Economy, Talking Point

When the chips are down

Qualcomm gets record fine, but says business goes on regardless

Qualcomm CEO Paul Jacobs speaks at the Qualcomm pre-show keynote at the CES in Las Vegas

Billion dollar problem: Qualcomm CEO Paul Jacobs has faced tougher times in China

When Lyndon B Johnson travelled to Paris to meet Charles de Gaulle in the early 1960s, he was taken aback by his host’s haughty manner.

“So, what have you come to learn?” de Gaulle asked his visitor – then the American vice president – in an imperious opening to the conversation.

But even de Gaulle might have learned a thing or two from the Chinese about treating outsiders in a high-handed fashion.

With a long history of imperial etiquette, the Chinese had refined the practice to a fine art by the time that Lord Macartney visited the Qing court in the late eighteenth century. Emperor Qianlong wouldn’t speak to the envoy directly, and he was then sent packing with a letter for King George III informing him that the Chinese had “no use” for British goods.

Fast forward a couple of centuries and foreign bosses in China are beginning to complain that their treatment by officialdom is marked by a similar sort of arrogance (as voiced again in an American Chamber of Commerce survey this month). British pharmaceutical giant GlaxoSmithKline was hit with a $492 million fine for bribery last year, for example, while 12 Japanese car component suppliers were recently fined $202 million.

Can Qualcomm claim too to be among the wounded parties? Caught up in a longstanding antitrust case, it has known that punishment was inevitable for months. And last week the case against the world’s biggest smartphone chipmaker finally reached its conclusion, when it was handed a record $975 million fine.

Qualcomm seems to have accepted its punishment meekly enough. Is that because it sensed that – in a bad situation – it had got the best possible outcome? And likewise that it couldn’t afford to offend the regulators further in what is now its most crucial market?

Perhaps its senior management took a page from LBJ’s book too. Responding to de Gaulle, the usually caustic Texan also opted for a more conciliatory line. “Why, General, I have come to learn whatever you have to teach me,” he told his host.

Why is China so important to Qualcomm?

The Chinese market is the American firm’s biggest, generating about half of its revenues last year. It was also one of the key bridgeheads from which Qualcomm prevailed in a vital standards war involving mobile phones more than 10 years ago.

The chipmaker was founded in 1985 by MIT professor Irwin Jacobs (the father of Qualcomm’s current chairman Paul Jacobs). In the same year it began working on CDMA, a digital wireless technology used by the US military for secure communications. The first commercial CDMA service was launched a decade later in 1995, by Li Ka-shing’s Hutchison Telecom in Hong Kong. But back then a European telecommunication standard known as GSM had grabbed most of the global market. To catch up, Qualcomm set its sights on China.

It was assisted by the political environment. Beijing wanted Washington support for China’s WTO entry, and Qualcomm managed to lobby for a key concession. Washington insisted the Chinese adopt American CDMA technology for at least one of its mobile phone networks. Accordingly, China Unicom, the country’s number two phone firm, was told to use CDMA.

China duly joined the WTO but as Sina Finance noted this month, Qualcomm was “the big winner”.

Indeed, its China operation really took off when 3G licences were issued in 2008. Three different 3G standards were used: China Mobile rolled out a TD-SCDMA system; China Telecom operated using CDMA2000 and China Unicom opted for WCDMA. Crucially, all three are a variation on Qualcomm’s technology.

“This put Qualcomm in the driving seat of the telecom industry because it has so many core patents,” China Business News points out, noting that Qualcomm’s market value overtook Intel for the first time in 2012, four years after the Chinese began building out their 3G networks. (Currently Qualcomm’s market cap is $116 billion, compared to Intel’s $163 billion.)

The problem today, Sina says, is that the American firm “has not fully met its promises to the Chinese side”. These include ensuring that Chinese buyers get the most favourable terms and that the Americans invest more in China’s own semiconductor industry, spurring greater capabilities among the domestic players.

So what do Chinese firms think of Qualcomm’s dominance?

The mobile carriers (the afore-mentioned trio of state telco giants), as well as equipment providers like Huawei and ZTE, and smartphone makers such as Xiaomi have all complained about Qualcomm’s market power.

“We have awoken to the reality that we have raised a wolf in the 3G era, and that this wolf is very greedy,” an unidentified telecom executive told CBN.

The newspaper noted that in the booming 4G market, Qualcomm accounts for 90% of the chips installed in China’s smartphones.

A China Mobile executive told CBN that Qualcomm already has a major influence on how it rolls out its services, offering an example. “Qualcomm kept delaying the production of chipsets for iPhones compatible with China Mobile’s TD-SCDMA standard,” he complained. “It only agreed to start producing them after various profit-sharing negotiations and agreements.”

Qualcomm’s influence has also been growing as chipsets start to feature in a wider range of consumer electronic products.

So perhaps it isn’t surprising that it has often been portrayed unfavourably, as Sina Finance puts it, for “sucking blood out of the Chinese economy”.

At the root of much of the frustration is how Qualcomm calculates its royalties from the prices of the products that employ its chipsets – doing so based on a percentage of the selling price of the final good.

Hence the joke that has been doing the rounds online.

In it, a Chinese official suggests to a Qualcomm executive that the American firm is relying on an unfair pricing model.

“If a BMW uses your chips in the future, do I also need to pay you 5% of the luxury car’s selling price?” the official asks.

The (fictional) Qualcomm executive pauses for a moment, but then replies: “Yes – this is the case – theoretically.”

We concur, it isn’t a side-splitter, but it does indicate why the regulator got interested.

Is it a settlement or a penalty?

Rather than call it a punishment, Qualcomm has said that the fine is a “resolution” with the Chinese regulators.

Mind you, the American giant is a veteran of antitrust disputes, tussling with regulators in Europe, Japan and South Korea over the last decade. China’s competition laws meanwhile only took effect in August 2008, with the National Development and Reform Commission (NDRC) setting up its antitrust bureau a year later.

So far, this has arguably proven its most high-profile case. Nor could anyone argue it has been rushed. NDRC officials have met Qualcomm representatives 28 times since the end of 2013 (when the commission made public its accusation that Qualcomm has been abusing its market position and employing unfair licencing practices). Many of the initial allegations were confirmed by the verdict last week.

As part of the settlement, Qualcomm has agreed to drop cross-licencing provisions in which its customers were required to surrender their own patent fees in exchange for the chipmaker’s technology.

This could be good news for Chinese companies that own plenty of patents themselves, like Huawei and Lenovo, as they may now try to charge their own customers for their use.

As such, M&A deals targeting tech-related intellectual property rights may get a further boost.

In the other major concession, Qualcomm will licence its IP at “standard rates” based on fees of 65% of the given device’s net sales price.

Qualcomm’s headline royalty rates – estimated at 5% of the wholesale price for 3G devices and 3.5% for those using 4G chipsets – will all be reduced.

That means that it will now cost less to licence its IP in China than in other markets, although the discount will cover phones to be sold in China and not those made for export.

And Qualcomm’s response?

Qualcomm seemed happy to reach a settlement. At worst the NDRC could have fined it a tenth of its annual revenues in China. But it has ended up paying just under $1 billion, or 8% of its 2013 income from the Chinese market.

“Although Qualcomm is disappointed with the results of the investigation, it is pleased that the NDRC has reviewed and approved the company’s rectification plan,” it said.

In fact, Qualcomm has been trying to present the verdict in a positive light. It has admitted that uncertainty over the case has made it difficult to collect the full royalties from some of its Chinese customers. Now, with the case concluded, the picture should be clearer at least.

“The result is that our business model and licencing model is intact, and actually more certain than it was before the investigation,” chief executive Derek Aberle said after the ruling.

The Wall Street Journal agrees that Qualcomm was spared the worst by the authorities. “It amounts to a slap on the wrist,” Edward Lehman, a Beijing-based patent attorney, told the newspaper, claiming that regulators had “just sidestepped the whole thing”.

Investors seemed to agree that the outcome could have been considerably worse. Qualcomm shares rose 3% after news of the fine was reported.

And the wider lessons?

The Financial Times said the case has come to symbolise the challenges faced by a host of major US tech firms in China in the wake of the Prism spying revelations by Edward Snowden.

As such, some believe that the Qualcomm probe was fuelled by anti-Americanism. But NDRC officials deny it, insisting that the investigation was prompted by complaints from two (unnamed) American sources in 2009.

Xu Kunlin who heads the agency conducting the investigation, laughed off accusations of heavy-handedness. “We don’t have superpowers, and the conditions under which we enforce the law are usually bad,” he told China News Service.

“We don’t have uniforms and we don’t have special vehicles for enforcing the law,” Xu continued. “During one of our raids on Qualcomm, our staff arrived by car but didn’t have one to pick them up for the return trip, so they had to take a taxi. How can such a big company be threatened?”

Meanwhile, the Wall Street Journal noted that there are few substitutes for Qualcomm’s chips, leaving many Chinese firms dependent on them. This may help to explain the relatively lenient punishment. A tougher settlement, an advisor to the NDRC told the Journal, would only “upset the company”.

Of course, this sense of dependency is why Chinese policymakers have set out to reduce the role of overseas firms in the semiconductor sector.

“Foreign firms need to adjust their mindsets. They are market participants, not rule setters,” the Economic Observer warned. “Qualcomm hasn’t taken into account the interest of its business partners in China. And most of them are important companies for China’s national strategies.”

Last week we reported that the authorities want to see Chinese firms move up the semiconductor value chain – for commercial as well as national security reasons – and create national champions able to compete with global leaders such as Qualcomm, Intel and AMD.

A string of acquisitions even had analysts speculating that there might well even be a Chinese takeover of AMD (see WiC270).

Firms in the sector are already getting privileged access to finance. Backed by the likes of China Mobile and China Development Bank, the so-called Integrated Circuit Industry Investment Fund was set up in September last year and is believed to have raised about Rmb100 billion ($16 billion).

Other funds are also being established. MediaTek, Taiwan’s biggest chip designer and a fierce rival of Qualcomm (albeit at the lower end of the market), has said it will invest $50 million in Shanghai’s IC fund.

There is speculation now that Qualcomm may have been ‘persuaded’ to contribute to similar schemes too, as well as to make new efforts to deepen its cooperation with local chipmakers such as SMIC. And if that turns out to be the case, Sina Finance argues Qualcomm will (finally) be fulfilling a couple of the pledges it made during China’s WTO accession talks in the late 1990s.

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