Patent Wars!


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Mobile patents were hot before Google’s purchase of MMI and its IPR portfolio.  Since then, the tortuous legal process for sorting out the IPR mess has a dominant topic for investors.  Market leaders are tactically litigating against one another in multiple jurisdictions, while patent “trolls” sue for royalties.  Along the way, incremental legal decisions should be viewed with skepticism, as embargoes, injunctions and damage awards are typically stayed on appeal and the appeals process typically takes many years IF it plays to final judgment.  Despite the market enthusiasm for IPR holders like Interdigital and Kodak, we believe that Google’s recent deals bring the industry into closer balance and that future bidding over patent-rich properties will be relatively muted.  We also expect the internecine battles to shift from costly litigation to negotiation, with comprehensive cross-licensing agreements between the biggest players more likely than not.  Meanwhile, patent trolls WILL exact a modest tax on the industry, but are unlikely to have a serious impact on either market demand or competitive balance.

Mobile device IPR has been a contentious issue for over a decade, after Qualcomm upset the status quo of big telecom equipment players cross licensing each other and squeezing rivals.  Qualcomm faced down a barrage of litigation, including fierce opposition from then dominant market leaders Nokia and Ericsson, eventually negotiating royalty bearing cross licenses with all of its major challengers.  Qualcomm succeeded because: a) they had unique and immensely valuable technology; b) they weren’t trying to sell equipment, and thus didn’t need to cross-license patents; and c) early deals with Korean manufacturers set the market rate for their portfolio.

The history of Qualcomm has several important lessons for investors vis a vis IPR battles.  The first –Lurid damages and injunctions imposed by lower courts or initial ITC judgments are usually stayed pending appeal, and the appeals process can take years to play out.  In particular, injunctions have a high standard – irreparable harm – that is difficult to meet on appeal.  These rulings should be considered as important inputs to negotiations over royalties rather than a penalty that is likely to be paid.

Second, the U.S. legal precedent for setting damages for patent infringement is a framework called “The Georgia Pacific Factors”.  These factors focus heavily on market precedents – what has been paid in the past for these or like patents? – favoring companies that have established long-standing licensing policies, such as Qualcomm.  Essentially, it is hard to avoid paying for IPR if other competitors have already agreed to pay.  Once the first licensing agreements with a particular patent holder are negotiated, the remainder eventually follow suit with terms based on the initial agreements.

Third, patent litigation is inherently one-way – the fact that you have a strong IPR portfolio is irrelevant in determining liability for infringing on someone else’s patents.  However, counter suits alleging infringement in the other direction are a powerful tool to force negotiations.  One key to Qualcomm’s success in extracting royalties is that it does not produce devices, and thus is far less subject to counter claims by the manufacturers with whom it is negotiating.  Most of the disputes in the current fracas are two way, suggesting a greater likelihood of a negotiated cross-licensing solution.

Finally, not all patents are equal.  Many patent infringement claims are thrown out on validity challenges, asserting that the patent is preceded by “prior art”, or that the patent is “obvious” – software patents have been particularly vulnerable.  We also note that the most important patents may be subject to industry standards association requirements that essential IPR be made available on “fair, reasonable and non-discriminatory” (FRAND) terms.  While many frameworks for assessing the value of IPR portfolios have circulated, we believe the proven ability to generate royalty bearing cross licenses is the best indicator.  On this basis, Qualcomm, Microsoft, Motorola and Nokia have been successful.

The number of patents involved in a single smartphone or tablet run well into the thousands, a reasonable share of which are not controlled by direct market participants, and thus, are unlikely to be addressed by cross-licenses.  Patent aggregators, who acquire patents from small holders or take on responsibility for monetizing them, and specialty IPR holders are an increasing presence in the space.  The value of these IPR portfolios will shake out over time through litigation and negotiation.  Once value is established, licensing will proceed quickly and act as a tax on devices in the market.

At the start, Google and its partners have been the most vulnerable to infringement claims, spurring Google’s acquisition of Motorola and 2,000 patents from IBM.  While these deals do not affect the trajectory of suits already filed against the Android ecosystem, they provide ammunition to pursue countersuits and bring Apple, Microsoft, Oracle and others to the negotiating table, eliminating the most damaging potential outcomes.  Despite this, Android is still at an IPR disadvantage, particularly vs. Microsoft, and licensees will still likely face a 300-500bp royalty gap unless Google is able add to its IPR via further acquisitions or IPR alliances with unaffiliated patent holders like Ericsson, Alcatel-Lucent or Sony.  In either case, we expect the Android platform to retain share leadership across form factors, particularly given Google’s proven ability to monetize its position via advertising.

Apple has been an aggressor in the patent wars, but it is also vulnerable to the licensing demands of other IPR holders.  Apple’s royalty bearing settlement with Nokia earlier this year was a watershed, confirming this vulnerability, but also revealing a pragmatic side to Apple’s previous stance.  Qualcomm, Microsoft and others will likely be next, leaving Apple with a royalty advantage vs. Android, but a deficit vs. Microsoft and its partner Nokia.  Again, this does not change our favorable opinion of Apple in this market, expecting it to retain a highly profitable #2 position, but it does highlight an unseen advantage for Microsoft as it looks to build relevance as a strong #3.

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