Apple dispute casts dark shadow over Qualcomm’s quarter, and its future

Accustomed to exceeding expectations in its quarterly results, Qualcomm had a rough ride when it announced its fiscal third quarter figures last week. Apple’s escalating lawsuit – which has now broadened to include antitrust filings from iPhone manufacturers – cast a long shadow over the chip giant as it reported a shocking 40% year-on-year decline in net income, to just $800m, with non-payment of disputed royalties by Apple’s contract manufacturers being a significant factor.

And the news that another, unnamed licensee has also initiated litigation and withheld payments created fears that the rot is spreading in the Qualcomm model, and that the chip company will have to make more radical changes than it had planned, to reassure customers and investors and prevent a damaging domino effect.

As well as the Apple issues, disputes with BlackBerry and the Korea Free Trade Commission (KFTC) also impacted profits in the quarter. Qualcomm blamed a fall in operating cashflow partly on payments of $940m to BlackBerry and $927m to the KFTC. This metric dropped from $1.8bn a year earlier to just $100m.

In addition, the company reported an 11% year-on-year decline in revenues to $5.4bn, and investors reacted with concern, with shares falling 4% on the news, even though the figures were largely in line with recent Wall Street forecasts.

Revenues at the licensing division fell by 42% year-on-year, to about $1.2bn, while the semiconductor unit reported a 5% year-on-year increase in sales, to about $4.1bn.

Qualcomm expects earnings per share to fall by 34% to 41% in the coming fourth quarter, to between $0.75 and $0.85. Revenues are expected to be “flat” year-on-year at best and to fall by 13% at worst, from the year-ago figure of $6.2bn.

The investor jitters were not because the company cannot bounce back – it has a Weeble-like history of adapting itself to meet apparently daunting challenges, even the decline of the mobile CDMA technology it invented and has controlled for so long. It was because, this time, so many of the challenges are driven by powerful parties, such as Apple and various national antitrust agencies, and they cannot be met in the usual way, with the power of Qualcomm’s engineering capabilities.

Yes, it is unlikely 5G can happen without the company – it remains the only significant participant in trials of pre-5G, and emerging LTE, technologies. But the way it is allowed to monetize that inventiveness, via patents licensing, may change profoundly in response to current events, and that would hit its famously profitable model, and perhaps reawaken the idea of splitting the company in two, to create clearer separation between the patents and the chip sales.

To make matters worse, there is uncertainty about Qualcomm’s hugely strategic deal to acquire NXP, which will help it with the much-needed expansion into new growth areas for its chips and patents, including automotive and other Internet of Things sectors. Dieter Ernst, a senior fellow at US government thinktank East-West Center, told EETimes, “Qualcomm is fighting for survival, and by far, its most important objective is the Qualcomm-NXP merger. Qualcomm needs NXP to implement its ambitious diversification strategy.”

The importance of expansion in the IoT and industrial markets was highlighted in the results – the growth in chip sales was fuelled by new sectors, and Mollenkopf said in his statement: “Our products and technologies continue to enable the global smartphone industry, and we are expanding into many exciting new product categories, including automotive, mobile computing, networking and IoT.”

The most immediate issues concern the Apple lawsuits and the probe by the Federal Trade Commission (FTC) in the US, which has the power to bar imports of devices containing offending technology, and its counterpart in Taiwan, the home of many manufacturers of iPhones and other mobile devices. Qualcomm is also appealing against an $868m fine imposed by Korea’s competition agency.

At the previous results call (fiscal Q2) in April, CEO Steve Mollenkopf said that the company has “more opportunities ahead of it than at any time in the company’s history” but has had “a series of legal and regulatory challenges that have unfortunately overshadowed otherwise strong operating performance”. Those challenges have only got worse in the intervening three months. Ross Seymore, an analyst at Deutsche Bank, wrote in a research note after the Q3 announcement: “Surprisingly, these uncertainties appear to worsen as the second (unnamed) disputing licensee joined Apple in completely halting payments to Qualcomm”.

Apple has accused Qualcomm of a wide range of offences including violation of Frand (fair reasonable and non-discriminatory) licensing terms for standards-essential patents (SEP) and anti-competitive business practices. Qualcomm has hit back with patent infringement and other claims, though it continues to sell modems for the bulk of the iDevices (though Apple has switched to Intel for some models).

The litigation is complicated by the fact that most of Apple’s patent licensing takes place through its contract manufacturers. Since the hostilities broke out, Apple has encouraged the manufacturers to withhold or underpay royalties, claiming that Qualcomm owes it almost $1bn in rebates under a previous arrangement.

On the earnings call, Qualcomm president Derek Aberle gave an update on this issue, saying: “With Apple’s contract manufacturers refusing to fully report their total reported device sales for Apple products, and the licensee with which we have a dispute also withholding reporting, we are not providing quarterly actuals or guidance for total reported device sales and related unit shipments and ASPs [average selling prices] by our licensee. Because the significant portion of quarterly activity is not available and would not be included in those metric, making them incomplete in a limited value.”

It is extremely serious for a company to leave the financial community unable to forecast and model its progress, and indicates the importance of the Apple business to its overall sales, and the escalating severity of this dispute. It is not unreasonable to question whether the Apple suit – coming on top of a string of national and European Union probes, including a huge settlement with China – will be the final straw for the Qualcomm licensing model, and it will finally be forced to spin off that business, or offer radical changes to its secretive terms and conditions.

It is already in the process of adapting its model of course. The settlement of the Chinese antitrust proceedings involved lower royalties for companies in that country – levels which other major and emerging mobile manufacturing bases, like India, will be eyeing jealously. Though Qualcomm has significant patent power in 4G, 5G and WiFi technologies, as well as others like wireless charging, it does not hold all the cards, as it did in 3G, when all the standards were CDMA-based. And it faces higher levels of competition than it has since CDMA first burst onto the scene, both in chips and in contribution to standards and other core technologies – much of this coming from the expanding Chinese and Taiwanese semiconductor industries.

Some fear that the rot from Apple and China will spread, even before there is any resolution of the former case (and may not be for years). One analyst on the earnings call asked: “How do we gain conviction that we don’t see further contingent, further spreading of this to other customers … bleeding out across the rest of your business?”

Aberle responded: “No. That’s not what’s happening. We have a dispute with Apple and their contract manufacturers and we have a dispute with one other licensee.” He insisted that non-payment is limited to those specific cases, and not spreading.

Qualcomm’s executive team were keen to stress that the fundamentals of the chip and licensing business were unchanged and positive, once the disputes were resolved. CFO George Davis dismissed any idea of splitting the company, and urged patience while the firm “gets through this period of higher litigation spending and the dispute period … The fundamentals behind the company’s licensing business outside of these disputes are quite attractive.”

Mollenkopf was working a similar theme, saying: “It’s important to remember that 3G, 4G device trends which are a key driver of QTL financial performance remain very healthy. We are forecasting 3G, 4G device shipments to grow by approximately 6% in calendar 2017”, and he added that the recent falls in ASPs were expected to moderate.

Despite the European Commission recently postponing a decision on clearance of Qualcomm’s acquisition of NXP, Mollenkopf insisted that the deal was still expected to close on schedule at the end of this year. It has been cleared without major concessions by authorities in the US, Mexico, Russia and Taiwan but still needs approval in the EU, China, Japan, South Korea and the Philippines. There are concerns that both the EU and China may impose stringent conditions to protect access to intellectual property for their companies, and other reasons.

General counsel Don Rosenberg said it was unsurprising that the EU had moved to a second, more detailed phase of investigation rather than clearing the takeover directly. “We’re dealing with a significant acquisition here, with both the US-based company and a major European-based company,” he said. “It’s not surprising that we are moving into phase two. We will listen to any concerns that may be expressed and we’ll respond to them.”

Assuming the NXP deal does go through in a form which is acceptable to both sides, it will certainly strengthen Qualcomm’s IoT and automotive arsenal and provide it with new options to offset the slowdown in the core smartphone market and the effects of licensing disputes.

The situation is certainly serious for the US company. However, Qualcomm’s position in 4G sales and licensing, and in pre-5G trials, makes it important not to believe the ‘end of Qualcomm’ analyses. Its engineering abilities consistently prove hard for others to match, and its licensing business is based on genuine invention, not on trolling. But it seems impossible that it will be able to cling on to its full royalties model, even in the diluted form that has emerged in markets like China. Ever the chameleon, Qualcomm will need to change its colors particularly rapidly and publicly this time.

Apple antitrust fight with Qualcomm extends to its supply chain:

Last week Apple managed to get its contract manufacturers to lodge antitrust actions in the US District Court of Southern California, one known for its ‘home court’ rulings in favor of Apple (though this time, it will be dealing with two stars of the Californian economy, not a battle between Apple and Samsung).

Four Taiwanese manufacturers – Foxconn’s parent Hon Hai Precision Industry, Wistron, Pegatron and Compal – have been placed in an uncomfortable position by Apple, which has pressurized them to file a counterclaim against Qualcomm’s accusations of patent infringement and license fee withholding. Few manufacturers can afford to antagonize as powerful a customer as Apple, but few really want a lengthy fight with Qualcomm’s legendary legal teams either.

The position of the manufacturers is weakened by the fact that they are choosing to pay Qualcomm royalties on devices they make for other handset vendors – Wistron makes Windows and Android phones; Pegatron and Foxconn have their own brands of handsets; Foxconn manufactures for Xiaomi, Sony and others; and so on.

They are responding to the Qualcomm suit brought in May, seeking to force them to pay licensing fees which had been withheld at Apple’s direction. One recourse may be for Qualcomm to lodge a suit in the Taiwanese court (although that would only apply to goods made in Taiwan itself, not in the manufacturers’ plants in China and elsewhere). The Taiwanese Fair Trade Laws prohibit concerted action and can impose fines of up to 10% of revenues – Qualcomm might make the case that the manufacturers acted in concern by withholding patent royalties in the first place.

However, Qualcomm is embroiled in its own antitrust probes by Taiwan’s authorities, and any actions it takes against Apple and the manufacturers which go beyond royalties claims and into business practices – for instance in the European Union – run the risk of intensifying the scrutiny of its own habits, and claims that it ties chip sales and patent licensing too tightly together, or that it ‘double dips’ on some royalty bills.

Qualcomm also lost an appeal in a European Union court last week. The original action was filed in 2010 by UK-based Icera (later acquired and subsequently shut down by Nvidia). Icera accused its larger rival of using unfair financial incentives to attract new customers. That became the basis of a wider antitrust probe and then a formal charge. In June, Qualcomm petitioned the European General Court in Luxembourg to suspend the order, arguing that EU demands would require “enormous work and significant financial costs estimated at no less than 3m euros as it involved more than 50 employees and 16 external advisers.” On July 12, the court dismissed the appeal. Qualcomm reportedly now faces the threat of a daily fine of €580,000 ($665,000) for failing to provide EU antitrust regulators with requested information.

Qualcomm has launched two US court actions against Apple, claiming six counts of patent violation, and has demanded damages and an FTC ban on infringing iPhones (those with Intel modem). It recently extended its actions to two German courts, in Munich and Mannheim, citing energy efficiency patents there. Intel has claimed to the ITC that the ban would be anti-competitive as Intel is the only remaining major competitor to Qualcomm in baseband chips for premium devices.