Archive for December, 2011

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Oracle’s disappointing 2QFY12 results, delivered just before Christmas, sent shockwaves through a tech tape that had been riding fairly high in the weeks prior.  3Q11 numbers had been generally positive, with a string of beats from the major enterprise IT vendors, with IBM’s strong quarter a bellwether for the sector.  Even companies with fiscal years askew to include October in the quarter – e.g. Cisco, HP, Dell, NetApp, and Brocade – showed up with good results for the period (Exhibit 1).  Generally, these companies suggested that IT spending was holding up, despite ongoing global economic distress, and although most managements cautioned that their vision of future business was unusually murky, guidance for deceleration in YoY sales was taken as conservatism.

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When the AT&T/T-Mobile deal was first announced on March 20^th, it seemed improbable that the deal would be allowed by either the DoJ or the FCC, both of which had the power to stop it, without significant concessions.  The collapse of the deal on Monday and AT&T’s subsequent guidance that 4Q11 earnings would be reduced by $4B to accommodate payment of a break-up fee to T-Mobile USA owner Deutsche Telekom is stinging indictment of AT&T management.  AT&T apparently believed that its powerful lobbying organization could win the day, despite obvious reservations from the Obama-appointed DoJ and FCC and a terminally gridlocked Congress.  While I believed that there were still options that could have preserved AT&T’s acquisition of T-Mobile’s spectrum without reducing retail competition – i.e. buying the network only and allowing T-Mobile a long term lease to capacity on the combined platform at favorable terms – such avenues were not seriously pursued, calling into question management’s assertion that the proposed acquisition was solely about network efficiency.  Ultimately, this folly leaves AT&T worse off, with a $3B cash payment to DT accompanied by a transfer of $1B in spectrum rights.

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Gary Hamel and C.K. Prahalad, “The Core Competence of the Corporation” Harvard Business Review, May-June, 1990

Historically, the study of organizational behavior has gotten very little respect.  First year MBA students use the class for surreptitiously reading casework from other classes or, simply getting in a little “Angry Birds”.  Business faculties sneer that OB research is lacking in the hard numbers that make management science a real “science”.  Noting that the mathematical foundations of modern Finance and Economics may not be as firm as academics like to purport, I suggest that TMT investors ignore corporate culture at their own peril even if it is a bit squishy.

The C.K. Prahalad and G. Hamel article linked above has proven to be extraordinarily influential, despite its lack of multivariate regression analysis.  This article was the genesis of the concept of core competencies, now a common consultant-speak catch phrase, but then a startling observation.  Company success is built on developing superior capabilities in areas that are important to success in a base business.  Successful diversification is often built by extending into new areas where the superior capabilities honed in the base business will also be competitive advantages.  Conversely, diversifying into a new area simply because your existing customers also buy the new product, or because it uses some of the same base materials, or simply because it seems like a big opportunity, may not prove to be a good idea.  Moreover, if a company competes in an industry that undergoes a major paradigm shift that rewards a very different set of competencies, that company will struggle.

We have written about the tech industry sea change that laid waste to a long roster of computer makers over the course of the ‘80’s. The mini-computer market required regular and highly customized architectural redesigns to deliver increasing performance and a high-touch direct sales force for distribution.  Many competitors focused on task specific niches – e.g. office document processing for Wang Labs, fault tolerant production systems for Tandem and Stratus, etc..  With the emergence of the x86 PC, product engineering was greatly simplified, distribution broadened dramatically, and niche markets were absorbed into the main.  The winners – Dell, Compaq and others – excelled in manufacturing, logistics and broad distribution, the old guard, with the exception of IBM, simply died.  How did IBM succeed?  To simplify, it was able to leverage its towering competence in large account sales into a dominant position in growing markets for services and software.

This concept is particularly germane today as the TMT industry barrels headlong into another massive paradigm shift.  We see proud Hewlett Packard, with its exceptional competence for elegant hardware design combining precision with reliability built over its 70 year history, struggling to transition to a business plan more focused on software and services.  We see Intel and its paranoia-driven focus on pushing the envelope of circuit complexity and semiconductor manufacturing processes, tripping up as the market demands lower power, lower cost and rapid product development rather than sheer processing performance.  We see Dell and its long vaunted manufacturing and direct distribution prowess faced with new product markets asking for design innovation and heterogenous distribution.  Nokia and RIM gasp for relevance in a mobile device market that is no longer just about the device itself, but the software operating environment and associated network delivered services that come with it.

The ramifications of industry transformation are not just limited to the PC value chain and cell phone makers that are struggling with the rise of tablets and smartphones.  As residential broadband gets more capable and more competitive, we believe the distribution of video entertainment will tip toward the Internet.  While cable operators have long standing competence in expanding their coaxial networks, negotiating programming fees and influencing regulators, years of monopoly have left them bereft of the customer service, consumer marketing, or user interface DNA that will be currency of the realm in the brave new world.  You could argue the same on behalf of the nation’s telephone carriers, as they contemplate ventures like on-line content distribution and mobile payments.

Similarly, media companies used to a role as gate keeping middlemen who could pick and choose the entertainment that would see the light of day, will find their networks of relationships less valuable once the Internet shortcut to the consumer for content creators is more firmly established, and will have to rely on their financing, marketing and branding savvy to carry the day.

On the enterprise side, traditional data center technology vendors – e.g. HP, Cisco, EMC, VMWare, Oracle, et al. – all of whom have defined differentiated value-added solutions for enterprise customers that value a strong hand to hold will face commoditization as data center demand shifts sharply to sophisticated cloud hosts looking to buy simple and cheap.  It is safe to say that this group of companies, used to thick margins and primed to integrate functionality rather than strip it out, would struggle to struggle to hit lowest cost benchmarks.  Moreover, the new opportunities created by the shift to the cloud, as consultants to enterprise customers, as providers of SaaS, or as cloud hosts in their own right will take very different skills.

Acquisitions are no panacea for a genetic problem.  No amount of new blood from hot silicon valley start ups was able to transform the phone company DNA of Lucent before it stumbled into its marriage of convenience with similarly impaired Alcatel.  A steady stream of new acquisitions and new CEOs has made little impact on HP.  While it won’t stop the likes of Oracle, SAP or Intel from further deals to shore up their cloud or mobile credentials, the potential success of these competency graft-ons should be considered with a bit of a jaundiced eye.

History says that leopards have a very difficult time in changing their spots.  This degree of difficulty vaults Lou Gerstner’s accomplishments at IBM into double-sized niche in the Pantheon of management achievement.   While I can’t say that none of the leopards in today’s TMT landscape will manage to come up with a convincing set of stripes, I will say that I wouldn’t bet on it.

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The Android Patent War: An Apple trade claim could bar imports of its competitors – December 5, 2011, The Wall Street Journal

December is a busy month in the patent wars.  On Friday, a U.S. District Court in California denied Apple’s request for an injunction against four Samsung products.  On the same day, a German Court held its third hearing on separate infringement issues raised by Motorola against Apple.  On Wednesday, the U.S. International Trade Commission will issue its ruling on Apple’s infringement claims against HTC, with an import embargo of infringing products the only remedy available (Exhibit 1).

Let’s start in California, where Apple was seeking injunction on the Galaxy S 4G, Infuse 4G, Droid Charge, and the Galaxy Tab 10.1 based on four design-based patents.  To grant an injunction, U.S. courts require not only that a finding of infringement is likely, but also that the IPR holder would suffer irreparable harm that could not be remedied by a financial payment at a later date if the injunction is not granted.  Apple failed to convince the Judge that these standards were met, and thus, injunction denied.  This removes a powerful weapon from Apple’s arsenal against Android licensees in the U.S., weakening its stance in negotiating royalty agreements in the process.

Ultimately, much of Apple’s litigation against the Android ecosystem worldwide is based on product design patents, both in the physical configuration of the device and the software interface, rather than on “hard science”.  The first stop for the defense in any IPR litigation is to show that the patent in question is based on prior art, that is the innovation has already been shown in other products prior to the patent, or that it is an obvious, incremental step, and thus unworthy of a patent.  This is much easier to do with design patents.   For example, Apple has been asserting a patent for a rectangular touch-screen tablet with a glass front and four evenly rounded corners.  In the California case, Samsung presented a 1994 study by Knight Ridder that postulated a tablet-like touch screen reader, and in Germany, it introduced the 1969 film “2001: A Space Odyssey”  into evidence, as it showed Mars bound astronauts using a similar device 9 years earlier than it was launched in real life.

Apple may have a better chance at an embargo at the ITC, where its motion will be decided by majority vote of a 6 person appointed commission.  As the WSJ opinion piece linked above (sorry for linking a restricted article, but I figured most of you would have a WSJ subscription) notes, the ITC is an anachronism with a substantial power that is often wielded in seemingly arbitrary fashion.  In this case, the ITC staff had recommended that the injunction be denied, but the Administrative Law Judge assigned to the case reversed the recommendation and ruled that an injunction was due on two Apple patents, pending appeal to the ITC commissioners.  If the commissioners reach the same conclusions, then President Obama will have 60 days to waive the ruling before the embargo takes effect.  This ruling is of particular interest, in that Apple has similar claims under way at the ITC against Samsung and Motorola.

Of course, even in the event of an embargo or an injunction, the infringing party can always re-engineer their products to sidestep the specific patents in question.  For example, in Germany, Apple was granted a preliminary injunction against Samsung’s Galaxy Tab 10.1 tablet based on the aspect of its tablet patent concerning an “all glass face”.  Samsung has quickly come to market with the Galaxy Tab 10.1N, which includes a metal bezel around the screen, prompting Apple to demand an injunction on the new product.  A hearing is scheduled for December 22.  If Apple manages to win another injunction based on a broader interpretation of its patent, we can expect another work around from Samsung, but more importantly, it makes it far more likely that the preliminary findings will be thrown out by the court during the actual trial, as it will be even easier to show prior art and to assert that the patented innovations are obvious.

In the same way, it can be assumed that HTC will be back in the US market quickly, with re-engineered products that skirt the specific patents.  Product lifecyles in the mobile device market are short and the asserted patents are not so central to the character and functionality of HTC’s Android products that non-infringing work-arounds would have a noticable effect on their consumer appeal.  Of course, Apple could then begin the process anew with fresh claims against the new products with the ITC and in various court jurisdictions.  Ultimately, the real winners are the lawyers.

Of course, Apple is getting a taste of its own medicine in Germany, as Motorola has asserted its own IPR against Apple products in three separate actions.  The first got off to a terrible start for Apple, which failed to meet a court filing deadline and received a default judgment barring Apple sales in Germany.  Apple was granted a stay, pending a hearing scheduled on February 3, 2012, but the action puts Apple on its heels at the start and missing a deadline demonstrates that even Apple’s legal resources may be running thin.  A second hearing in mid-November, with Motorola asserting patents against Apple’s European distribution arm – N.B. German courts allow separate actions against various subsidiaries of a parent company – appeared to support Motorola’s position against all Apple products that support iCloud or MobileMe, which is, all iPhones and iPads, prompting Apple to request that any injunction require Motorola to post a bond to reimburse it for lost sales should the eventual trial verdict invalidate Motorola’s claims.  The third hearing was inconclusive, according to Foss Patents website guru Florian Mueller.

A quick note on the “Fair, Reasonable, and Non-Discriminatory” (FRAND) terms that all standards body participants agree for licensing IPR that is essential to complying with a public technical standard.  This principle dictates that all companies have equal access to essential technology licenses at market established terms.  A company accused of infringement can claim that the asserted patents should be subject to FRAND licensing, taking injunctions off of the table and establishing a specific basis for damages.  Non-essential IPR carries no such FRAND requirement, but typically, leaves room for the accused infringer to redesign their products to avoid the patents in question.  In its defense against Motorola, Apple is claiming that the patents in question should be subject to FRAND although the preliminary hearings do not suggest that the German courts entirely agree.

Considering the whole of the mobile platform patent war, we remain firmly convinced that it must end in comprehensive cross-licensing spanning the industry.  Steve Job’s emotional call to thermonuclear war against Android aside, IPR litigation is too expensive and time consuming to be worth taking all the way to the end.  Design patents, which have been the core of Apple’s claims against the Android ecosystem, offer the out of a work-around redesign, making it hard to keep opponents out of the market.  Since infringement suits must be brought against specific products, each generation of phones and tablets will require a new wave of litigation.  Apple may be able to gain a modest royalty stream by licensing its IPR to its competitors, but it Steve Jobs’ vow to “destroy Android” is likely an empty threat.   As for his threat of “Thermonuclear War”, to quote the movie WarGames, “The only winning move is not to play.”

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While AT&T twists in the wind in its quixotic press to gain approval for its acquisition of T-Mobile USA, Verizon has sprung a deal of its own, announcing agreement to buy roughly 20MHz of spectrum with a nearly national footprint held by cable operators (Spectrum Co.).  This purchase, at $3.6B, is for less than 10% of AT&T’s tab for T-Mobile and its 53MHz and gives Verizon more headway to extend its already substantial lead in 4G LTE services.

From AT&T’s perspective, this is awful news.  Fierce opposition to the structure of the T-Mobile deal by both the FCC and DoJ, both of whom must approve the transaction, will certainly send AT&T back to the drawing board to restructure and could scuttle the deal entirely.  (N.B. I have long believed that the right answer is a comprehensive network sharing agreement, with T-Mobile transferring its network assets and spectrum licenses to AT&T, and signing a long term wholesale agreement that preserves T-Mobile as retail competitor with a competitive cost basis.)  Meanwhile, T’s arch-rival scoops up spectrum that lets it expand its LTE lead while the rest of the field stands flat footed.  Moreover, it removes the possibility that AT&T could turn to the cable operator spectrum if the deal does go sour.  The only ray of hope is that Verizon’s actions shift the legal and regulatory focus from the loss of T-Mobile as a competitor toward a need to field a credible 4G alternative to VZ.

For Verizon, it is a coup.  The Spectrum Co. holdings are in a reasonably attractive frequency range used for commercial wireless services in many parts of the world and already supported by leading network and device makers for 4G LTE.  The 20MHz would double the amount of spectrum that Verizon has allocated for its LTE service, easing the costs of capacity expansion while doubling the potential throughput.  The price paid is reasonable, particularly in light of the $39B price tag for T-Mobile.  While the deal carries provisions for Verizon Wireless and its new Cable friends to co-market each others’ services, a similar arrangement with Sprint over the past several years has borne very little fruit.  It would seem that Verizon will be able extend its first mover and scale advantage in mobile 4G services, with the very real threat that it could stimulate substantial churn of its rivals’ most valuable customers.

As for the Cable Companies, they get to split $3.6B and put their moldering spectrum assets into the hands of someone that won’t likely use them to aggressively compete for residential broadband – at least in the next few years.  I’m not inclined to put much value in the agreement for Verizon Wireless to bundle and market cable products, but to the extent that the deal blunts the potential of direct competition, that is a very good thing.

For the FCC, this deal is likely to pass muster, but raises serious policy questions.  If the AT&T merger is thwarted, how can the agency promote competition in wireless broadband?  Can a solution be found that preserves consumer choice, but also allows scale and spectrum headroom for AT&T’s 4G network?  Can a third or even fourth 4G network reach competitive scale?  The long term answer needs to come from new spectrum auctions, currently held up by Congressional gridlock.

Clearwire’s ongoing funding soap opera is another wild card in this game.  With 150 MHz of largely contiguous spectrum at frequency ranges that seriously limit the practical range of cell radios, Clearwire is at a great economic disadvantage with regard to providing blanket coverage, but at a great capacity advantage for serving many customers within a fixed geography.  Eventually, we believe this spectrum will be turned to its obvious best use – fixed wireless broadband in direct competition with wireline networks.  The Verizon-Spectrum Co. agreement takes options of the table for many players, but could, in the process, make Clearwire a more valuable property.

The same could be said for the wireless broadband plans of LightSquared and Dish Network.  Verizon’s deal highlights the value of spectrum and, from a government perspective, the importance of stimulating competition in 4G.