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David Rolfe Comments on Qualcomm

- By Holly LaFon

In mid-February we sold our long-held position in Qualcomm (NASDAQ:QCOM). Note that we have been invested in Qualcomm shares continuously since 2007. Our primary thesis was predicated on Qualcomm's continued preponderance of technological advancements in the cellular industry over the past three decades. Key to the requisite spending of tens of billions in R&D is the Company's royalty business model that generates many billions per year in profits, that in turn, fund the Company's future intellectual property and patents. Note too that we have long witnessed the Company's success in fighting and defending its global patented IP.

However, even after articulating a bullish position in our last Client Letter in January, we have increasingly become less bullish, indeed, quite fearful that the Company may not prevail in its current lawsuit with the Federal Trade Commission (FTC v. Qualcomm). Germane to this case, unlike any previous lawsuit, litigation or accompanying settlement, is the possibility, even remotely, that if the FTC prevails in even just one of its stated remedies, such a loss for the Company could lead to a permanent impairment of the Company's lucrative royalty business.

In our past written communications and verbal discussions with clients we articulated our befuddlement on the merits of the FTC v. Qualcomm from the beginning. Even as the trial proceeded, we became convinced that the FTC did not present a winning case, as well as Qualcomm's lawyers' successful impeachment of key FTC witness testimony, yet here we are in mid-April with no settlement and anxiously awaiting Judge Koh's verdict. Even considering the likelihood of a successful appeal, there is risk of a Judge Koh stay in her ruled remedies awaiting appeal, which would require immediate enforcement by Qualcomm.

A recap of the FTC v. Qualcomm case will be instructive to our new opinion. Recall that this case was brought by the FTC back in January 2017 in a politically charged, eleventh hour decision by Obama-nominated FTC commissioners. In a rare public and scathing dissent, then Commissioner of the FTC, Maureen K. Ohlhausen wrote the following:

I do not depart from that policy lightly. Yet, in the Commission's 2-1 decision to sue Qualcomm, I face an extraordinary situation: an enforcement action based on a flawed legal theory (including a standalone Section 5 count) that lacks economic and evidentiary support, that was brought on the eve of a new presidential administration, and that, by its mere issuance, will undermine U.S. intellectual property rights in Asia and worldwide. These extreme circumstances compel me to voice my objections.

The FTC filed suit against Qualcomm alleging antitrust claims, including exclusionary tactics in violation of fair, reasonable and non-discriminatory (FRAND) obligations. The Company is subject to agreements signed with standard-setting organizations (SSOs). Such organizations exist to promulgate technical and technological standards to support innovation, growth and protection of IP. The two key SSOs in this matter are the Telecommunications Industry Association (TIA) and the Alliance for Telecommunications Industry Solutions (ATIS). Both organizations' intellectual property rights policies that apply to patents are considered essential to the standards set by those organizations, including 3G and 4G cellular standards. Over successive and future generations of cellular standards, Qualcomm has provided written assurances to the TIA and the ATIS that its patents accepted as standard essential patents (SEPs) by those organizations would be licensed pursuant to the IP rights policies for those organizations. In addition, Qualcomm as a member of cellular standard-setting organizations, patents that a member declares to be essential to a standard endorsed by one of these SSOs, the member must disclose its SEPs and agree to license them on fair, reasonable, and non-discriminatory (FRAND) terms.

In FTC v. Qualcomm, the FTC alleges that Qualcomm is a dominant supplier of modem chips, holds several SEPs that are essential to widely adopted cellular standards and has violated Section 5 of the Federal Trade Commission Act. Those alleged violations include Qualcomm's refusal to sell modem chips to a customer unless the customer pays what the FTC termed "elevated royalties" for a license to Qualcomm's SEPs, Qualcomm's refusal to license SEPs to competing modem chip suppliers and Qualcomm's "exclusive dealing arrangements" with consumer tech giant Apple.

Fast-forward to last August, when the FTC moved for a partial summary judgment on the issue of whether Qualcomm's agreements with TIA and ATIS required it to license its LTE and CDMA SEPs to modem chip suppliers on FRAND terms. Specifically, the FTC declared that Qualcomm's patents are essential to LTE and CDMA standards, Qualcomm was required to license its SEPs to "all applicants," and no language in the TIA or ATIS IPR policies limited that commitment to a particular type of product or partner occupying a particular level of the supply chain. Note, "all applicants" means exactly that - "all," including competitors.

On November 6, 2018, U.S. District Judge Lucy Koh of the Northern District of California (Apple's backyard, by the way) granted the FTC's motion and held that Qualcomm was required to license its SEPs to competing chip manufacturers on FRAND terms. The court emphasized in its ruling that the Ninth Circuit had previously characterized FRAND promises as "sweeping" and established that patent holders "must license [their] SEPs to all applicants." The court then found that the TIA and ATIS IPR policies, which were "mirrored" by Qualcomm's own assurances to those SSOs, included non-discrimination provisions that prohibited Qualcomm from distinguishing between types of applicants - an interpretation that the court determined was further reinforced by the respective SSOs' IPR guidelines.

In a blow to a hoped-for, if not expected settlement between Qualcomm and the FTC, it has been reported that Judge Koh had been notified that Qualcomm and the FTC were in serious settlement negotiations and both parties had jointly requested a delay in ruling on the FTC motion for partial summary judgment. Astonishingly, Judge Koh refused to grant such a delay.

This is the juncture in FTC v. Qualcomm where our view of the downside risk to Qualcomm's royalty business became heightened and moved to the forefront of our minds. In the extreme, Judge Koh's partial summary judgment in and of itself scuttled the chance this case could be settled. Indeed, settlement may now be only possible where one side must capitulate. We doubt the FTC is suddenly going to drop the essence of its case now that the judge has ruled in their favor on this specific remedy. In addition, Judge Koh's ruling has significantly tilted any remedy settlement in the FTC's favor. Again, in the extreme, Judge Koh has, according to ipwatchdog.com, "unilaterally created an obligation of patent owners of SEPs that cannot be found in the IP policies of the SSOs and which is not the industry norm."

The other key remedy, along with the requirement of Qualcomm to license its IP to competitors, is the FTC remedy requiring Qualcomm to charge its royalty rates at the notably cheaper chip-level, rather than its current method at the considerably higher cell phone device-level. All told, either remedy is a severe hit to the Company's royalty business.

In sum, Judge Koh is on an uncharted path. Her summary judgment is prima facie evidence of that. If Qualcomm loses any part of the case, we believe the downside to the stock would be severe, immediate, and likely permanent without years-long successful appeal at the appellate level, if not the Supreme Court. Further, the stock could be uninvestable while such a lengthy appeal takes place. On the other hand, our downside fears may be wrong. If Qualcomm prevails, we lose considerable and immediate upside in the stock. A Qualcomm win also could bring Apple to the negotiating table before the Apple v. Qualcomm case begins in April.

Net, net in our view the downside would be a significant and permanent loss of client capital.

It's a risk we choose not to take.


What would a Qualcomm loss mean for Apple? Very short term, Apple could gain added documentary evidence and testimony for its pending trial (Apple v. Qualcomm) to begin this April, plus a further lack of necessity to settle with Qualcomm. Intermediate term, if Apple could license Qualcomm's technology, which would likely add momentum to Apple's efforts to bring modem technology completely in-house. (Jobsian Apple always desired to control all of their software and hardware technology in-house.) If successful, Apple would no longer need Qualcomm (or Intel or MediaTek) to source discrete modems for not only iPhones, but also iPads, Apple Watch and likely cellular connectivity for next generation 5G connectivity for their future Mac notebooks. All told, Apple could source the totality of its prospective 300 million annual modem needs completely in-house. In addition, if Qualcomm would fail to appeal royalty at the chip-level versus device level, Apple's royalty expense would meaningfully decline. Apple's stated reasons for litigation have been voiced by none other than CEO Tim Cook. Apple views Qualcomm as an unfair monopoly and wants a "judge to determine how much Apple must pay Qualcomm" for Qualcomm's IP. Lastly, longer term, a defanged Qualcomm would likely render Android smartphones an increasingly competitive disadvantage to iPhones. After all, the smartphone industry is largely a battle of iOS versus Android (Google and Qualcomm). Despite the growing list of Android manufacturers (Huawei and Samsung) sourcing their smartphone microprocessors in-house, Qualcomm remains the multi-billion R&D arms-merchant for Android. Perhaps one can see the most critical reasoned means to Apple's litigious ends.

From David Rolfe (Trades, Portfolio)'s first-quarter 2019 Wedgewood Partners client letter.
This article first appeared on GuruFocus.