Everything is connected

December 19, 2013, 5:21 PM UTC
Illustration: Fortune

Is Qualcomm getting into the fashion business? In late 2013 it launched the Toq, a “smartwatch” that sends email and other notifications straight to users’ wrists. Pronounced “talk,” the new device was a departure for the semiconductor company, which has largely remained behind the scenes even as its technology ignited the smartphone revolution. But the Toq wasn’t the chipmaker’s only deviation from the norm. Lately it seems Qualcomm (QCOM) is doing everything it can to shed its image as a nerdy purveyor of microprocessors and radio chips for phones and wireless networks. Long a stalwart at telecom trade shows, Qualcomm last year secured the keynote slot at the glitzier Consumer Electronics Show, serving up a wide-ranging presentation that previewed its forthcoming watch, highlighted an all-electric Rolls-Royce charged up by Qualcomm technology, and touted an augmented-reality application demonstrated by Sesame Street’s Big Bird. It also unveiled a software platform that allows all sorts of household gadgets to communicate with one another.

Qualcomm isn’t rejecting its past; rather it is trying to expand its potential market by bringing wireless connections to tens of billions of devices, from mundane items like washing machines and coffeemakers to lifesaving tools like defibrillators and pacemakers. The vision is simple: If everything is connected to the Internet, those items can tell the network, and by extension a consumer, when something is wrong (an irregular heartbeat or an intruder in the garage), an object is missing (the fridge knows there’s no milk), or conditions have changed (traffic on the highway has cleared). The consumer, or another device, can in turn talk back and alert a doctor to the heart issue, send a homeowner a reminder to stop at the store, or, in the not-so-distant future, program the car to take the freeway home.

This concept of the Internet of Things is hardly new; the term dates back to 1999. But Qualcomm, which reported almost $7 billion in profits on $25 billion in sales in the 12 months ended Sept. 29, is breathing life and considerable resources into the effort. The San Diego-based tech giant will spend a chunk (it declines to say exactly how much) of its $5 billion annual R&D budget to make what it calls the “digital sixth sense” a reality.

Qualcomm’s effort to redefine itself comes as the company is undergoing another transition: In mid-December the chipmaker said CEO Paul Jacobs would be replaced in March by current operating chief Steve Mollenkopf. Sources say that Mollenkopf had long been the board of directors’ pick to eventually run the company, and that the directors accelerated the succession process when it learned Microsoft (MSFT) was courting Mollenkopf to replace Steve Ballmer as the head of the software giant. Jacobs will remain executive chairman of Qualcomm. “It’s a very unique place in the industry, and I’m humbled to have the opportunity to shepherd it further,” Mollenkopf told Fortune the day his promotion was announced.

Mollenkopf and Jacobs have an interesting challenge ahead: For its Internet of Things gambit to become a reality, Qualcomm needs to do more than retool the chips and sensors the company makes today, though that’s a big task. The company needs to build other parts of the ecosystem (such as the operating language that allows devices to talk to one another) just to get potential partners to see the potential of Qualcomm’s vision. Thus, Qualcomm has created AllJoyn, an open-source software platform for Internet-connected devices, and Toq, which looks a lot like a giant Casio Classic. (Okay, so maybe Qualcomm isn’t ready to move into couture.)

And yet Qualcomm has played this hand before, with fabulous results. Today Qualcomm’s chips are found in about two-thirds of the world’s 3G and 4G broadband phones. Its components power Apple’s iPhone (Apple designs its processors but uses some Qualcomm parts, such as radio chips), Samsung’s line of Galaxy devices, and Amazon (AMZN) Kindle Fire HDX 7. Apple (AAPL) and Google (GOOG) get a ton of credit for making smartphones accessible, but there might not be smartphones if it were not for Qualcomm.

That’s because Qualcomm didn’t just invent stuff for the innards of the phone: Management tried to show mobile computing in action. Long before the release of the iPhone and the opening of Apple’s App Store, Qualcomm built and tried to commercialize its own smartphone and app store. Back when consumers eschewed the idea of watching video on phones, Qualcomm created a business to stream live television to handsets. The company has since exited those businesses (and a few were total bombs, like the broadcast TV unit), but not before it showed the world the potential of smartphones — while selling loads of its chips and components in the process. Can Qualcomm, which has already helped radically redefine the way consumers work, communicate, play, and learn, shape the future yet again?

Paul Jacobs has folded his lanky frame into a cream-colored Ikea armchair — and, more important, onto a teeny-tiny motion sensor that’s been tucked into the seat’s foam-filled cushion. He’s maneuvering around a lab at Qualcomm headquarters, test-driving some of his engineers’ latest innovations. Jacobs stands up, and a nearby lamp shuts off. He sits back down, and the light flickers on again.

“Here’s the issue,” Jacobs says, looking up at the two engineers standing beside him, eagerly awaiting his approval. “This thing is a battery-operated deal, so how does it let me know that my butt-sensor battery is out?” The engineers assure him that the sensor can be programmed to stay in sleep mode until it’s activated by, well, the pressure of someone’s derrière, which minimizes its power consumption. Jacobs peppers the team with more questions: What’s the control interface? Does the lamp have a dimmer? How much do the added components cost? “This is a good idea,” he finally says, to the engineers’ relief.

Conversations about butt sensors and programmable lamps are becoming increasingly commonplace at the Qualcomm campus. There’s an urgency to the company’s push into new areas. Nearly all of Qualcomm’s revenue is tied to sales of phone components such as baseband chips and application processors or licensing fees that phonemakers pay for its patents, and while there’s still plenty of growth in markets like China, where carriers are now building out data-driven broadband networks, smartphone growth is declining for the first time in more mature markets. That slowdown hits Qualcomm in two ways: Its sales growth in components slows down, and its customers, the handset manufacturers, shift their energies to cheaper phones for emerging markets, phones that generate lower patent royalties for Qualcomm.

As a result, investors are clamoring for Qualcomm to diversify. Analysts at Gartner predict that the trend of turning everyday objects into data-spewing machines will help add $1.9 trillion to the economy, spread across manufacturing, health care, and other industries, over the next six years. Jacobs believes there will be an average 22 connected devices per U.S. home by 2020. “The digital sixth sense is the next evolution of smartphones and tablets,” says Francis Sideco, an analyst with research firm IHS. “It will be a dynamic new market for Qualcomm and its competitors to attack.”

To understand where Qualcomm — and quite possibly the future of wireless technology — is going, it’s helpful to look at where the company has already been. Irwin Jacobs, a former computer science professor and Paul’s father, founded Qualcomm along with six other engineers back in 1985. Their mission? Commercialize CDMA (the abbreviation stands for “code division multiple access”), a digital wireless technology once used by the U.S. military for secure communications. In so doing, Qualcomm introduced a new wireless standard in the market, in competition with GSM, the system favored by Europe and much of the rest of the world. U.S. carriers ended up picking sides, with Verizon (VZ) and Sprint (S) using the CDMA standard for its digital network and AT&T (T) picking GSM.

Qualcomm filed thousands of mobile patent applications, which forced anyone who wanted to make a phone that ran on a CDMA-based network to shell out royalties to the company. That resulted in many heated legal battles with handset makers, as even rival chip companies were forced to pay licensing fees to Qualcomm. But Qualcomm prevailed, and by 2000 it realized that its cash cow was chipset manufacturing and intellectual-property licensing; the company sold off its other businesses. But that didn’t keep it from having a starring — albeit behind-the-scenes — role in the explosive entrance of smartphones. “Paul, as far back as I can remember, was saying that the wireless Internet was going to be greater than the wired Internet,” says Peggy Johnson, a Qualcomm executive vice president who helped Jacobs convince now-defunct PDA maker Palm in 1999 to launch the pdQ, a predecessor to today’s smartphone.

According to Johnson, Jacobs, who was in charge of the company’s wavering handset division back in the pre-smartphone days, walked into a meeting one day holding a cheap Qualcomm-made cellphone taped to a PalmPilot. “That’s what I want to build,” he told the team. “Not many people even texted at that point,” says Steve Sprigg, senior vice president of engineering at Qualcomm and lead of the company’s early smartphone initiative. “The biggest hurdle was somewhat of a mindset issue — convincing people that, in effect, you were holding a little computer in your hand.”

Pushed by Jacobs, Qualcomm execs spent months wooing Palm’s then-CEO, Donna Dubinsky, and top mobile operators, trying to convince them that consumers would want to use one device for making calls and sending email. The 6.2-inch pdQ finally launched to great fanfare. “Once you use the pdQ, you will not want to go back to using a standalone Palm unit,” wrote one reviewer. The problem was that there was little else to do but email. So Jacobs created Brew, an open applications platform for CDMA-based phones. (Some handset manufacturers still use the operating system for “feature phones” — lower-price devices that don’t have as much computing capability as smartphones.)

Jacobs is clearly proud of Qualcomm’s role in promoting mobile computing, but he’s the first to acknowledge that others are better at app stores and phone manufacturing. “I give Apple a lot of credit for exploring the consciousness of what a phone can be,” he says. “And obviously Google getting into the space with Android was very good for us too.”

While the barriers to entry in much of technology are crumbling, the chip business has remained relatively protected, largely because of its complexity (it’s hard for a design-school dropout to launch the next Intel) and production costs. But the Internet of Things has the potential to change that. The extremely low-power chipsets for low-tech devices like refrigerators and espresso machines could open doors for new entrants to the chipmaking business that embrace the same “fabless” model, in which semiconductor companies farm out silicon manufacturing to mostly Asian factories. It is a model that has worked well for Qualcomm. Meanwhile Intel (INTC), which missed the shift to mobile computing, to the dismay of investors (in the past decade its stock has fallen 20%; Qualcomm shares are up 185%), is determined not to miss the Internet of Things movement. Under new CEO Brian Krzanich, Intel also is pursuing a new family of chips especially suited for “wearables” and other devices.

Jacobs insists that Qualcomm’s move into new devices isn’t a defensive step but a complement to its existing mobile-computing business, where it enjoys a commanding technology lead. (Qualcomm is on its fourth generation of chips for so-called LTE broadband networks. Rivals Intel, Nvidia (NVDA), MediaTek, and Broadcom (BRCM) are producing their first generation of LTE processors.) The Toq watch is programmed to sync with the user’s smartphone. The watch’s face tells you when you have incoming calls and messages, for example. “I gave one to Shaq,” Jacobs says during a stroll on Qualcomm’s campus. Jacobs co-owns the Sacramento Kings with the former Los Angeles Lakers center Shaquille O’Neal. Jacobs also is a funder of La Jolla Playhouse and a big donor to the University of California at Berkeley. In a later conversation Jacobs expressed no angst about having to relinquish the CEO role earlier than expected. (Having a net worth of more than $400 million perhaps helps cushion the blow.) “The fact that Steve is taking over as CEO is a great outcome for us,” he says. “I really want to focus on things I’m passionate about.”

A decade ago Fortune ran a story titled “Heads We Win, Tails We Win,” about telecom’s transition from narrowband networks to 3G broadband networks. It turns out that all 3G systems, regardless of whether they started out as CDMA, rely on Qualcomm patents, and therefore Qualcomm has been entitled to a toll.

Incoming CEO Mollenkopf believes a similar opportunity applies to the Internet of Things. “Our ambitions are to really be much more pervasive, not only in the phone space but in whatever replaces the PC, whatever happens in the home, in the car,” he says. “But we also know that those things will be running some form of smartphone ecosystem, and it’s going to be connected all the time, and it’s very likely going to be through some sort of Qualcomm technology.”

And so just as Apple took the smartphone further than Qualcomm ever could with the pdQ, other companies will build the software, apps, watches, and, yes, even the butt sensors that will power the Internet of Things. And that’s just fine with Qualcomm. Put another way: Heads we win, tails we win.

Qualcomm and the Birth of the Cool

Here are some of the products the San Diego tech company has pioneered.

1993: First CDMA phone. The CD-7000 was the first in a series of CDMA-based cellphones manufactured by Qualcomm. It later sold its handset business to Japanese manufacturer Kyocera.

1999: pdQ smartphone. Jacobs’s vision to combine the data capabilities of a PalmPilot with voice functions found on basic cellphones finally materialized in the pdQ, the first CDMA smartphone.

2001: Brew platform. Well before the Apple App Store, there was Brew, Qualcomm’s attempt at a mobile-applications store and developer platform, which made over-the-air downloads possible.

2004: MediaFlo. The company announced plans to stream live network television to phones; it shuttered the unit, but not before showing that people could watch video on small screens.

2007: Snapdragon system-on-a-chip. The company’s popular Snapdragon line of chipsets combines wireless connectivity, multimedia performance, and superfast data processing, and is found in the Google Nexus 7 and the Amazon Kindle Fire HDX.

2013: AllSeen Alliance. In an effort to ramp up the Internet of Things, Qualcomm open-source software, an extension of AllJoyn, lets devices communicate with one another, allowing any manufacturer to embed the technology in TVs, washing machines, and other gadgets.

Correction: An earlier of this version incorrectly referred to the AllSeen Alliance as the AllSense Alliance. Fortune regrets the error.

This story is from the January 13, 2014 issue of Fortune.