Tuesday 28 May 2024

Measuring value and royalty costs in standards and SEPs passed along the value chain to consumers

An economist in the audience asked my panel on “transparency” at the Patents in Telecoms and the Internet of Things conference in London recently about achieving this by demanding detailed company financial disclosures. This is my first of two articles on topics in my wheelhouse that were addressed at this superlative biennial event. 

Rough judgments

Companies are generally unwilling to reveal such accounting figures that would help show how royalty costs are passed on and where profits are generated. Furthermore, some major value transfers are non-monetary and would not show up in these measures. Nevertheless, it is possible to surmise where most economic value is generated, captured or passed through, and where royalty costs are passed on in supply chains to customers.

Aggregate royalties paid of around five percent of handset revenues are very modest in comparison to total value in standards and the consumer welfare derived by several billion people using devices such as smartphones for many useful purposes.

Most of the value created in technology standards such as 4G and 5G is passed through to consumers. How much and where the rest of it is harvested across the supply chain and in the broader ecosystem is more complex and subtle.

Royalties paid and passed on can have a significant bearing on the financial performance of individual companies where competitors are paying and absorbing different amounts.

My analysis here includes some unashamedly qualitative assessments, as well as my usual quantitative support. But first, some definitions and background.

Economic pie sharing

Economists describe value created, for example, from technology innovation, as a total “surplus” that’s divided between producers and consumers. Producer surplus is obtained where the price received is higher than the minimum at which the producer is willing to sell. Consumer surplus is where the price paid is lower than the maximum the consumer is willing to pay. However, in the real world, it’s more complicated than this binary split with various different players in the ecosystem benefiting from standards such as 4G and 5G including standard-essential patents (SEPs).

Those who derive value from standards including SEPs, and share the total surplus include patent licensors, device OEMs, device ODMs (i.e. contract manufacturers), network equipment OEMs,  MNOs and MVNOs (i.e. physical and virtual mobile network operators), Big Tech Internet platforms and software publishers as well as end-users. Suppliers that generate no more than their cost of capital might be regarded as not capturing surplus, but superior returns and deficient returns can be generated in various ways. Reasons that possibly explain weak or strong profitability include (in)efficiency and other business activities. For example, Apple is by far the most profitable smartphone OEM and has accounted for between 70 percent and 80 percent of total handset profits over many years because it has a lot going for it. It is a more specific empirical question to what extent its superior returns result from it paying less than economic value or harvesting surplus in other ways in use of the cellular standards including SEPs.

Upstream creation, downstream consumption

Communications standards such as 4G and 5G are enormously valuable overall. This is resoundingly indicated by more than five billion mobile phone users (i.e. unique subscribers) and with rapid uptake of new standards. In addition to using mobile devices for calling and text messaging, with the vast majority of devices now being smartphones these are the primary or only means of accessing the Internet for most of these people. For a large and increasing proportion of them, these devices are also the dominant means of receiving news, sharing photos, paying for purchases, navigating and even watching video.

Some of the surplus created by standard-technology developers is retained or used to subsidize product business in network equipment or devices; but most of it flows to consumers within a few years of new technologies becoming commercially available. In between, a few major OEMs are likely retaining significant surplus. However; most OEMs and ODMs that are paying their dues in patent licensing fees are probably not keeping much of the surplus at all. Various Over-The-Top (OTT) players are taking significant value indirectly—in competition with MNOs and in information exchange barter trading with consumers, as explained below.

Fruits of competition and dominance

Vigorous competition bringing innovation and rapidly-declining quality-adjusted prices has delivered exceptional growth in new higher-performance services and network traffic growth. By the mid-2000s, unsubsidized new mobile phones could be purchased in most nations for under $50 and for as little as $20 in developing nations. By 2010, around half the world’s population had a mobile phone. Now, for example, there are plenty of 4G Android smartphone models on sale in India in the price range of RS5,000 to RS10,000 ($55 to $110) that include at least 4GB of RAM, front and rear cameras and 6 inch or larger displays that can stream video and deliver location-based services. Consumer surplus is clearly high in use of these, despite the relatively low willingness or ability to pay much higher prices in nations with modest income-per-capita such as India.

Meanwhile, the prices of high-end smartphones have increased. For example, many consumers happily pay more than $1,000 for various iPhone and Android models. Apple thus appears to be deriving significant producer surplus. While much of that arises from its strong brand, favored designs and manufacturing cost control, it also seems likely that a significant proportion of that is from standards-based technologies, after its payment of SEP royalties. It’s notable from recent FRAND decisions in the UK (i.e. in Interdigital v. Lenovo and Optis v. Apple) that large OEMs—such as Apple, Samsung, Xiaomi and Huawei—paying royalties in large lump sums up-front spend relatively low amounts per unit, and as percentages of unit selling prices, in comparison to many smaller OEMs paying running royalties. The larger OEMs are evidently receiving deep discounts of up to 80% for volume and prepayment.

In comparison to Apple and Samsung, most handset OEMs are in a rather more commoditized (i.e. less product-differentiated) and price-competitive market segment. Marginal costs also tend to be passed on to customers in the latter, but with little scope to increase prices much above costs no matter what goodies become available (to all) in the standards. The contract manufacturer ODMs also operate on thin margins. While owing their existence to the new technologies that fuel handset market growth and replacement, most manufacturers do not appear to be making exceptional profits in doing so.

Even some major OEMs have failed financially in the face of competition, regardless of ever-improving and increasingly valuable standards. It’s notable that despite Nokia being the handset market leader commanding the vast majority of the sector’s profits in the 2000s, and with peak financial performance around 2008, the firm’s floundering smartphone business at the beginnings of the 4G era was divested to Microsoft in 2014 and then subsequently closed with declining sales a couple of years later. With LG’s market share falling from 9% to 2% during the 2010s, it stopped selling smartphones in 2021.

All being things equal, one would expect costs including royalties to be fully passed on by suppliers in their prices. One would also expect that prices could be elevated little more—despite standard-technologies creating more total surplus than is paid for them in royalties—due to fierce downstream price competition among OEMs. Given the many competing suppliers at the commodity end of the market, one way a supplier might retain substantial supplier surplus would be if that company was avoiding royalty payments (e.g. through hold-out) while its competitors were incurring those costs and passing them on to customers. Alternatively, if that supplier was the only one, or if few are, paying such royalties, it might be unable to fully pass-on such costs to its customers without diminishing its sales volumes and market share.

Quid pro quos

MNOs and MVNOs do not pay directly to use the standards or SEP technologies that have kept them competitive in generating their service revenues. Instead, MNOs pay for new standards-based technologies in their network equipment purchases that are licensed with payment of patent fees by the manufacturers. MNOs and MVNOs commonly subsidize consumer purchases of new handsets that also employ these manufacturer-licensed technologies.

The fortunes of MNOs worldwide vary significantly: however, with a few exceptions such as US market leaders AT&T, Verizon and T-Mobile in recent years, profitability is generally modest or meagre. For example, Vodafone and 3 in the UK are hoping their proposed merger will improve lacklustre financial performance in competition with two other MNOs.

While some MNOs may have been able to capture some of the economic surplus in 4G and 5G, it seems that the MNOs and MVNOs overall are not major hoarders of surplus. Instead, consumers benefit, for example, by getting more and more data for around the same expenditure as for much less data previously. While global MNO revenues have been rather flat over many recent years, MNOs are supplying exponential network traffic growth of 1,000x over fifteen years since 2010. Fierce competition among operators is causing all the cost-per-gigabyte reductions and increased value MNOs receive from technological improvements to be passed through downstream to consumers with an unrewardingly constant unitary elasticity in the market demand curve.

In contrast, Big Tech Internet platforms are making money hand over fist in comparison to most MNOs, even though surging mobile data now accounts for almost 60% of all Internet traffic. Google (Android, Google Play Store, YouTube), Meta (Facebook, Instagram, WhatsApp) and Apple (iOS and App Store) are indirectly appropriating some of the surplus generated by standards and SEPs. For example, as WhatsApp is free for end-users, it cannibalizes the higher profits mobile operators could otherwise make on picture messaging, international calls and roaming calls. Even though consumers pay for mobile data so they can use this app, MNOs’ supplier surplus is diminished by these substitution effects. And, there’s is no free lunch for consumers: the Faustian bargain in using WhatsApp is in allowing Meta to access personal phone contact information. Consumer surplus is thus diminished and Meta’s supplier surplus is increased by this payment made in-kind.

Big Tech is also taking significant slices of the surplus from OEMs. For example, when you browser search or ask Siri for an Internet search on your iPhone it uses Google’s search engine. Payments by Google to Apple, to be the default search engine on iPhones, reportedly accounts for 14 to 21 per cent of Apple’s profits.  Payments were expected to be between $18 billion and $20 billion annually by 2021. That’s not all economic surplus from the value of communications standards and SEPs, but a significant proportion of it surely is given that Google, like Meta, also harvests value from consumers’ personal information including use—such as location—of mobile devices.

And, what about the SEP licensors who also develop the standards in the first place? Some of them are probably obtaining some producer surplus and using it to support their complementary product businesses in communications processor chips, network equipment and devices. Nevertheless, with aggregate royalties paid only around five percent of handset revenues, a much lower percentage when also including MNO and mobile OTT revenues and declining over the last decade, the remaining surplus passed through downstream in a vibrant and innovative ecosystem where almost everyone now is a major consumer is much, much more.

Keith Mallinson, founder of WiseHarbor, has more than 25 years of experience in the telecommunications industry as a research analyst, consultant and testifying expert witness.