The RF Semiconductor Market – And Why It Matters

The RF Semis Market is about to undergo some dramatic shifts. For the past two years I have been neck deep in that market, but am no longer employed there. So I want to put my thoughts about the market into writing. These are my opinions, they do not reflect those of my previous employer, and they are based on public information only.(It has been a while since I was involved in day to day of operations.) Some of this may look familiar from the public transcripts I helped write, and some is just based on my estimate on the strategic shift in the landscape.

This site looks at a broad swathe of technology. I think the audience can be divided between those who know about RF and the vast majority of the population who do not. So first, let me explain a bit about why I think the market matters, even to those who did not know that RF stood for Radio Frequency. For those in the market, you can skip a couple paragraphs down, or hopefully be able to cut and paste those paragraphs and use them to explain to your in-laws what you do.

When we talk about things being ‘mobile’ or ‘wireless’, we mean they are connected to the Internet using a radio. Yes, I mean like the radio you listen to in your car. Half the history of communications technology over the past fifty years is the story about how we made those radios much more useful. Today, the radio in your smartphone is extremely complicated. Think of your car radio as a paper airplane, and a cell phone radio as the space shuttle, or the Starship Enterprise. There are two sides of this story. First, the industry had to find a way to cram huge amounts of information into some coding scheme. That is the story of getting very powerful computers to fit inside a phone, and is exemplified by the rise of Qualcomm. That is a pretty amazing feat, given how much data we are now cramming into the airwaves. But there is another part of the story, and that is the way we manipulate the physical radio waves, bridging the digital computer of a Qualcomm chip and the physical world of radio waves. This area has been marked by some truly incredible advances, that fifty years ago would have been thought of as defying the laws of physics (sortof). This is the story of RF chips, and today’s vendors do some pretty incredible things. We need both sides of this to work, and the major transitions of cell phone technology of the last 20 years (2G, 3G, 4G, etc.) have occasionally been held up by bottlenecks on one side or the other.

I want to make clear that both sides need to work and advance. Without the achievements of the RF semis makers we would still be wire-bound. And the coming years promise to really push the technological envelope further. The shape of the market’s participants will likely have a very real impact on the rate of progress we can expect from our wireless networks.

Market Dynamics [RF people can start reading here]

Over the last ten years this space has seen tremendous changes. When cell phones became a mass market product in the 90’s (thank you Motorola and Nokia) a large number of component suppliers appeared to support the handsets’ RF needs. There were something like 30 vendors in 2002.

Today, there are effectively three and a half left. The story of RF semiconductors is like the story of all forms of semiconductors. Big vendors slowly get bigger, their chips get smaller and they add on functions. Vendors who cannot keep up, who fail to integrate the parts that sit next to them get acquired or exit the business. This process is cyclical, with waves of growth followed by waves of consolidation, and you can track these cycles back 20 years. In the consolidation phase, the big vendors grow and become more profitable. We are at that stage now. It has become fashionable on the Street to imagine that the cycles are now over, but I think that is unlikely, for reasons I discuss below. The cycle will continue and gravity will re-assert itself. The flip side of this progress is that there is now very little room left for small vendors. Some of this is ‘good’ in that it makes the whole industry more profitable, but it is also decidedly bad (no quotes, just flat out bad) because it is now very hard for anyone to bring a disruptive technology to market.

As I said above, there are three and half vendors left. In alphabetical order, they are Murata of Japan, Qorvo (the merger of RF MicroDevices and Triquint) and Skyworks. The half is Avago, which I will explain in a moment. In the past 18 months, the last of the small companies were sold – Peregrine, Amalfi, Black Sand and Javelin. Acco also seems to have moved in a different direction. There a couple of small, private entrants pushing the technology envelope, and a handful of domestic suppliers at the low-end of the market in China. And as far as I know, that is pretty much it. Oh, yes, there is also one more entrant, coming to the market someday – Qualcomm the industry giant. I will get to them too.

When I segment the market, I think there are three basic product groups. And when I say there are only three vendors left, I mean there are only three left who can supply all three products. That is what happens with integration, there used to be a dozen different products involved, but to survive today at scale, companies need to supply all three. The three products are:

  • Power Amplifiers
  • Filters
  • Packaging (aka integration, modules, or just plain solid operations)

[To be clear, I am simplifying greatly, there are many other parts involved, but these are the big profit pools left.]

All three companies can do all of these, but each has their strengths and weaknesses. Let me walk through them now.

Murata – Murata is a poorly understood company, at least poorly understood by US investors. It is one of the most dynamic electronics companies in Japan, and really deserves to be compared not with its domestic peers but with the global group. They have a very strong filter business, completely dominating certain categories. The filter business is very much driven by economies of scale. Murata has a very strong manufacturing operation, that is now reinforced by its sheer size. They are weakest in Power Amplifiers. They acquired a small, legacy PA business four years ago from Renasas. I would argue that they now have a potentially very strong PA business which they acquired with Peregrine. But as that company’s public comments say, it will still be a while before that PA is shipping in meaningful volume. Overall, I think the market greatly underestimates Murata’s position and prospects.

Qorvo – First, a warning. It is almost impossible for me to be objective (or even polite) about Qorvo. I will not get into the reasons for that. You can probably work it out. So take what I say with a grain of salt, and I will do my best. Qorvo deservedly has a reputation for making some of the best products on the market. They are also very good about winning leading share at the biggest customers (Nokia and Motorola then, Apple and Samsung now). With the acquisition of Triquint, they also now have some filter capabilities. They have struggled with the operations piece. This is not really a product, but just a reflection of how well a company is run and how it gets its products to market. RFMD had a history of struggling to allocate capital in a wholly efficient manner (there, that sounded polite). And as a result, they have occasionally run into serious hurdles hurting their growth and/or profitability. Right now, they have a great tailwind in the form of merger synergies and cost-savings through the removal of redundancies between legacy RFMD and legacy Triquint. However, I would argue that at some point they will have to make some hard choices about how to integrate the two companies. If history is a guide, they may not got all the answers right on that quiz. But let me close by repeating, they make some great products.

Skyworks – In my opinion, Skyworks has one of the best-run operations in the industry. They are ruthlessly efficient in driving cost out of packaging. They have solid Power Amplifiers, arguably not as good technically as Qorvo’s but still solid. They have also been much more efficient about capital allocation which has given them the opportunity to attack much more business than anyone else. Skyworks is weakest when it comes to filters. The only filter capacity they have comes from a joint venture they run with Panasonic. This is a small-volume operation, and as I noted above, filters are very much about economies of scale. They also have a relationship with a very small company called Resonant. Despite having essentially no revenue, Resonant is public, and valued by the Street entirely on its ability to provide a disruptive filter technology to Skyworks. If Resonant can do what they claim, this would be a big boon to Skyworks. (Leading to the assumption that they would then acquire Resonant.) I am watching this development closely.

That leaves Avago. First, let me say that I think very highly of Avago. They are a very strong company, with tremendous RF semis revenue. When I say I only count them as being half in the market, I am referring to my view that they are cherry picking only a small subset of business. They are one of only two companies that manufacture a special flavor of filters know as BAW or FBAR. These filters are much in demand for certain challenging applications. The other company in the space is the Triquint side of Qorvo, but this business is much smaller than Avago’s operations. As a result of this elder brother role in a tight duopoly, Avago has been able to make a lot of money. Companies that need BAW filters (e.g. Apple, Samsung) are willing to let Avago bundle other products with those filters (a module with a PA and the filters). But Avago is very much bucking the trend towards integration demonstrated by the rest of the industry. They are not a one-stop shop, and show no sign of wanting to become one. They enjoy the best profit margins in the industry as a result. However, I really question how much longer Avago will be in the RF business. I regularly predict that some day they will sell their wireless business. Someday, someone will feel that they really need to own their own BAW filter capacity. When I make this prediction, people treat me like I am crazy, but Avago’s management are some of the smartest deal people around. They know the value of their assets, and show no sentimental attachment to them. I do not often make definitive predictions, but I think within five years Avago will get a very nice price for their wireless business. Until then, they will continue to sell in their large, profitable niche.

 

The Rest

Let me round out the entire bestiary of RF companies. There is one other sizable filter vendor left – TDK Epcos of Japan competes with Murata but has struggled in recent years to break into the smartphone market, and thus do not have the volume to scale meaningfully. They are out there fighting away, but I imagine ultimately they will sell the business to someone who needs filters. There is also a private company known as IO Semi, that is working on some interesting parts of the component stack. They have the advantage of being small and focused, which lets them push the technology envelope. It is unclear how their future will play out. Finally, in China there are about a half dozen small PA vendors. Many of these companies spun out of RFMD, in the sense that during a restructuring a few years ago, many of the engineers who were let go set up shop on their own, supplying the China OEMs. RDA of Shanghai had a fairly sizable PA business also, but it is unclear how well this is faring inside of Spreadtrum, or whatever that bundle of companies is called now.

Technology Trends

I should probably mention at the outset of all this, that I am writing about the RF market for consumer devices. The market for carrier products like base station RF is very different.

The whole theme underpinning this industry is the trend towards greater integration of all the components. Single Band Power Amplifiers (PAs) have become PA modules, and are well down the path to becoming monolithic multi-band PAs. The next big shift will come as the industry moves from Gallium Arsenide (GaAs) parts to chips made in standard silicon processes. (Technically, these are silicon on insulator or SOI, but that over complicates the underlying reality.)

Peregrine built itself as the pioneer on SOI technology, and is the first company to demonstrate a working silicon PA that offers the same performance as GaAs PAs. In theory, that will give Murata an advantage, depending on when they finalize the commercial product.

Eventually, the whole industry will find some way to make the same move. And whether other companies develop their own SOI processes or license Peregrine’s, the benefits of silicon are immense.

Silicon has two key, closely related advantages – one technical and one economic. The technical advantage is that silicon readily allows the addition of other functions into the RF silicon product. Historically, RF components were largely analog machines, they took a physical signal, and then handled it in some pre-determined way. Using silicon, it is much easier to embed a little bit of memory and a little bit of digital logic, giving the RF semi some ‘intelligence’. This opens up all kinds of doors, and most likely will lead to systems that allow the other components in the phone to ‘communicate’ or ‘control’ the RF semi. Someday, this will bring about tremendous gains in RF performance in the form of better reception and better battery life.

The economic advantage is that using silicon means companies can take advantage of the huge silicon foundry industry. The shorthand way to describe this is to say that by using silicon, RF component vendors can take advantage of Moore’s Law and the steady improvement in chips that has brought about. The actual details of this are a bit more complicated, but the reality is no less powerful. RF component vendors using silicon will get a big boost in performance just by participating in the global silicon ecosystem. This has played out many times over history in other markets, and there is no reason to expect RF semis to be any different. When silicon can match the performance of some more exotic material, silicon quickly drives out the other material. In RF, we have not yet gotten to the point where commercial silicon PAs are available which can match that of the incumbent Gallium Arsenide (GaAs) Pas, but it is clear that GaAs’s days are numbered.

The Big Q?

All of this us brings us to what could be the biggest change to the RF market this decade. When more of the RF semis of the phone can be produced in silicon, they will get integrated into the other silicon components of the phone. But when we talk about ‘integration’, that really means one thing – the companies that make the key digital chips in the phone (aka basebands) will find a way to own the RF stack as well. This has already happened with another half dozen parts, and RF is one of the last left standing.

Which brings us to Qualcomm. Two years ago, Qualcomm announced that they were entering the RF market. Qualcomm is by far the market share leader in advanced basebands. They have something like 95% share of the market for LTE (4G) basebands, and a very large share of 3G as well. If they can produce a working RF product, their control of other parts of the phone will give them an immense advantage in determining which RF products get built into devices. So Qualcomm’s entry, in theory, means the other RF components vendors face a bleak future.

Then something strange happened. To date, Qualcomm has not yet shipped a working PA. They have a couple other RF parts, but they are missing the key elements. As I write this, I expect Qualcomm to make some big pre-MWC announcement about RF, but at this stage, they are far behind. Their RF product, which they call RF 360, is so far behind expectations that the Street no longer thinks Qualcomm can ever deliver. I think that view is misplaced. Qualcomm has the brains and the resources to eventually get RF 360 shipping, but its slow start has made the industry aware of the company’s vulnerabilities.

Even when they can build a silicon PA, they are going to need filters. Filters are not semiconductors, they are essentially ceramic parts, that require the kind of manufacturing expertise that Qualcomm cannot build internally. So they are going to have to partner with someone to get filter capacity.

Also, the small pieces of RF 360 which have shipped have gotten very poor reviews from the industry. This has made handset OEMs very nervous, as they are worried about having no choice but to use poorly-performing Qualcomm RF parts. Or worse, being forced to use some Qualcomm partner’s GaAs parts, delaying for years the potential benefits of silicon RF.

Finally, when Qualcomm originally launched RF 360, investors hoped that this would open up a new market for the company, extending and protecting their core baseband market. Instead, RF 360 has had to rely on the baseband business to protect it and build its toehold. It is unclear how long it will take for this situation to be reversed.

 

 

 

Conclusions

So if the whole history of the RF market is one of steady, cyclical moves towards consolidation. And we are now poised for a major technology transition to silicon which tilts the board heavily towards further integration. Does this mean the end is near for makers of RF components?

First, I think there are more mergers in store. I am speaking solely from my view of the market, I certainly have no inside information that anything is pending. My guess is that we need a few more catalysts to really get things going. In practical terms, the next move is really Qualcomm’s. If we can leave Barcelona with tangible signs that RF 360 has made technical advances, and can expect a commercial product in the next year, then that will set the course for the rest of the industry as everyone scrambles to respond. On the other hand, if they announce that they are partnering with an incumbent vendor, then the industry can breathe a sigh of temporary relief. The last vendors will have time to develop their products and integrate their acquisitions fully.

Regardless of where they stand with their silicon products, Qualcomm will still need to source filters and packaging from someone, and there are few choices left. Whoever that supplier is, it will get a big boost from an attachment to the leading baseband vendor. But it will the kind of partnership where both sides are always wary of the other. The filter vendor will have to face an eventual retreat from their PA business, as Qualcomm slowly gets that part working. And Qualcomm itself will have to watch as its filter partner supplies the other baseband vendors like Mediatek and Spreadtrum, who likely have their own RF ambitions.

Set behind all of this are ongoing changes to the smartphone component market. The past few years have seen tremendous growth in RF content in phones. The transition to 4G has required much more complex, expensive RF components. For the next few years, the big growth in 4G devices will come at the bottom end of the price spectrum, as operators deploy 4G networks in markets that emphasize low-cost, simpler devices. This will mean a steady erosion in average prices for RF parts and a return to less heady times for the RF vendors. We saw this with 2G and 3G as well, the cycle will re-assert itself.

The one exception to this may be Apple. The iPhone has been a huge driver of RF dollars in recent years. The latest devices have very complex RF circuitry, but this will likely peak at some point. Apple, and all the handset OEMs, want to see more integrated RF components, as it will save them money and space inside the phone. I have no idea if this will happen in this year’s iPhone or next year’s, but it will happen at some point.

I recently wrote a note about the positives and minuses of being an Apple supplier. That note may never see the light of day, but suffice it to say, that Apple pushes all of its suppliers hard. If the past year or two have seemed like glory days for the RF industry… well, glory fades. There are still a lot of people competing for Apple sockets, and eventually that will take its toll on industry dynamics.

In the past decade, we have gone from roughly 30 RF component vendors down to roughly a half dozen. All indications are that five years from now, there will be even fewer.

If Apple Built a Car in the Forest, Would We Hear It?

By now you have probably heard the Wall Street Journal has reported that Apple has “hundreds” of people working on building a car. I have absolutely no idea if this is true. No clue. But it got me to thinking. How does the Journal know? Well, they spoke to more than one person “familiar with the matter”, a fine old journalistic gem. They appear to have multiple (two? three?) sources. The journalists in question have a mixed track record on Apple predictions, which is not an insult, as no one has a perfect record. They also have a fair number of data points:

  • A code-name, “Titan”
  • A form factor, “a design that resembles a minivan”
  • They have spoken with an Austrian contract manufacturer
  • And a secondary motivation that makes a lot of sense – its a great way to retain talent by giving them a super big, exciting project to work on.

I can think of all kinds of reasons why this is true, and plenty more why it is not (e.g. it forestalls for several years discussion of what they are working on after the watch). So I do not know what to think. But I found that I kept thinking about this as I would have if I were still an analyst. There is a vein of speculation that Apple announced the Apple Watch several months in advance of its availability, in part, because they wanted to get ahead of leaks coming from their own supply chain. If building a watch risks leaks, imagine the leaks from a much larger project like building a car. I could almost see them entirely hiding the supply chain for the watch, but I think hiding the production of a car would be impossible once it got to a certain size or level of commitment.

Imagine the scenario. The major contractors would be sworn to silence with triple confidentiality contracts. Those companies could have hundreds of people working on it internally without anyone else at the company knowing. If Apple could get AT&T do to that, imagine how much more pliable an auto manufacturer would be in their willingness to keep secret. Nonetheless, building a car is immensely expensive (something the Journal points out twice in their article). Prior to manufacturing, Apple would need to invest billions into tooling and machinery. The general contractors could conceivably be silent, but there would still be a lot of money sloshing through the ecosystem. At some level of the supply chain, some small company would inevitably have to announce to their shareholders that they are going to double or triple capex next year “for an unnamed customer” This would probably be in some non-electronics sector, so conceivably all the Apple watchers might miss it. How many people reading this blog could even name a major European industrial tools supplier? I cannot, but I imagine eventually someone would figure it out.

In theory, we might be able to pick it up from Apple’s numbers. But their operations are so huge now, it might be hard to pick out. That being said, Horace Deidu at Asymco does a great job of analyzing Apple’s capex numbers, to the point that he is probably one of the best predictors of Apple’s unit shipments.

The other difficulty in looking at Apple’s numbers is that they are among the best of leveraging their suppliers to do their R&D for them. Apple runs some very lean teams in key areas because they know their suppliers will do a lot of the manual labor for them. So a car may not appear in Apple’s opex numbers until after it starts shipping.

As an aside, I know that several large semiconductor manufacturers have been doing a lot of research around auto electronics. A couple of key, big Apple suppliers have been investing heavily in auto electronics over the past two years. In theory, they could have gotten an invitation from Apple to start those projects. However, it is equally plausible that they would be there anyway. Auto electronics are an area ripe for an attack from the consumer electronics supply chain. In regards to Apple specifically, I do not know of anyone in the Asian supply chain who has seen or heard anything about a car.

A few people have already started digging through Tesla’s history as a benchmark. The problem with that is Tesla started almost wholly from scratch. They had to build up a company first. Apple already has massive infrastructure in place. It can also fund its work internally, so need to tell outside investors about it.

My best guess is that we would start to hear leaks from the supply chain one to to two years ahead of launch. Order times on industrial machinery are long enough that there would be some advance notice. So if Apple deliberately leaked the story to stay ahead of such leaks (a big IF), it would be entirely possible that we are now two years away from having an Apple car. Personally, I think it is further out than that, and to tell the truth, I am not entirely convinced this is a truly serious project. But I do know that next time I am in Asia, I am going to ask everyone about it (and get a lot of questions myself).

Who Should Attend MWC?

How to approach Mobile World Congress?
As I mentioned in my last post, I am now preparing for my trip to Mobile World Congress (MWC) in Barcelona in two weeks. As with many things, I find that I can be better organized when I write my thoughts out. Hopefully, someone reading this will find it useful as well.

MWC is a BIG show. Not quite as big as CES, but getting close. I think they had something like 80,000 attendees last year. Getting there is not easy, flights are crowded, hotels employ ‘surge’ pricing that would make Uber blush. And it is crowded. There are a lot of frustrations with the show. There is a strain in the blogosphere this time of year with people lamenting that they have to go, or celebrating that they do not. This is followed in a few weeks by people complaining that they will never go again.

That being said, I would not miss this show for anything. (Well, almost anything, I had to skip 3 years ago for the birth of my second son, but that is the only time I have missed the show in almost 10 years.)

So if you are going, or are thinking about going, it is important to understand what the show is and is not. I attend because it is the most efficient work week of the year. I can do 80 meetings in a week, plus two cocktail receptions and a dinner each night. There is no other event which concentrates this many people in the mobile industry in one place, nothing else comes even close.
However, it is important to remember, Mobile World Congress is a Telecom Operator event. The point of the show is for anyone who sells anything to an operator to meet all the carriers’ decision makers. If you are not interested in carriers and what they are doing, think twice about attending.
Take Google as an example. When they launched Android, they had to first evangelize the operating system to handset makers. And since most handset makers sell a lot of phones through carriers, Google knew that they would be able to find their audience at MWC. That lasted to about 2012, after that, it was clear that Android was the leading OS for handset makers not named Apple. There was no one left to evangelize, and Google stopped having a booth at the show. They still send attendees, but they have a much quieter presence as there is no need to do mass promotion.
If you are a developer of apps for consumers, and probably for the enterprise, there is no reason to attend the show. You do not want to promote your app through the carriers (Just trust me, you do not want to do that), and so there is little reason to show up at the event and camp out in Hall 8 (i.e. the back). Last year, several of the ad networks did have sizable booths, but their showing in Hall 8 is really an exercise in marketing to the European app community, arguably a niche better reached through other events.
For some of the very large Internet companies (e.g. Facebook or Twitter) some presence makes sense if you want to tap into the carriers for wider distribution, but that is a relatively finite use case not meriting a large presence. Send your corporate development team to sign a few deals and figure out if zero rating is going to take off.
But for anyone in the hardware and component space, MWC is still the place to go. It is a great venue to launch products, or to promote recently launched products. For instance, my last employer launched a major product just ahead of the event, and were able to demonstrate working silicon at the event. Half of our meetings, and some of the most important ones, came about through word of mouth. One engineer told another about our demo, and everyone wanted to stop by and see it for themselves. This led to a level of interest high enough that it effectively kicked off the process that resulted in our sale six months later. If you want to build buzz for your app, you run the gauntlet of PR and tech blogs. If you want to build buzz for a telecom or radio product, you show off that product at Mobile World Congress.
This year, I am searching for the next interesting thing to do. I outlined the sectors I will be watching in my last post, but I also hope to encounter the unexpected and find something (or many somethings) new.

What Should We Be Looking For?

I had breakfast with Benedict Evans this morning. I enjoy chatting with him, and always learn many things, albeit at the expense of exposing the very large gaps in my reading of English Literature. One of topics we touched on was the center of his post New Year’s Day Post “20 Questions for 2015″.

At the heart of this discussion is a sense that there is nothing new or exciting on the horizon. At least nothing obvious. For years, we have been preoccupied with topics like the Operating System (OS) platform wars, but as he points out, that question is settled. Apple and Google have both won something they were after. Many of his 20 Questions revolve around second derivative effects from that.  Moreover, the industry is now fully aware of the twin forces coming from China – low-cost hardware and that country’s very different take on the Internet application stack. Not so long ago, both of these topics were still poorly understood, but that is no longer the case.

This topic of what comes next has been on my mind a lot this week as I prepare for meetings at Mobile World Congress next month in Barcelona. I have been scheduling my meetings, not quite sure where I want to direct my attention. [Quick side note: My schedule is not quite full, please reach out if you would like to meet there.] In this post, I want to outline some of the things I will be looking for at the show.

However, it should also be clear that when I wonder “What is the next big thing?”, I do not view it as an academic question. I am also in the process of sorting out what I want to do next. If you believe that 90% of the challenge for any start-up or career is to pick the right market, this subject takes on a new weight. [Again, if you have suggestions or need some consulting work done, please reach out.]

I think there are four areas that could be very interesting at MWC.

  • Change is coming to networking. We can throw around a sea of acronyms – SDN, NFV, WebRTC, etc. – but that risks losing the forest for the trees. The networking industry is poised for big change, albeit in a direction that is not entirely clear to anyone. I think the days in which progress in networking is measured by ‘speeds and feeds’ are over. Building a bigger, better box is no longer sufficient. Cisco has won that game, and so the game itself is changing. MWC has become a place where the equipment vendors push their particular interpretation of proprietary hardware. So I will be looking for ways in which this is starting to break down. In particular, smaller networking vendors have little left to lose and are thus pushing some truly innovative solutions. Will they take? Ask me in a few weeks.
  • A corresponding change is the rebirth of enterprise, carrier and data center software. For the first time in years, the list of companies I most want to see at MWC are software companies. There is a huge universe of new, small software companies attacking telecom markets. There are more than I can list here, that run the gamut from analytics to applications (not apps). Figuring out how all these companies interact and determining who has real momentum will matter hugely to the market in coming years.
  • “5G” There is really no such thing. Even as consumer demand for data is surging, the industry’s ability to support that demand has never been more in question. We are going to ship something like 600 million LTE devices this year, yet the next steps are not that clear. Future improvements in data rates are going to be a combination of hundreds of little advances. Adding these up will be meaningful, but are also likely to take a lot of time. In particular, I am looking for companies that manage competing device demand for network resources. This is about more than just cramming more handsets into a single cellular base station. Managing the relationship between small cells is still a very interesting problem to solve. As I noted last year, this involves some very serious math around Game Theory, which just sounds like a fun topic to explore further.
  • The Economics of Networking. How much does it cost to deliver a bit? When should we route and when should we switch? What will peering relationships look like? These are incredibly important topics, that remain poorly understood. I am not sure that anyone at MWC will have the answers, but I plan to ask everyone. We are 20 years into the Internet revolution, and we still have a very poor understanding of the economic forces at work. Everyone tends to think of computing as becoming ever cheaper, but the trade-off between complexity of computation and size of datasets remains a largely artisanal calculation. I love this topic, in part because it has been so poorly explored.

So that is what I will be looking for. Later this week, I plan to post more on my thoughts on how to approach MWC.

A close-read of Qualcomm’s China press release

Today Qualcomm announced that it has settled with the NDRC of China which has ruled that Qualcomm has violated their anti-monopoly law. The settlement had been close for some time, I posted about it two weeks ago, and despite some onerous terms, the stock traded up after-hours as the headlines certainly look similar to what the Street was expecting.

That being said, there is an enormous amount of detail and nuance in this agreement, with some potentially large implications. I have re-read the press release a few times and the accompanying presentation (which is just a power point version of the press release). I could not dial in for the conference call. Maybe someday I will track down the transcript, but life is short.

Overall, I think this is a positive development for Qualcomm, but it leaves a lot of questions unanswered, which makes me think there are still more developments to come. And in anything this complex there are always unforeseen effects.

I think today’s announcement also deserves attention because it sheds a lot of light on Qualcomm’s Technology Licensing (QTL) business which is usually shrouded in secrecy and confidentiality clauses.

First, Qualcomm has effectively admitted to being a monopolist, at least in China. In their slides, they claim this should have no impact on their business outside of China. In effect, Qualcomm has issued a self-criticism, which is an important part of China’s political system. In the US, if you admit to being a monopolist, you end up being burdened with a regulatory regime in perpetuity watching over your shoulders. This is not how it works in China, and if Apple is any example, a self-criticism can open the door to big sales.

Second, they have agreed to change their licensing practices in China. The press release’s coverage of this was so maddeningly obscure that it almost made me want to read the transcript in a false hope that they may have actually clarified this. Basically, they are making it easier to become a Qualcomm licensee in China. This is great news for China’s handset vendors, and seems to make their negotiating position a little bit easier. However, crucially it appears that Qualcomm still maintains the right to audit its licensees compliance with their contracts. This is a major advance for the company, as it has been impossible for them to enforce contracts without these.

A third key point is the headline figure of a reduction in royalty rates. For any device with 3G the rate is 5%, and 4G-only phones the rate is 3.5%.  This is one area where you have to pay close attention, because it sounds like almost no change. Qualcomm’s global average royalty rate is something like 4.5%, and they have always said it would go to ~3% for 4G-only devices. So no big change, right? Not quite. To start, the company admits that it will only charge 65% of the full royalty. This is a sizable hit, but roughly in line with what I and the Street was expecting. However, there is one more wrinkle to remember. The headline rate of 5% (minus 35% discount) is actually a big step down. For years, Qualcomm has charged closer to 6% royalties, especially for smaller, newer handset vendors with no IP to cross-license.

Netting all this math out, the royalty rate goes from 6% to 3.25% (65% of 5%), which is a 46% reduction in their rate.

My Qualcomm model is not up to date, but I suspect this will end up being a significant hit to QTL earnings. On the positive side, they should be able to start charging royalties on many more handsets (more on this in a moment) but the rate comes down a lot. Moreover, they acknowledge that they will give added credit for companies with IP to license. This should be read as a direct benefit to Huawei, ZTE and Lenovo (incl. Motorola) – companies with significant IP. They already enjoy discounted royalty rates because of their IP, and reading between the lines, it seems likely that their royalty rate goes down further.

Of course, modeling all this out is going to be very hard, which is my fourth takeaway from today’s news. In their press release, they raised guidance very slightly. Essentially, the removed the legal expense. (To put this context, they raised EPS guidance by $0.10, which implies they were preparing to spend $160 million on legal fees in the next nine months!)

The main point is that revenue outlook is unchanged. And they say that it will take some time to update this because every customer in China now gets a chance to renegotiate their contract. The end result of all this is that no one will be able to model Qualcomm clearly for another year or so, until everything gets tied down.

I am going to make a prediction. At some point this calendar year, Qualcomm is going to change the timing of when they recognize QTL revenue. Currently, they recognize it one quarter in arrears, meaning that licensing revenue generated in the March quarter is not recognized until the June quarter. Over its history, Qualcomm has periodically changed this to report QTL revenue in the quarter they are generated. Every few years, the company switches from one to the other. This has made it impossible to fully gauge the impact of any big change in licensing, too many variables in the equation. They switched it when they shifted from largely CDMA licensing to largely WCDMA licensing. And I think they will switch again. I am not saying the company is gaming the system, these changes happen and QTL is hard to fully understand.

A fifth revelation is that Qualcomm will be able to charge royalties on ‘TDD’ phones. This matters as China claims ownership of most TDD related patents. So this is a major positive for Qualcomm.

One of the most interesting terms of the agreement center on how Qualcomm will improve its licensing practices in China. Case in point, under the new agreement, when they negotiate with companies in China, they will “provide patent lists during the negotiation process.” Let that sink in. It implies that in the past, they made companies sign patent licenses without specifying the patents.

Several years ago, I had the chance to read one of Qualcomm’s licensing agreements with a China handset vendor. It was a stunning document, with terms that would clearly be hard for that company to stomach. So while I was surprised that they did not include patent lists previously, I was not that surprised.

All in all, I think this opens a lot of doors for Qualcomm in China. There will be a near-term hit to earnings. But by removing some of the more onerous practices, this agreement may make it much easier for Qualcomm to business in China, opening new doors.

China VIE trouble for BABA?

That didn’t take long.

Over the past few months I have been writing (also here and here) about Alibaba (Ticker: BABA). I mentioned one of the key risks with buying BABA stock is that when you do you are not really buying a share in Alibaba the company. Instead, you are buying a share in a Cayman Islands-registered Variable Interest Entity (VIE) which is tied to Alibaba through a ream of contracts. But there has always been the risk that this relationship is vulnerable.

One of those risks has now perked up. Last week the Chinese government issued draft legislation overhauling the law covering VIEs. For a good break down on this, check out the China Law Blog (CLB) which has a great overview of the changes and a list of other experts writing on the subject. (Side note: If you are currently or are about to do business in China, save yourself a fortune in legal fees and future headaches and go read the entire China Law Blog now.)

I will leave the details of the changes to those posts, but put simply the announcement last week calls into question the whole basis for the relationship between VIEs and the actual underlying companies to which they are tied. Now some people will say this is just another example of bad faith in Chinese business law, which many see as being increasingly tilted against foreigners. I disagree that sentiment. In particular, the problem is that everyone working around VIEs has always known they were a grey area, at best. It says so in BABA’s S-1 Risk Factors.

The whole VIE structure grew up as something of a hack. Foreigners are not allowed to have equity in Chinese media companies (as well as several other ‘strategic’ industries). Going back to the 1990’s ‘.com’ era, as Chinese Internet companies went public, some clever lawyers (or bankers) stumbled on this VIE structure as a way to separate ‘ownership’ of the companies from ‘economic participation’ in those companies. From a philosophical perspective it is unclear if that is even possible. But from a technical legal standpoint, it has always been a bit shaky. So now the government of China is going to clarify the law. Seemed like this latest news was inevitable, and I have to wonder if the high profile of the BABA IPO did not play a role in catalyzing the matter.

So what happens now? The answer is unclear. It seems possible that BABA and some of the other China Internet names may get some sort of one-time exception, or be ‘grandfather-ed in’. However, as CLB points out, that penalizes any private BABA competitor. Alibaba has raised a lot of money from foreign investors, and can use that to build its business (not least through strengthening its loan book), but anyone coming after them will be prevented from doing so. Leaving them at a permanent disadvantage. At the other extreme, there is a non-zero possibility that Alibaba’s VIE structure is ruled entirely invalid, leaving investors in the lurch. This would be some pretty bad publicity for the Chinese marketplace, but that may not matter to the lawmakers. If I had to guess (and that’s all I can do), I imagine we will end up with some highly pragmatic compromise that further erodes the control that the BABA VIE has over Alibaba the company, but nothing disastrous.

The odd thing is that there has been no affect on BABA’s share price. The stock is down about 5% over the last five days, exactly in line with the broader market. I have not read all the research out there, but as far as I can tell, no one seems terribly worried about this change, or even mildly interested.

From all of this, I imagine that most investors had some earlier warning that a legal change may take place. This may have come up in the IPO roadshow. Or investors may just assume that Alibaba can find some way to a reasonable settlement with the new law. In fact, if they do get an exception, penalizing all the smaller competitors may help the company. Nonetheless, a part of me suspects that many investors outside China are just treating this as a non-event because it falls in the bucket of China Politics, and thus unknowable.

For me, this latest news is just one more example of the uncertainty underlying BABA that keeps me from buying the stock. After my earlier posts, I had a few investors mention to me that they felt the same way (although they put it a little more cynically). The logical interpretation of this is that BABA should trade at a discount to its peers, but little about current Internet stock multiples are ‘logical’.

As much as I like Alibaba’s underlying business, I am staying on the sidelines for now.

Don’t Talk to VCs – A Reply to Paul Graham

Last week Paul Graham posted a note titled “Don’t Talk to Corp Dev”. I have nothing against Paul Graham. It is hard to argue with his track record, and most everything I have heard about how he treats startups is positive. But I do have a problem with sweeping generalizations sitting beneath alarmist headlines.

His post starts off reasonably enough. Young start-ups should not get distracted when corporate development teams from large companies come calling. Fair enough, big companies move at their own pace, and start-up management teams can lose a lot of time dealing with that.

He then goes on to talk about how these conversations can be demoralizing causing management teams to lose faith and give up too soon. That seemed exaggerated. If you are going to start a company, you will face many doubters and haters. If you have gotten to this point, chances are you know how to deal with ‘demoralizing’ outsiders.

Up to this point, I am willing to give Graham the benefit of the doubt. He is talking to a specific audience of start-ups he is close to. And maybe he had a recent, bad experience with someone, and wanted to use that as a teaching moment.

But then he goes off the rails.

Their tactics in pushing you down that slope are usually fairly brutal. Corp dev people’s whole job is to buy companies, and they don’t even get to choose which. The only way their performance is measured is by how cheaply they can buy you, and the more ambitious ones will stop at nothing to achieve that. For example, they’ll almost always start with a lowball offer, just to see if you’ll take it. Even if you don’t, a low initial offer will demoralize you and make you easier to manipulate.

He continues:

I remember once complaining to a friend at Google about some nasty trick their corp dev people had pulled on a YC startup. “What happened to Don’t be Evil?” I asked. “I don’t think corp dev got the memo,” he replied.

Yes, there are ruthless corp dev people out there. But there are ruthless people in every field and every role. And I am not being naive about Corp Dev. I have seen many of the tricks Graham deplores, and seen them recently. Corp Dev professionals can be sharp negotiators, but they have no monopoly on ruthless streaks.

Up to a point I wanted to argue that management teams have many reasons for wanting to talk to Corp Dev. A basic conversation can be a good way to learn about the industry or about competitors. When I was in Corp Dev, I was much less interested in buying companies than in finding strategic partnerships. Even if the Corp Dev people only want to talk about acquiring you, its worth having the conversation. Most start-ups that do not fail end up being acquired. There is nothing wrong with that. And many times, the only way to achieve a small company’s full vision is to do so as part of a larger company. Talking to Corp Dev people can help you understand that avenue better.

But when I got to those paragraphs quoted above, I realized there is a darker interpretation of “Don’t Talk to Corp Dev”. Let’s not pretend that venture capitalists, as a group, are any holier than Corp Dev people. All the ‘tricks’ that Graham mentions in his post have been perpetrated on start-ups by VCs. I am not accusing Graham of that, again, everything I hear about him is quite positive. But he is laying out a blanket accusation in his post. So I think it is fair to turn the spotlight around. Is anyone going to argue that VCs do not have  their own basket of psychological tricks to play on management teams?

VCs like big exits, and Corp Dev M&A processes dampen those exits. No one likes competition.

If you are running a start-up, listen to everyone, but keep your own counsel. You know your business and prospects best. And never let anyone tell you who to talk to.

Follow

Get every new post delivered to your Inbox.

Join 715 other followers