Fair returns on R&D from SEP licensing with smartphone success and upcoming 5G

Patent licensing remains a flashpoint for mobile telecom as it moves towards a future of 5G and the Internet of Things (IoT)

Cellular technology pioneers are being marginalized with diminished financial returns on their research and development investments while leaders in devices and “over-the-top” services are flourishing. Calls to weaken the basis of licensing standard-essential technologies are misplaced. There are no indications of profiteering or harm caused by licensors. All evidence is to the contrary.

Innovations in standards including technologies based on standard-essential patents can be exploited in product and service implementations by anyone. Undermining the value of SEPs will choke off vital R&D investments along the path to “5G” and cause other harmful disruptions to the mobile ecosystem, including reduced contributions to or withdrawals from standard setting.

The innovation game

As I noted here a couple of months ago in a cellular industry trade publication I also write for, innovation in cellular and other supporting technologies as well as in applications will be able to sustain the rate of smartphone improvements. New technologies can also advance the “internet of things,” automotive and other capabilities. And the financial rewards could be substantial. A European Commission study has identified a potential annual benefit to its member states of 113 billion euro ($124 billion) annually as early as 2025, from deploying 5G, with trickle-down benefits from 5G investment totaling as much as 141 billion euro.

However, technology developments and infrastructure demand large investments globally. According to a study report on the “mobile revolution,” by the Boston Consulting Group in 2015, “to reap the economic benefit of [5G] networks and beyond, mobile players will need to invest approximately $4 trillion in R&D and capital expenditures by 2020.” BCG estimates mobile players invested an aggregate of $1.8 trillion in capex and R&D from 2009 through 2013, and are expected to invest approximately $4 trillion between 2014 and 2020. While the bulk of this is capex by mobile operators, BCG also estimates R&D technologies continue to accelerate, reaching almost $100 billion annually, and growing at a rate of 9% year-over-year since 2009.

R&D investments by their very nature can be very risky: consequently, these rely on the possibility that adequate revenues might be earned to compensate for these risks and the long time it takes to generate these revenues. With short device lifecycles, returns on product R&D are relatively quick and can be reasonably certain for market leaders with new models annually in popular lines such as iPhone and Galaxy, notwithstanding the occasional disaster like the incendiary Galaxy Note 7. Returns are significantly slower and less certain in network equipment product developments, for example, with big bets on once-per-decade generational changes including GSM, WCDMA/HSPA, LTE and upcoming 5G.

In the case of the fundamental technologies that contribute to these standards, lead times before any revenues can be generated are even longer and risks are much greater. For example, less than 17% of contributions to Third Generation Partnership Project standards have been approved for inclusion in the standards. Many contributions are based on and preceded by many years of R&D by individual companies before a technology is presented to any standard-setting organization working group. Nevertheless, for those technologies that are adopted the entire ecosystem including chip, device and network equipment manufacturers, as well as network operators and OTT service providers benefit from improved capabilities. In cellular, these have included thousand-fold increases in data rates over little more than a decade, much reduced latencies, higher network availability, high-definition voice, plunging costs per gigabyte for operators and users, and so on.

Ecosystem disruptions

However, there is significant and increasing divergence between those who have largely borne the costs of developing the standard-essential technologies and those who benefit most financially from exploiting them. Whereas most of the developers of the standard-essential technology employed by all implementers used to be vertically integrated with mobile phone manufacturing, those companies including Qualcomm (2000), Alcatel (2005), Siemens (2005), Motorola (2012), Ericsson (2011) and Nokia (2014) have sold off their handset businesses. The sellers, including those that have merged, have continued with sales of network equipment or chips and patent licensing. Handset brand names Motorola and Alcatel have lived on under licensing arrangements with Lenovo and TCL, respectively.

Handset OEM market shares have therefore changed dramatically.And many new entrants have appeared.Meanwhile, the mobile devices market has expanded enormously along with demand growth for data services. These are the largest money makers in the mobile ecosystem, while use of OTT services including Facebook, YouTube and Netflix has surged on mobile devices, and as mobile advertising revenues have grown to nearly half of total internet advertising revenues.

Collecting the rents

Revenues and profits in smartphones are much larger than those generated by the leading five cellular SEP licensors that derive most of their revenues from sales of network equipment or chips. The difference is widening with a lackluster market in network equipment as LTE orders taper off. For example, Ericsson recently issued a profit warning and its interim CEO Jan Frykhammar forecast the total mobile infrastructure (RAN) market is set to fall by between 10% and 15% this year, and by between 2% and 6% in 2017.

Economic rents, which are profits exceeding the cost of capital, are increasingly accruing to leading device OEMs and OTT service providers in the mobile ecosystem. Largely from exceptional commercial success with dominance in mobile, Apple with iPhone and Alphabet with Google’s Android have become the world’s two most valuable companies. Sales of iPhones accounted for 60% of Apple’s revenues last quarter. Its service revenues in mobile are in addition. A news release reporting Apple’s fiscal fourth quarter earnings quoted its CEO, Tim Cook, as saying “we’re thrilled with … the incredible momentum of our Services business, where revenue grew 24% to set another all-time record.” Apple’s services revenues (including Apple Pay, Apple Music, iTunes and its App Store) generated $24 billion revenues in the year to September 2016. This substantially exceeds all cellular SEP licensing fees paid, as indicated in the next section, even though Apple’s user base from which it derives these revenues is only around 1 billion devices, in comparison to 7 billion cellular devices connected worldwide. With Android in 80% of smartphones, Google also profits most significantly from mobile, also including apps, search and advertising. On a conference call with investors this summer, Google CEO Sundar Pichai said “mobile is the engine that drives us.”

Paying their dues

Companies that develop SEP technologies are highly dependent on licensing revenues as well as their sales of network equipment or chips. SEP licensing brings compensation from those who implement the standard-essential technologies in their products to those who develop those technologies. The widening disparity in revenues and profits between the smartphone device market and those who significantly rely on cellular SEP licensing revenues limits the ability of the latter to invest in technology development for standardization and implementation ahead of the anticipated 5G launches from around 2020.

Cellular SEP licensing revenues at no more than around $20 billion are modest in comparison to and are being significantly outpaced by growth in other ecosystem revenues and costs. There are around $1 trillion dollars in operator service revenues. Total handset revenues have increased from $378 billion in 2013, to $439 billion in 2015, according to IDC.The five leading mobile SEP licensors that contributed around half the patents declared essential to 3GPP standards collectively generated approximately $11 billion per annum in licensing fees between 2013 and 2015. This accounts for more than half the $20 total billion (at most) paid to all licensors. Licensing fees have declined slightly as a percentage of handset revenues.

Unholy intervention

Despite the stellar financial performance of the leading device OEMs and OTT players, there is mounting pressure to change consensus-based and established SEP-licensing practices, including by government intervention, which would further undermine the ability of cellular technology vendors to make an adequate return on their standard-essential technology investments through licensing. Measures such as making injunctions more difficult to obtain, enforcing licensing or calculating royalties at the chip level, as advocated by the so-called Fair Standards Alliance and as already implemented in the Institute of Electrical and Electronics Engineers new patent policy are all undermining SEP technology developers. Some antitrust authorities, including the U.S. Department of Justice, support such changes.

R&D investments and contributions to SSOs will be significantly reduced by measures to weaken SEP licensing. For example, proprietary and 3GPP-based technologies are vying with those based on IEEE standards for short-range communications in emerging next-generation IoT and automotive vehicle-to-x applications. Technology developers will shy away from participating in standard setting or investing at all where they cannot make sufficient returns on their investments.

The system of Fair Reasonable and Non-Discriminatory licensing in standard setting has worked extremely well with phenomenal innovation, extensive new market entry and significantly improving quality adjusted prices. There is no evidence of harm to competition or consumers. In the absence of that there is no basis to undermine the position of licensors in FRAND licensing, and particularly no justification for government agency interventions to force such change.

I originally published this article, here, in cellular industry trade publication RCR Wireless on November 16, 2016.

Statistics: make of them what you will - UK patent box vs R&D reliefs

The UK tax authority has recently released statistics for take up of the patent box in 2013-14 (the first year of the relief); on the same day, it released the latest statistics on use of the UK’s R&D tax reliefs for the same tax year. The reports make for some interesting compare and contrast points:

Total claims in 2013-14
- patent box: 700
- R&D tax reliefs: 22,415

Total value of claims in 2013-14
- patent box: £342.9m
- R&D reliefs: £2.45bn

SME claims in 2013-14
- patent box: 475 (68%)
- R&D reliefs: 19,990 (95%)

Value of SME claims in 2013-14
- patent box: £15.7m (5%)
- R&D reliefs: £1.165bn (48%)

The largest claimant sector (for both patent box and R&D) is, unsurprisingly, manufacturing (63% of patent box claims; 30% of R&D claims). The second largest for R&D is Professional, Scientific & Technical, with about 20% of claims - but this sector only made 6.3% of patent box claims. This might relate to the nature of the patent box, and particularly the extra hurdle for claiming on services income. The other sectors are somewhat more difficult to analyse as numbers of patent box claims are so low that sectors have been combined to prevent commercial information being disclosed.

The R&D relief requires a company to be undertaking a project which seeks an advance in the global state of knowledge in an area of science or technology, it would seem logical that a successful R&D-relief qualifying project would often lead to something capable of being patented – and, in the 14 years for which we have R&D statistics, 141,000 claims for relief have been made. Fair enough, R&D relief claims can be made for unsuccessful projects, but out of 141,000 R&D relief claims, it seems pretty likely that there are more than 700 companies within the scope of the patent box … the report doesn’t speculate upon why the take up is so low in terms of numbers (and for comparison, the impact note when the patent box was introduced estimated the first year cost to the Treasury at £500m).

R&D tax credits for SMEs - help the government get it right (or at least better)

Heads up - HMRC is consulting improvements to the radically underclaimed R&D tax credits for SMEs.

They're looking at how to promote awareness of the credits, the design and understanding of the rules, and - most importantly in my view, the new advance assurance process. One of the main stumbling blocks to claiming the R&D credit has been uncertainty about what does and doesn't qualify: most people seem to assume you need to be doing something that involved a long and complicated chemical name, but it's much wider than that. The advance assurance process is intended to enable SMEs to get confirmation that their R&D qualifies ahead of time, rather than putting a claim in and hoping for the best.

Have a look at the consultation and think about commenting - the more people contribute, the better the chances of getting something workable for SMEs. Comments need to be with HMRC by midday on 27 February 2015

Licensing mobile technologies becomes even more essential

Dramatic structural changes in mobile communications technology supply, with the demise of vertical integration, is forcing those who are developing standard-essential technologies for 4G and "5G" networks to monetise these efforts through patent licensing, as well as their own product sales. Exiting the handset business, as have most of the original major technology suppliers, including former market leader Nokia earlier this year, eliminates participation in the largest product market, and the need for cross-licensed patent protection there.

Under New Management

The market size for mobile standard-essential patent (SEP) royalties paid remains below 5 per cent ($19 billion [€15.2 billion]) of the $377 billion in annual smartphones sales.

Netting-off
Once upon a time, new mobile communications technologies such as 2G GSM were developed by small clutches of vertically integrated players. Mobile technology pioneers including Alcatel, Ericsson, Nokia, Nortel Networks, Motorola, Qualcomm and Siemens all manufactured handsets, as well as network equipment. Some of these companies also produced communications chips.

Business models were predominantly oriented towards generating income from product sales. Technology development costs and risks of failure (e.g. with demise of the rival U.S. 2G TDMA standard) were compensated for through product sales and in cross-licensing, for little or no cash royalty payments among these major players, to obtain access to all the SEP technologies required to make and sell products.

Vertical disintegration
Over the last decade or so, virtually all the diversified mobile technology manufacturers have exited the handset market. From among the above, brand names Alcatel, Motorola and Nokia live on in handsets, but ownership is now completely removed from the original parent companies. I tracked the demise of some of these in the face of new market entrant challengers in another of my recent postings. Some of them have also ceased sales of other mobile products, including network equipment and chips.

Consequently, all the above parents have lost their ability to obtain a financial return on their mobile technology R&D investments directly through sales of handsets, which is by far the largest product market in the mobile sector. Global market revenues in 2013 were $377 billion for handsets, according to Morgan Stanley; $61 billion for network equipment, including radio, IP & transport and core equipment, according to Ericsson; and around $20 billion in baseband modems (which are mostly embodied in handset products). Nevertheless, the pace of technology development is continuing relentlessly in standard-essential technologies and in mobile technologies in general.

R&D spending continues to increase
Despite so many mobile technology vendors no longer selling handsets, mobile R&D spending, of approximately $42 billion in 2013, has grown 50 per cent since 2008, as indicated in table below. The figures include 12 large technology companies with a predominant or exclusive focus on mobile communications, including several named above. Some of these are quite diversified and do not break out their wireless R&D expenditures in public disclosures, so these figures include some R&D related to other technologies and product markets. However, my total excludes many companies that also invest significantly in cellular R&D; so I believe the table provides a fair, yet approximate, and consistent representation of total R&D investments and their growth by the mobile technology industry as a whole.

 Total Sales and R&D for Leading Cellular Technology Companies

	2008	2009	2010	2011	2012	2013
Total Sales (millions)	$399,917	$353,836	$401,722	$510,840	$559,173	$582,011
Total R&D (millions)	$27,990	$27,854	$30,829	$37,922	$39,970	$41,927
R&D/Sales	7.0%	7.9%	7.7%	7.4%	7.1%	7.2%

Sources: Includes public disclosures for Alcatel-Lucent, Apple, BlackBerry, Ericsson, Huawei, LG Electronics, MediaTek, Nokia, Qualcomm, Samsung, Electronics and ZTE.

New business model
Value is derived from standard-essential and other patented technologies through the manufacture and sale of one's own products, through cross-licensing to protect one's own product sales from infringement claims and through licensing for receipt of cash royalty payments.

Licensing value, in kind through cross-licensing or in cash, tends to correlate positively or proportionally with product sales revenues. Significantly for Alcatel-Lucent, Ericsson and Nokia, as indicated above, the network equipment business has only around one-sixth the market value of that for handsets. This means the value potential for royalty-generating licenses or royalty-mitigating cross-licenses is also likely to be correspondingly lower there for the mobile SEPs, which tend to apply to both networks and devices.
Therefore, in order to maintain R&D investment levels or increase them, technology developers are increasingly dependent on licensing others' handsets for cash royalties to recoup returns on their costly and risky R&D.

Qualcomm has been able to focus on developing its patent licensing while substantially growing its R&D. It needs to do so because R&D spending (e.g. $5 billion in 2013) exceeds the profit it makes on its chip sales. Qualcomm led the way in licensing with the company being the majority developer of CDMA technologies in the 1990s. Qualcomm's exit from network equipment and handset businesses around the turn of the millennium eliminated its need to patent-protect those operations through cross-licensing. Qualcomm's licensing revenues of $7.9 billion in 2013 are equivalent to a royalty rate yield of 1.77 per cent of total global handset revenues indicated above.

The opportunity to grow licensing income with SEPs and non-SEPs (also referred to as implementation patents) was presented as a significant strategic objective by Ericsson and Nokia at their recent Capital Markets Days in Stockholm and London. Ericsson's 2013 licensing income was around $1.6 billion, which corresponds to a royalty rate of 0.42 per cent on the same basis as for Qualcomm above. Corresponding figures for Nokia were $650 million and 0.17 per cent, respectively.

Nokia, in particular, has a history of handset patent licensing agreements which sought to minimize or eliminate royalty out-payments through cross-licensing, rather than to maximise royalty income. The company needs to unravel previous arrangements and substitute sales volume-dependent agreements for legacy sales volume-independent agreements. The latter were highly beneficial while handset market shares were up to around 40 per cent last decade. These two companies and Qualcomm are also including non-mobile SEPs and non-SEPs in some of their licensing. Ericsson, Nokia and others still need cross-licensing to provide "freedom to operate" in design, manufacture, sale and use of network equipment.

Low barriers with modest royalties paid
The mobile device business--including smartphones, feature phones, tablets and Internet of Things connectivity--has relatively low barriers to market entry through the freely available 3GPP standards. That is why there are so many new handset OEM names in recent years--with the most notable successes including Apple since 2007 and Xiaomi since 2011--seizing substantial market shares.

Ericsson, Nokia and Qualcomm are widely regarded as holding, in total, a substantial proportion, and quite likely the majority, of SEPs reading on 3GPP standards. On this basis, and the fact that Qualcomm has a far more well-developed patent licensing programme than any other company, a total aggregate SEP royalty across all handsets worldwide is most likely to be no more than a mid-single-digit percentage. Five per cent is conservatively more than double the total of 2.36 per cent in royalty rates I have calculated for Ericsson, Nokia and Qualcomm. Other significant SEP holders account for only relatively small licensing revenues. For example, InterDigital Communications, with a business model entirely focused on patent licensing, reported $264 million in patent licensing revenues in 2013. That corresponds to a comparable royalty rate of 0.07 per cent.

Smartphones designers also seek to include features which are subject to non-mobile SEPs and which might be subject to non-SEPs. But the latter are more easily ignored or worked around with alternative technologies, and some features might be omitted if this is not possible. In the case of SEPs, it is at least in theory not possible to implement the standard or part thereof without infringing.

On the basis of financially audited royalty incomes from leading licensors, my estimate that total mobile SEP royalties amount to less than a mid-single-digit percentage of handset revenues is in marked contrast to the erroneous aggregate royalty rate estimates of Intel and others. Elsewhere, I have published a detailed rebuttal of Intel's defective assessment that the smartphone "royalty stack" could amount to $120 on an average $400 smartphone, including SEPs and non-SEPs. That would correspond to a 30 per cent royalty rate, or around $100 billion per year in total royalties. This is more than five times my estimate of less than $19 billion, which includes all mobile SEPs, many non-cellular SEPs and many non-SEPs also thrown in to the licensing bundles. This figure is less than half the mobile industry's R&D spending.

Royalties paid on non-cellular SEPs (e.g. H.264 video and 802.11 Wi-Fi) and non-SEPs amount to no more than additional single-digit billions of dollars. It has been disclosed that Samsung, with 2013 smartphone revenue share of 34 per cent, paid Microsoft an annual $1 billion in licensing fees to implement Android. This is exceptional and accounts for a significant proportion of all non-SEP royalties paid.

I originally published this article in the mobile communications industry trade press with FierceWireless.

The Patent Box Coming to the United States Soon?

Congresswoman Allyson Schwartz recently introduced a bill in the House of Representatives to establish a patent box similar to that adopted by some European countries (she previously introduced the bill in 2012 and here is the press release for that bill).  The bill provides a lower tax rate on profits from the exploitation of patented technology developed in the United States.  The patent box is designed to lure entities to the home of the box and thus, create jobs.  The effective tax rate for qualifying profits appears to be 10%.  Here is a link to the proposed legislation and links to several news articles about the 2012 and 2013 proposed legislation here, here and here.  In a helpful 2012 article by Pricewaterhouse Coopers, Is it Time for the United States to Consider the Patent Box, the authors state:

According to the most recent OECD data, as of 2009 the United States ranked 24 out of 38 countries (including 32 OECD members plus Brazil, China, India, Russia, Singapore, and South Africa) in the value of tax incentives provided per dollar of R&D. Because the U.S. research credit expired December 31, 2011, the U.S. incentive provided for R&D is now even lower than indicated by the OECD ranking.

Moreover, according to 2011 OECD data, the combined federal and average state statutory corporate tax rate in the United States (39.2 percent) is second highest among OECD countries, and more than 14 percentage points greater than the average for the other countries (25.1 percent). Therefore, royalty and license income earned from U.S.-held IP is taxed at a 50 percent higher rate than IP held in the average OECD country. The disparity in taxation of IP is even greater when compared with countries with patent box regimes, where qualified IP typically is taxed at rates between 5 and 15 percent.

The time appears to be closer.  What do you think?  The article also has a useful chart comparing patent box legislation in Belgium, France, Luxemburg, Netherlands, Spain and the U.K.