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Chip-making giant Qualcomm has found itself firmly in the FTC’s spotlight, and Apple has now piled on with a lawsuit of its own. Let’s take a quick look at the developments.
By Kris Rosemann
Qualcomm (QCOM), the world’s largest maker of semiconductors for mobile phones, has a fantastic business model based on the licensing of technology that has been declared essentail to industry standards, but is it too good to be true? The Federal Trade Commission thinks it might be, and the company was charged Janaury 17 with using anticompetitive tactics to maintain its monopoly in the supply of baseband processors, the devices that manage communications between mobile products.
The FTC alleges that Qualcomm threatened to disrupt its supply of baseband processors to obtain higher royalties and secure other license terms for its patents that mobile device manufacturers would otherwise reject were it not for the industry-essential designation of the technology. The elevated royalties Qualcomm was able to realize effectively amount to a tax on mobile device manufacturers’ use of competing baseband processors, and the FTC further alleges that such a tax resulted in increased costs for consumers as well. The tactics, and the resulting ‘exclusion’ of competitors, hinders innovation across the industry, further reducing potential benefits to ultimately be realized by consumers.
The FTC’s three main allegations are that Qualcomm:
–> Maintains a “no license, no chips” policy under which it will supply its baseband processors only on the condition that cell phone manufacturers agree to Qualcomm’s preferred license terms.
–> Refuses to license standard-essential patents to competitors.
–> Extracted exclusivity from Apple in exchange for reduced patent royalties.
On January 20, Apple (AAPL) announced that it is suing Qualcomm for approximately $1 billion, the amount it claims was withheld “in payments from Apple as retaliation for responding truthfully to law enforcement agencies investigating” Qualcomm. Apple claims that Qualcomm has insisted on “charging royalties for technologies (it) has nothing to do with” and as Apple continues to innovate, Qualcomm continues to expand its collection of royalties, increasing the financial burden of innovation.
Apple further states that, while Qualcomm is just one of twelve companies or so that has “contributed to basic cellular standards,” it charges Apple at least five times more than all other industry standard patent licensors combined. Qualcomm has responded to Apple’s claims calling them “baseless.” The semiconductor giant also argued that the FTC complaint, which is the result of an investigation that started in 2014, is “based on flawed legal theory, a lack of economic support and significant misconceptions about the mobile technology industry.”
It is worth noting that these developments come after Qualcomm was fined $854 million by South Korean regulators for violating competition laws; the fine was based on rulings that Qualcomm abused its dominant market position and forced mobile device makers to pay royalties on unnecessary patents, a claim similar to those being made by the FTC and Apple. In February 2015, the company agreed to pay a $975 million fine in China that resulted from an antitrust probe, and the European Union also charged the company with anticompetitive practices in late 2015.
Though the developments surrounding Qualcomm’s business practices are not likely to be settled anytime soon, we have a difficult time envisioning things working out well for the company. The $1 billion price tag on Apple’s lawsuit is a nice headline grab, but not terribly material in light of the cash hoard on Qualcomm’s balance sheet. However, because Apple is essentially targeting the very nature of the firm’s royalty-based business model, or challenging just how ‘essential’ its technology is to the industry, the ramifications can be much more serious for Qualcomm if substantial changes are implemented to its business practices (and how much it can charge customers). We have a difficult time believing the FTC would bring a complaint against an industry bellwether after a 2+ year investigation if its findings were entirely “based on flawed legal theory, a lack of economic support and significant misconceptions about the mobile technology industry.” Qualcomm may be in hot water.
We’ve reduced our fair value estimate for shares of Qualcomm to $62 per share, as a result of lower revenue expectations due to potentially decreased future royalty payments, but also due to a lower probability of the completion of the company’s pending deal with NXP Semiconductors (NXPI), which still requires regulatory clearance in a number of countries that are currently investigating Qualcomm. Perhaps most consequential is the possibility that Qualcomm could get left behind in the world of the “Internet of Things,” which requires a level of connectivity we’ve yet to witness. The NXP deal was largely seen as Qualcomm cementing a piece of that pie, but anti-competition charges may have effectively put the kibosh on Qualcomm’s dominance in connectivity. We’ll be monitoring the situation closely.