Qualcomm Hits The Big Time Pushing a little-known digital cellular technology from surf's-up San Diego, this $4-billion-a-year hotshot wants to be THE NEXT INTEL.
(FORTUNE Magazine) – Irwin Jacobs and his wife, Joan, blended right in. Nary a head turned as we made our way to our table at Donovan's Steak & Chop House in La Jolla. Here was the boss of arguably the most successful startup San Diego has ever seen, a $4-billion-a-year venture that has made thousands of employees and local residents millionaires and Jacobs a billionaire three times over--yet he was nearly invisible. Though their name is on the Irwin and Joan Jacobs School of Engineering at UCSD, the Joan and Irwin Jacobs Radio Broadcast Center at the local PBS station, and the Joan and Irwin Jacobs Theater at the Museum of Photographic Arts, the Jacobs themselves stirred barely a ripple of recognition.
Jacobs remains an enigma, even here in his hometown. He's not like Andy Grove, Scott McNealy, Larry Ellison, or Steve Jobs--public figures all. Even though Jacobs has accomplished as much as any of these Info Age barons, he's largely unknown outside the insular world of the cellular industry. San Diego itself is one reason; until recently, it has been a high-tech backwater. Another reason is that Jacobs has never worked high tech's Borscht Belt--the endless round of Silicon Valley gatherings and high-tech conferences. Instead, he has focused relentlessly on getting Qualcomm's so-called CDMA (code division multiple access) technology established as the world's digital wireless standard.
But notoriety is coming. Last year Qualcomm leaped into the public eye when its stock outgrew all other major issues on the Nasdaq and NYSE, rising 2,621%. It surged because Qualcomm earned $420 million on $3.9 billion in sales and because Jacobs is close to achieving his standard-setting goal. What's more, wireless these days is hot: both digital voice, which continues to grow rapidly, and wireless data, which now seems the Next Big Thing.
Qualcomm's technology, it turns out, is almost ideal for the wireless Internet. Not just phones could incorporate it, but all sorts of mobile devices--portable computers, Palm units, even cars. If Jacobs has his way, Qualcomm will supply both know-how and chips for all these, emerging as a kind of Intel of the wireless era.
The buzz began last spring, when Qualcomm reached an agreement with Ericsson and other major European wireless companies on a unified standard for next-generation phones and networks. Service providers like Vodafone had been pushing for this so-called third generation, or 3G, standard to supersede the multiple ones that exist now. They're betting that a unified standard will have the same galvanizing effect on wireless that the rise of the IBM PC had on personal computing. It should bring down the price of phone gear, increase the variety of software and services--and cause an already booming market to explode.
Qualcomm had spent ten years playing David to the rest of the industry's Goliath. CDMA still has the fewest users of any major cell-phone technology, though it also has the fastest-growing market share and, according to Jacobs, is by far the best.
Now, thanks to the 3G accord, literally billions of phones and other devices will incorporate CDMA. Because Qualcomm holds the vast majority of CDMA patents, that means money for the company--lots of money. Qualcomm collects a royalty of about $10 for each CDMA phone sold, a figure that may shrink in the future, but won't go away. Multiply $8, $6, even $4 by the billions of devices people will buy, and you get immense sums--nearly all profit. This prospect helps explain why investors stampeded into Qualcomm stock last year.
Still, Jacobs can't simply sit back and collect royalties like some retiree clipping coupons. Nor can Qualcomm's 7,000 employees, most of whom are now millionaires, simply hang out at Black's Beach all day. The company faces the formidable challenges of staying at the forefront of wireless technology against competitors like Nokia and Motorola, and keeping its rapidly growing chip business humming against an even more fearsome rival--Intel. That's why this year will be critical to Qualcomm's future, and why, after the initial euphoria over Qualcomm's coming riches, investors in recent months have taken the stock price down by 50% from its late-December high of $200 a share. They are waiting to see if Jacobs, like David, can make the transition from fearless upstart to wise and powerful king.
Irwin the Brave
San Diego is one of the last places in America you'd expect to find a company like Qualcomm or a man like Jacobs. I know. I grew up there. For years San Diego was dominated by the Navy, defense contractors, retirees, and twentysomethings looking for a good time. It was said that you could never build a successful technology company in San Diego; the beach is just too enticing. No one is really surprised that while San Diego is the sixth-largest city in the U.S., it boasts only a handful of major businesses (Birmingham, Ala., has more companies on the FORTUNE 500) or, for that matter, that when the San Diego Padres made it to the World Series in 1998, the New York Yankees crushed them. The Padres, it was said, lacked the will to win.
Well, Jacobs is proving San Diego's critics wrong, and here I was, sitting opposite him in his seventh-floor office above the sprawling neighborhood of wireless startups Qualcomm has helped spawn. As we talked, F/A-18 Hornet jetfighters roared past, one after another. The planes take off with clockwork regularity from the nearby Marine Corps air base. Even though they were a few miles away, they sounded as if they were right outside.
Jacobs ignored the thunderous noise. Why shouldn't he? He's been listening to jets roar ever since he left his teaching post at MIT and moved to La Jolla 34 years ago. The military has been good to Jacobs. Defense contracts provided much of the early revenues for his first startup, Linkabit, and a sizable portion for his second, Qualcomm. Ex-defense industry engineers made up much of both companies' starting work force. And CDMA is based on technology developed for battlefield radio communications. You might even say the military created Qualcomm, except that would be ignoring Jacobs' leadership.
Over the past 15 years, Jacobs has done what few would even have tried: He took on the giants of telecom, and he won. In early 1989, when he first approached wireless carriers to pitch CDMA, no Las Vegas bookie would have given Qualcomm any odds of success. AT&T, Motorola, and others had already opted for the so-called TDMA (time division multiple access) digital standard. "TDMA had won," says Jacobs, "and we came along and said, 'Perhaps there's a better way.'"
The one thing Jacobs had going for him was CDMA's technical appeal. CDMA systems could carry up to three times as many phone calls as TDMA systems, and many more than existing analog systems. They do this by dividing a phone conversation into packets, tagging each packet with a unique ID, jamming lots of packets through the airways, and reassembling them at the other end--a highly efficient scheme that works much like the Internet. A technology edge alone, however, would not suffice. There are plenty of cases in which superior technology has been marginalized in the market, such as Sony's Betamax or Apple's Macintosh. And Qualcomm did not even have Apple's or Sony's brand recognition.
Fortunately for Qualcomm, deregulation was changing the game. In the U.S., the federal government auctioned off new bands of radio spectrum for cellular use, enabling competitors to challenge entrenched operators. Big, well-financed newcomers liked the edge CDMA offered. PacTel Cellular, later to become AirTouch, was among the first to sign on, in 1993. Sprint and others followed.
Much the same thing happened in nations just beginning to build wireless networks. The first commercial system to deliver CDMA was not in the U.S., but in Hong Kong, in 1995. CDMA grew quickly to become the world's third-most-widely-used wireless technology, behind GSM (global system for mobile communications, the dominant European standard) and TDMA (the dominant U.S. one); it has an estimated 60 million subscribers, or 13% of the world market. More important, it is the fastest-growing of the three, with subscribers up 118% in 1999.
The standards war forced Jacobs to become a public advocate for CDMA, a role that didn't come naturally. "In college, the one course I did poorly in was public speaking," he says. "But if I know what I'm talking about, I'm okay." As he won followers for CDMA, critics accused the ex-professor of combativeness, of exaggerating the technology's virtues, of being unwilling to compromise--all charges he denies. Says Jacobs: "People have referred to it as a religious war. I always tried to keep it rational."
Jacobs hardly seems the kind of guy who can strong-arm opponents and roil an industry as big as telecom. He was born and raised in New Bedford, Mass., a seaside community grittier than San Diego by far. It was once one of America's wealthiest cities, flush with money from its whaling fleet. But the emergence of petroleum in the late 1800s eliminated the demand for whale oil. New Bedford fell into decline and has never recovered.
Jacobs, 66, grew up in a lower-middle-class family during the Depression and World War II. His father held a series of jobs: electrician's apprentice, taxicab driver, insurance salesman, restaurant owner. "We never missed a meal, but never had much else," remembers Jacobs. "I got my first bicycle when my cousin unfortunately died at an early age." He had an affinity for math and science, but when considering college was steered into hotel management by a guidance counselor who reasoned that since Irwin's father was in the restaurant business, Irwin should join him. After 18 months, Jacobs made perhaps the biggest move of his career by switching to electrical engineering. He graduated from Cornell in 1956 and earned a Ph.D. at MIT in three short years.
MIT offered Jacobs what seemed a dream job, stay-ing on to teach electrical engineering. He did so for seven years, earning $5,500 a year, before he felt the call of the West Coast. In 1966 he took a position at the University of California at San Diego, then just six years old; he and Joan packed up their four young boys in a Ford van and headed west. "It was a bit of a risk, but it was exciting because it was a brand-new school that had a very good reputation even at that time," says Jacobs. Then there was La Jolla, just north of San Diego and one of the prettiest spots on any coast. "We decided that if we were going to come out anytime before retirement, the sooner the better, because land prices would only go up." The one-acre lot overlooking La Jolla and the Pacific Ocean that Jacobs bought in 1968 for $37,000, where he still lives, is now worth many millions of dollars.
Jacobs and two pals from UCLA, Andrew Viterbi and Leonard Kleinrock, soon formed a part-time consulting company called Linkabit. Viterbi later helped found Qualcomm; Kleinrock won fame as one of the fathers of the Internet. As it happens, one of the first jobs Linkabit got was a contract with DARPA, the federal research agency that funded the Internet's early development. The assignment was to get some European universities, government agencies, or phone companies to tie in to ARPAnet, the precursor to the Internet. Jacobs recalls: "Bob Kahn [then head of DARPA] and I went wandering through Europe trying to convince people that packet communications was the right thing to do. There was zero interest." Linkabit, however, kept growing, and in 1972 Jacobs left UCSD to head it full-time. He sold Linkabit to a larger firm in 1980, staying on until 1985, when he decided to try his hand once again at a startup--Qualcomm.
Patents, Patents, Everywhere
Just inside the locked doors that separate the lobby from the work areas at Qualcomm headquarters is a vivid testimonial to one of the great engines of Qualcomm's growth: an entire wall lined top to bottom with plaques, one for each of the 327 CDMA patents the company holds. Jacobs and his executives pass this innovation shrine every day on the way to their desks. On each plaque appears the name of the inventor, the patent number, a description of the technology, and a diagram. Jacobs' name is on ten plaques. Viterbi has his name on ten. Paul Jacobs, Irwin's son, is on 27 (Paul has a Ph.D. in electrical engineering and computer science, and is executive vice president in charge of wireless data).
Some of the patents are minor, like one covering the physical design of a now-discontinued Qualcomm phone. Some are fundamental, like one detailing how calls are handed off from one cell to another when a person talking on a CDMA phone drives down the highway. The 327 patents make up a portfolio so broad and deep that "you can't deploy a CDMA product without infringing," boasts general counsel Steven Altman. Nor have Qualcomm's inventors slowed down; it has 846 patents pending.
Altman's job is one of the most important at the company. He negotiates licensing deals with companies like Lucent, Ericsson, and Motorola. Qualcomm amassed so many patents because for many years it was the only company developing CDMA. Today any company that makes CDMA products, be they chips, phones, or infrastructure gear, has to get a license from Qualcomm. Licensees pay a one-time fee for access to the patent portfolio and then royalties based on the value of the CDMA products that they sell. For cell phones, analysts estimate the royalty averages 4.5% of the sales price. In 1999 the average sales price of a CDMA phone was $245. So each time one sold--ka-ching!--Qualcomm was $11 richer. In the fourth quarter of 1999 alone, Qualcomm took in $177 million in patent royalties, up 140% over 1998's figures.
Some Wall Street analysts, like Paine Webber's Walter Piecyk, are extremely bullish on Qualcomm's royalty stream. You may remember Piecyk: He's the analyst who put a $1,000 price target on Qualcomm stock in late December 1999--two days before the stock, which had rocketed 80% in the previous weeks to nearly $500 a share, split four to one. Piecyk believes Qualcomm could pull in $20 billion a year from its CDMA patents by 2010. That is a big number, and 2010 is a long way off, but the prediction isn't as crazy as it may seem. Piecyk predicts that three billion wireless phones will sell in 2010, that 85% of them will incorporate CDMA, that the average price will be $180, and that Qualcomm will continue to get a 4.5% royalty on each phone sold. Do the math, and you arrive at $20 billion. And Piecyk isn't backing off: "I should probably have said 100%" of the wireless phones will use CDMA, he says.
Not everyone agrees. "Qualcomm is the most overvalued stock known to man," says Andrew Cole, an analyst at Renaissance Strategy. "The share price is built on the belief that all new phones will have some kind of CDMA. That is a big question mark." Here's why the royalty stream may never reach $20 billion: First, Qualcomm may not be able to enforce its patents on successive generations of wireless technology. With so much money at stake, companies like Nokia, Ericsson, and Motorola will likely seek ways to design around Qualcomm's patents. "If intellectual property is too blocking in one area, people will go another way," says Tom Engibous, CEO of Texas Instruments, the No. 1 maker of cell-phone chips. And new technologies may be invented that supersede CDMA. Second, the average sales price of CDMA phones has been dropping steadily; competition may force it down unexpectedly far and fast. Finally, Qualcomm may not be able to extract a 4.5% royalty from all vendors over the next ten years. Most large companies, Engibous explains, have patent portfolios of their own; big players within an industry often sign cross-licensing agreements that let them use one another's technology without paying fees.
For now, however, nearly all wireless manufacturers have signed patent licenses with Qualcomm. These cover not only CDMA products but also products that incorporate so-called WCDMA (wideband code division multiple access), the technology slated to become part of the European standard. The licensees are practically a who's who of telecom: They include Ericsson, Lucent, Nortel, Motorola, Hitachi, and Samsung.
The big holdout is Nokia, the largest cell-phone maker of all. It pays royalties to Qualcomm on CDMA, but has yet to sign a WCDMA agreement. The two companies have held talks, "but at the moment, we're not 100% sure how [Qualcomm's] patents will apply to WCDMA," says K.P. Wilska, president of the Finnish company's U.S. arm. Qualcomm's Altman says bluntly that Nokia has little choice if it wants to sell WCDMA phones: "Absolutely. Nokia has to get a WCDMA license." Piecyk, the Qualcomm bull, predicts that Nokia will sign rather than try to face down Qualcomm in court: "You'll see an agreement before year-end. Nokia is not known for being litigious." If Nokia and Qualcomm reach a rapprochement, Qualcomm's stock could take off again.
Real Men Rent Fabs
The building that houses Qualcomm's other great growth engine--its chip operations--is five miles from Jacobs' office. One of 30 Qualcomm buildings that dot the La Jolla area, it's down the block from Nissan's Design Center, where new cars are dreamed up, and across from a large facility belonging to SAIC, San Diego's homegrown defense-consulting giant.
Qualcomm's building is spare, with a rudimentary lobby--clearly a place meant for working engineers. It's a lot like Donald Schrock, president of Qualcomm CDMA Technologies. He's a no-nonsense guy, totally focused on building CDMA chips. Except that Qualcomm doesn't literally build them. Instead, Qualcomm is the world's second-largest "fabless" semiconductor manufacturer, on track to become the largest this year. Rather than spend billions of dollars to build its own chip plants, Qualcomm designs the chips and contracts with others, principally IBM, to make them. That's different from Intel, Motorola, TI, and other chip heavyweights. The fabless approach lets Schrock concentrate the company's money, energy, and 800 engineers on designing new chips, not making them.
Being fabless has paid off. Qualcomm sells 90% of the chips that go into CDMA phones. In the fiscal year ended September 1999, that translated into $1.1 billion in sales, more than one-quarter of Qualcomm's total revenues. Analysts estimate that Qualcomm will pass $2 billion in chip sales next year, with a pretax profit margin of more than 40%. Qualcomm has actually run a few competitors out of the business. Oki Electric, LG Electronics, and Sony all made CDMA chips for their phones but dropped those efforts in favor of buying chips from Qualcomm. Why? Because Qualcomm has been able to add features, like geographic-positioning circuits and MP3 music-playing capability, sooner than anyone else. What's more, Qualcomm's "chip sets" use fewer chips than those of competitors, making possible cell phones that are more compact and that need less power. The chip sets also cost less to produce, giving Qualcomm the freedom to cut prices or make higher margins.
Qualcomm's chip success stands in marked contrast to its failed efforts in other CDMA hardware. In the early years, when it was the only company backing CDMA, it had to supply everything a cell-phone carrier needed to provide the service. That meant building phones and infrastructure equipment as well as chips. For a while, Qualcomm looked a lot like such vertically integrated vendors as Nokia, Ericsson, and Motorola, except for one key thing--it was much smaller. Ironically, its very success at getting the industry to adopt CDMA crippled the handset and infrastructure business: As larger manufacturers entered, Qualcomm was unable to compete. Its infrastructure gear--antennas, switches, base stations, and the like--never garnered more than a few percentage points of market share against the likes of Nortel and Lucent. Qualcomm sold that business to Ericsson last year as a sweetener in the deal resolving the 3G standards. The handset business, which Qualcomm developed with Sony, sold a lot of phones but continually lost money. Qualcomm sold that business to the Japanese electronics firm Kyocera last year.
Schrock was happy to see Jacobs unload these dogs. Not only did the losses they generated put a drag on Qualcomm's stock, but the businesses also competed with the very manufacturers he was trying to sell chips to. "Competitors tried to use that" to sell against Qualcomm, says Schrock. Now, when a Qualcomm chip salesperson walks into Motorola, Ericsson, or Nokia, she doesn't have to explain why Qualcomm is competing with them.
Which is a good thing, because the CDMA chip business is about to get much tougher. Qual-comm has overshadowed smallish chipmakers like PrairieComm, LSI Logic, and DSP Communications. But last year Intel, the $29-billion-a-year king of the chip hill, spent $1.6 billion to buy DSP as part of a major push into communications semiconductors. And some observers expect TI, which dominates the markets for TDMA and GSM chip sets, to enter CDMA. Though most analysts think Qualcomm will fare well even with increased competition, few believe it can maintain its 90% market share. Nor does Qualcomm. "More than likely it's hard to hold 90% share," says Schrock. "We expect it to come down, but I'd be disappointed if it came down to 50%."
All the same, the wireless market is growing fast enough for Qualcomm's chip business to continue to expand. The company shipped some 50 million CDMA chip sets in 1999. Analyst Piecyk expects that to grow to 73 million this year and 100 million in 2001. And that's just CDMA chip sets. Some expect Qualcomm to shed its single-minded devotion to CDMA and introduce chips for other standards. Qualcomm's design expertise and portfolio of technologies, like geographic-locator circuits that work even inside buildings (acquired when it bought startup SnapTrack this year, for $1 billion), could be put to good use in these markets as well.
The Future Is Data
The most important new market for Qualcomm is weaving together the Internet and wireless worlds--a challenge that takes Jacobs back to his Internet roots. Though he's not the type to get giddy about anything, the CEO's cadence does pick up a bit when he describes the possibilities of bringing wireless voice and data together. "The excitement is the Internet," says Jacobs. "The phone you carry in your pocket will be as much of a computer as most anyone needs." Soon, he predicts, cell phones will handle simple tasks like getting news, weather reports, and e-mail on the road. Eventually people will use them for more exotic purposes like locating the closest gas station, downloading music, and buying and selling stocks.
The primary obstacle to progress, Jacobs says, is that today's wireless systems were designed for voice communication, not data. They can handle data at a much lower speed than people have become accustomed to on their PCs. Today's CDMA phones offer only 14.4 kilobits per second, vs. 56 kilobits for a standard dial-up modem--itself pathetically slow compared with the broadband cable and DSL modems that are gaining popularity among users.
Cell phones are starting to speed up. Japan recently introduced a generation of CDMA phones that offer up to 64 kilobits per second. To help wireless networks gain still more speed, Qualcomm has a technology called HDR (high data rate), which offers a fast 2.4 megabits per second. "We can actually do full-motion video with HDR," says Jeff Jacobs, another son of the CEO's and the senior vice president of business development. (The Jacobs' other two sons, Hal and Gary, do not work at Qualcomm.) HDR has the support of Ericsson, Lucent, Hitachi, and others. It can work in existing CDMA networks but does require cellular companies to add costly equipment at each cell site. Nokia and Motorola have a rival solution they call 1XTREME. The differences between it and HDR are too technical to get into--just one more battle in the standards war.
Qualcomm has other powerful advantages in the race to provide wireless data: ancillary businesses it can use to flesh out its offerings. The first is Eudora, a popular e-mail program; e-mail is one of the first things consumers want to do with a data-enabled cell phone. Then there's Omnitracs, a satellite-based system that provides position-location and messaging services for long-haul truckers. Qualcomm started the business in 1988, and today there are some 325,000 Omnitracs-outfitted rigs on the highway. The system lets trucking companies integrate information from the trucks into their inventory and accounting systems. Now Qualcomm wants to apply Omnitracs to the auto industry. Company executives won't provide details, except to say they are interested in supplying CDMA chips for this market.
It won't be easy for Jacobs to take these and other technologies scattered throughout Qualcomm and meld them into an integrated offering. What was once a small, close-knit startup is now large and somewhat bureaucratic. Only one person reports to Jacobs these days: Richard Sulpizio, president and COO. This frees up Jacobs from the day-to-day headaches but isolates him somewhat. Nor is Qualcomm any longer the big happy family many say it once was. As a minor example, take the doors to the executive suite. Until recently, the area was open to anyone; now employees must be buzzed in. Another example: a lawsuit, now settled, by former employees who were transferred to Ericsson when Qualcomm sold off the equipment division last year. The employees were distressed that Qualcomm didn't vest all their options, depriving many of big financial gains, especially after news of the deal helped trigger last year's fantastic run-up in Qualcomm stock.
Oh yes. The stock. That's changed a few things around Qualcomm as well. Jacobs bought a private jet last year. His 3.5% stake makes him worth just under $3 billion. He can't count on staying anonymous much longer. And with fierce competitors like Jacobs and Qualcomm in its midst, nor can my hometown necessarily hang on to its underachieving ways. The next time the World Series comes to (what else) Qualcomm Stadium, the visiting team may discover a Padres squad that is burning to win.
REPORTER ASSOCIATE Christine Y. Chen