apple also cut off royalty payments to Qualcomm, a revenue stream of about $2 billion a year.
Within a matter of weeks, Qualcomm, which had been valued at more than $100 billion in December 2016, had lost a quarter of its market capitalization, an outcome that Qualcomm executives say was Apple’s intent all along. “Apple’s game plan is to squeeze people until they finally say, ‘OK, the pressure’s too hard. I’ll just take a deal,’ ” said Derek Aberle, then Qualcomm’s president and the company’s chief negotiator, in an interview in July. Apple, on the other hand, presents the dispute as a matter of fairness. “It’s not that we can’t pay,” Sewell says. “It’s that we shouldn’t have to pay.”
The case, which could go to trial in a San Diego federal court as early as next year, could have a profound impact on the mobile phone business. A Qualcomm win would hamper Apple’s efforts to cut costs and preserve margins that have allowed it to capture most of the profits generated by smartphone makers worldwide. If Apple wins and succeeds in ending the Qualcomm tax, that could marginalize one of the most powerful American technology companies and upend the balance of power in the semiconductor industry.
There are two ways of looking at any new Apple product. The first, the way Apple prefers, is to focus on the exterior. At launches, executives linger over the technology’s physicalities, enthusing about new materials, new manufacturing processes, and the seamless integration of hardware and software. Apple has always cared about a phone’s technical capabilities, but it’s tended not to call attention to those things as such. “It just works,” co-founder Steve Jobs liked to say.
The second way of looking at a phone, the one Qualcomm prefers, is to focus on what’s inside. Modern smartphones, thanks in no small part to chipmakers such as Qualcomm (and Apple, which now designs its own chips), are computers that can more or less do everything a desktop can while producing little heat and using almost no electricity. They do it all wirelessly: A 4G, or fourth-generation, cell phone can receive and transmit data at speeds comparable to those of your home Wi-Fi network, from almost anywhere in the developed world. Most of us have gotten so used to this that we’ve stopped being impressed by it. “You pay roughly the same per month today as you did 20 years ago, and you get a million times more data,” says Matt Grob, Qualcomm’s executive vice president for technology. “That’s because of the advances in the craft of digital wireless communications.”
Grob, one of the company’s top engineers, is standing in front of a robotic arm that has a mannequin’s head where a hand would normally be. This is at one of Qualcomm’s several dozen labs at the San Diego headquarters, part of a research and development operation that spends more than $5 billion a year. “There’s a lot of heads and body parts,” Grob says matter-of-factly when asked about the lab’s Frankenstein quality. He explains that each body part is filled with a viscous saline solution—“a particular standardized goop”—designed to simulate the goop inside a real body. The idea is to test how the presence of flesh affects signal strength and to make sure Qualcomm’s modems adjust for it.
After accounting for all the things that can mess with the strength of a signal, wireless companies have to manage spectrum. Imagine an enormous radio dial. In the U.S., the major cell phone carriers each own some spectrum—as do TV networks, radio broadcasters, the Coast Guard, and so on. Inside a given block of spectrum are channels. Carriers get hundreds of channels each, and each phone needs access to at least one of them. The trick, if you’re in the wireless business, is in figuring out how to cram lots of phones’ data into a single channel, and to then transmit those signals between phones and radio towers even when they’re bouncing off buildings, moving at highway speeds, or blocked by foliage.
Pre-Qualcomm, cell phone carriers accomplished this by giving each caller a narrow time slot—less than a millisecond—to send a burst of data. Callers had the illusion of a continuous conversation, but, in fact, everyone was taking turns; your phone was sending data in little chunks, which were then reassembled by the receiver’s phone. This system, which is still used on older networks, works well, with minimal lag during calls and download speeds fast enough to allow users to browse the web slowly or maybe stream music. But because there are only so many time slots, it’s inefficient, as if you gave a dinner party in which only one person were allowed to talk at a time.
Qualcomm’s big innovation, developed by co-founder Irwin Jacobs, a former computer science and engineering professor at the University of California at San Diego, was to have all the conversations play at the same time, each identified by an individual code. This system, based on a protocol known as code division multiple access, or CDMA, allowed five times as much data to be exchanged on the same amount of spectrum. Your cell phone listens only for data packets that are coded to it, in the same way your brain picks out individual conversations in a crowded room.
Qualcomm’s CDMA specification was approved by the wireless industry in 1993 and was included in the spec for 3G, the high-speed data protocol that hit the market in 1999. It took almost a decade for 3G to catch on—the first iPhone lacked the technology—but it ultimately paved the way for the popularity of smartphones, including Apple’s. Since then, Qualcomm’s licensing revenue has almost tripled, from $2.8 billion in 2007 to $7.7 billion last year. About 85 percent of that was profit.
Visitors to Qualcomm’s headquarters, situated in a suburban office park a few miles from Jacobs’s old UCSD lab, are greeted by a monument to this business: the Patent Wall. The two-story-high installation displays hundreds of Qualcomm filings. Jacobs’s original CDMA patent is there, blown up and annotated, and his original CDMA specification has been printed out and preserved nearby, in its 685-page glory, behind glass in a separate corporate museum. Other works given prominent placement: U.S. Patent 6,725,060 (“Method and apparatus for conserving power in an integrated electronic device that includes PDA and a wireless telephone,” which Qualcomm claims is a patent for the first smartphone); Patent 7,099,663 (“Safe application distribution and execution in a wireless environment,” essentially an app store); and Patent 8,516,607 (“Facilitating data access control in peer-to-peer overlay networks,” which means … something).
“I can’t think of a keystroke that you can do on a phone that probably doesn’t touch a Qualcomm invention,” says Steve Mollenkopf, the company’s low-key chief executive officer, who succeeded Paul Jacobs, Irwin’s son, in 2014. Mollenkopf is, like most Qualcomm senior managers, an electrical engineer by training. In addition to noting that he’s CEO, Mollenkopf’s business card has the word “inventor” stamped at the bottom right-hand corner, a distinction employees earn if they’ve been awarded a patent. Mollenkopf has 13. Grob has more than 70.
Inventors in the cell phone business strike agreements with industry standards bodies to charge a price that’s “fair, reasonable, and nondiscriminatory”—“Frand” in industry-speak—as a condition of their inclusion in a given wireless standard. The system provides guaranteed income to the companies that invent the standards and makes it relatively easy for upstarts to build handsets without worrying about getting sued for patent infringement, as long as they pay the prescribed royalties. In theory, the fairness requirement prevents a company such as Qualcomm from squeezing its customers for patents that are part of the standard.
“Our business is really designed to allow as many players as possible to go into the industry,” Mollenkopf says. He notes that Essential, the new smartphone company founded by Android creator Andy Rubin, began selling a handset in August that more or less matches the new iPhones feature-for-feature despite being produced by a company that has about 100 employees and $300 million in venture capital. Reviews of the new phone have been mixed, but that the Essential handset is even being compared to the iPhone X is an achievement given that Apple spent more than $10 billion on R&D in 2016. “We have democratized access to mobile connectivity,” Mollenkopf says. “I mean, anybody can do it.”
“Anybody can do it” is not necessarily good for Apple, though. By offering its technology for a fee based on the price of a device, Qualcomm is in effect giving manufacturers of inexpensive phones a discount—at a time when iPhone sales have been unchanged and sales of phones by Chinese upstarts have been spiking. According to an estimate by technology consulting company International Data Corp., Huawei Technologies Co. increased shipments by 20 percent in the second quarter of 2017, which puts it just behind Apple in worldwide market share. Sales by the fourth- and fifth-place manufacturers, Oppo Electronics Corp. and Xiaomi Corp., grew by 22 percent and 59 percent, respectively. By contrast, Samsung, the top-selling device maker, and Apple, No. 2, saw gains of less than 2 percent each.
From the outside, the difference between a new iPhone and a device made by Huawei or Xiaomi is pretty apparent, but on the inside all phones look alike. There’s a battery that takes up much of the volume, some connectors, and a small motherboard (a “logic board,” Apple calls it) that fits around the battery. The board is home to a dozen anonymous squares, the chips that make the smartphone smart. Somewhere on the board is the baseband processor, aka the modem, which turns radio waves sent from cell towers into voice and data.
“Here it is,” Apple’s Sewell says, sliding a fingernail-size square covered with electrodes across a conference room table: a Qualcomm modem. “That thing sells for about $18.”
He means the chip itself, before any royalties. Qualcomm’s business model, which is either ingenious or diabolical depending on whom you talk to, is to allow any chip company to use its technology royalty-free. Phone manufacturers can choose to buy chips from Qualcomm or one of the other five companies that make modems using Qualcomm’s technology. Either way, they still have to pay Qualcomm its 5 percent.
Because Qualcomm spends more on R&D than any of its peers, its modems are the most advanced. For years, Apple considered Qualcomm’s to be the only modems good enough for the iPhone. That, Sewell says, is why Apple put up with Qualcomm’s licensing scheme for years. If Apple refused to pay the royalty, Qualcomm could cut off its modem supply, forcing Apple to rely on inferior chips. That calculation changed in 2015, when Apple began working with Intel Corp. to develop a modem that was used in some versions of the iPhone 7. “What prompted us to bring the case now as opposed to five years ago is simple,” Sewell says. “It’s the availability of a second source.”
Around the same time, Apple began demanding more drastic concessions from Qualcomm. Although the specifics of the negotiation are secret, Sewell, who spoke to Bloomberg Businessweek in August, two weeks before the big iPhone launch, was able to lay out the company’s thinking. As Apple sees it, a cell phone modem is one of many components—and of no special significance. Sewell points out that if your cellular network is down, it’s possible to get online using Wi-Fi, which uses a different chip. Moreover, phones aren’t just phones anymore; they’re also navigational tools, digital wallets, health monitors, cameras, and more. All of those functions work with or without cell service. “Cellular connectivity is important,” he says, “but it’s not as important as it used to be.” On another table behind Sewell, an Apple representative has laid out two versions of the iPhone 7: One model, which has 128 gigabytes of memory was sold by Apple for $750. The other, which has 256 GB, sold for $100 more. How is it fair, Apple asks, for Qualcomm to charge as much as $5 more for the technology in the more expensive phone, given that the two devices are otherwise identical?
Starting in 2015, Apple argued that it should pay patent royalties to Qualcomm based on the price of the modem rather than the price of the phone, which would imply a much lower figure. Sewell says Apple believes it shouldn’t have to pay more than $4 or so per device, 60 percent less than what it was paying Qualcomm after rebates, according to analyst estimates. Qualcomm, not surprisingly, refused.
The negotiation intensified when Korean regulators began investigating. In August 2016, the KFTC interviewed Apple. Qualcomm says Apple’s statement to regulators contained lies, which is why, the next month, Qualcomm stopped paying its usual rebates to Apple, effectively raising the company’s per-phone royalty rate.
In retaliation, in January of this year, Apple sued, accusing Qualcomm of operating an “extortion scheme.” Around that time, Apple informed the five contract manufacturers that assemble iPhones in China that it would no longer reimburse them for Qualcomm’s royalties. The manufacturers promptly stopped making the payments.
Qualcomm executives see themselves as victims of a powerful company that’s attempting to wring a little more profit margin out of a maturing product line. In July, Qualcomm sued Apple, claiming it had infringed on six new Qualcomm patents related to battery life and graphics processing. It also asked the U.S. International Trade Commission—the government agency charged with protecting American companies—for an injunction that would ban the import of iPhones that use Intel chips. In August the ITC opened a formal investigation into Apple’s alleged infringement and said it would decide on the matter by September 2018—right in time for Apple’s next iPhone launch.
The suit appears designed to disrupt Apple’s supply chain and push the company to negotiate. “You know, there’s always a lot of legal rhetoric,” Mollenkopf says. “It’s not going to be like that forever.” That is, Mollenkopf expects Apple to settle soon.
There are, however, signs of strain within Qualcomm. Shortly after Mollenkopf spoke with Bloomberg Businessweek, the company disclosed that a second major cell phone manufacturer, which some analysts say is Huawei, had stopped paying royalties, sending Qualcomm’s stock crashing again. Then, in August, the company announced that Aberle, its top technology licensing executive, was leaving the company. Mollenkopf points out that Qualcomm, which has more than $38 billion on hand, can afford a protracted fight. It sounds impressive until you realize that Apple has almost seven times that much cash.
The iPhone X is, as Cook says, full of futuristic technology. But one feature the new phone will not have, say people familiar with its components, is a state-of-the-art modem. Because Intel hasn’t yet been able to match Qualcomm’s top-of-the-line version, Apple has opted not to add so-called Gigabit LTE capabilities to its new device, meaning that the latest Samsung and Essential phones, which use Qualcomm modems, will be faster than the iPhone in certain markets. That Apple uses slightly slower modems won’t hurt iPhone sales yet—its modem can handle streaming high-definition video perfectly well—but it’s a preview of the possible costs to Apple if it can’t make a deal with Qualcomm.
Next year, carriers will begin testing so-called 5G, an even faster standard that’s widely seen as necessary to the development of technologies such as augmented reality and driverless cars. Qualcomm has been working on parts of the standard for a decade, which Mollenkopf says is a reason the dispute with Apple is coming to a head now. “This is maybe a little bit wonky,” he says, “but there’s always a period of time where the industry is a little bit stable and there’s a battle for margin.” Once 5G hits the market, he argues, electronics companies will have new opportunities for growth and will be happy to pay Qualcomm’s fees again.
Apple’s lawyers say that’s self-serving nonsense, and they’re preparing for a trial. “There’s no way that this case settles, absent a complete reinvention of the licensing model that Qualcomm has adapted in the industry,” Sewell says.
That would do further damage to Qualcomm’s market value and stature, something that wouldn’t be unprecedented. Earlier this year, a longtime Apple supplier of graphics chips, Imagination Technologies Group Plc, disclosed that Apple would no longer license the company’s technology. The move followed reports that Apple had been hiring engineers from Imagination and investing in its own development of the chips, known as GPUs. In a matter of days, Imagination’s stock fell more than 50 percent, and the company put itself up for sale.
Could something similar happen to Qualcomm? Mike Walkley, an analyst who covers Apple and Qualcomm for Canaccord Genuity Inc., notes that Apple has been hiring radio engineers in recent months, a possible prelude to an effort to develop modems in-house. “Apple’s become so powerful in the market,” he says. “It’s great to have them as a customer, but sometimes it doesn’t end well.”
Another hint that Apple is aiming directly at the core of Qualcomm’s business came during the introduction of the iPhone in September. For the first time at a launch, design chief Jony Ive, who’s usually brought in to purr about industrial design and pronounce aluminum the British way, spent time on the iPhone’s guts, praising the “neural engine” on the A11 Bionic application processor, which Apple says is what allows a user to unlock the device by simply looking at it. When talking about the company’s new watch, the Series 3, Apple Chief Operating Officer Jeff Williams grew emotional describing the power of the device’s cellular modem, which allows users to make calls from their wrist, Inspector Gadget-style. “That’s just darned close to magical,” Williams says. “Who would have thought?” He didn’t mention that the watch uses a Qualcomm modem to help make this magic possible.
While Apple talks up its new devices, Qualcomm has tried to make itself less reliant on licensing fees. It is attempting to buy NXP Semiconductors NV, a Dutch company that makes the chips used for mobile payments in most phones. Qualcomm has also been trying to promote itself as much more than a company that owns some modem patents. It’s airing ads that promote its inventions on wonky podcasts and the Washington metro, among other places. “Qualcomm is why you love your smartphone, no matter what phone it is,” an ad says.
Back at headquarters, Grob makes a similar case, running through dozens of technologies Qualcomm has developed that are unrelated to modems or wireless standards, including cameras, augmented reality, video compression, surround sound, and on and on. All those technologies, he adds, are more or less worthless without a cellular connection. “What’s the first thing you do when you land on a flight? You turn off the airplane mode,” he says with a grin. “By the way, we invented airplane mode. That patent’s out in the lobby.” —With Sam Kim