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.
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.
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