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Qualcomm’s Post-Antitrust Future

Evan Niu, CFA, The Motley Fool

Antitrust regulators around the world have been paying close attention to Qualcomm (NASDAQ: QCOM) for years, given charming business practices like their "no license, no chips" policy for industry-standard parts. This week, the FTC's trial against Qualcomm came to fruition: Federal judge Lucy Koh ruled in favor of the FTC on pretty much everything.

In this week's episode of Industry Focus: Tech, host Dylan Lewis and Motley Fool analyst Evan Niu break down what we know about Qualcomm's shady practices, what we do and don't know about what this means for the company and industry going forward, why Apple (NASDAQ: AAPL) settled its case against Qualcomm during all this, why investors should not try to catch this falling knife, and more.

To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. A full transcript follows the video.

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This video was recorded on May 24, 2019. 

Dylan Lewis: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It is Friday, May 24th, and we're talking about the FTC's case against Qualcomm. I'm your host, Dylan Lewis, and I've got Evan Niu on Skype. Evan, what's going on? 

Evan Niu: Not a whole lot. It snowed a couple of days ago in late May, which is normal here in Colorado, so it's cold here, actually, even though it's almost summer. 

Lewis: Are you serious? Was it a significant amount of snow? 

Niu: It was a couple of inches. And it was 30, 40 degrees yesterday and this morning.

Lewis: Well, it is about 70-something and lovely here in Washington, D.C. And it's gearing us up nicely for the Memorial Day weekend. You have any fun long weekend plans, Evan?

Niu: Not really. They open up our neighborhood pool on Memorial Day, and then my daughter's birthday is next week. We're just getting ready for that stuff. 

Lewis: Yeah, it's the official opening of summer. Of course, we also want to take a second to acknowledge the sacrifice of all the fallen servicemen and -women. Memorial Day is a lot of things, but it's also a day of acknowledgement and appreciation, and a tough one for a lot of people out there. Hope all you guys are doing all right, and thank you to all of our vets as well. 

Evan, we are talking today about a story that we first talked about back in January. That is the antitrust case against Qualcomm. We had some sense of maybe what might be happening. We have a little bit more of the details now. 

Niu: Yeah, we had covered the case when the trial was going on in late January. It wrapped, but it's not a jury trial. It was all up to the judge to make a call here. We've been waiting a few months to see what she was going to decide. And at the time, it did appear that the FTC did had a pretty strong case against Qualcomm. And indeed, what's happened now is that she has ruled in their favor. It's pretty a big news event here for Qualcomm. 

Lewis: Yeah, we saw some early signs that federal judge Lucy Koh seemed to think that a lot of the business practices that Qualcomm was using may not hold up under antitrust law. That's what we got here. This centers on Qualcomm's "no license, no chips" policy. 

Niu: Right. They have a bunch of different aspects of what they were doing wrong. But basically, the FTC sued Qualcomm back in January 2017, around the exact same time that Apple did. Both cases alleged that Qualcomm engages in this anticompetitive conduct and has done a lot of damage to the cellular modem market, including the "no license, no chips" policy, where, in order for them to sell you chips, they basically require you to sign a licensing agreement. And they have a lot of standard-essential patents, in which case they're supposed to license those patents out at what's called fair, reasonable, and nondiscriminatory or FRAND terms. And they were not offering their patents on FRAND terms, and demanding really excessive royalties, and have been using that as leverage to say, "Hey, if you want our chips, you have to sign these agreements with really high rates." At the same time, they were able to use that combination to force even Apple into an exclusivity deal from 2011 to 2016. Apple's, obviously, such a massive company. Not many suppliers can get the upper hand on Apple. 

Lewis: Yeah, you know you're coming to the table in a position of strength when even Apple has to say, "You know what, we have to do it." And a lot of what we saw in some of these cases, both Apple's and the FTC's, was some specific documentation about what Apple estimated these chips should be costing and what they were actually costing as a case for the markup that Qualcomm was throwing on things. 

Niu: Right. Apple's long been the largest stand-alone modem buyer in the world by a very large margin, because over the past 10 years, and the vast majority of smartphone makers have been moving toward and have been using integrated modems, often Qualcomm Snapdragons that have integrated cellular connectivity. Apple is the biggest discrete modem buyer. And Qualcomm basically is forcing them to pay exorbitant rates.

For example, during this trial, COO Jeff Williams testified that Apple was paying Qualcomm about $7.50 per device after rebates, which is about five times what Apple considered a fair rate. They wanted to pay $1.50 per device. They're paying $7.50 after rebates. One other crazy part of this, showing how brazen Qualcomm was, is that in 2013, Qualcomm tried to jack up the per-device rate even further, adding another $8-$10 on top of the $7.50, which was already five times more than what Apple thought was fair. Basically, instead of taking that huge increase, Apple renewed exclusivity, which was also not a good deal. Obviously, if you're blocking any rival from even competing for a chance to score the biggest modem customer, that's going to do a lot of harm to the modem market.

Lewis: Yeah, and the reason that the FTC was interested in the case, and the reason that this case even happened was, you think about competitive dynamics -- if there is one player that is pretty much industry-standard for something, and they are able to set prices at whatever they think they should be able to set the prices at, that is a tough spot for anyone reliant on that input. It's also something that ultimately gets passed to consumers. If all the inputs for these products go up, well, that's going to get passed along when people are actually buying the end product in stores or online. 

Niu: Right. Of course, Apple prices are pretty already high to begin with [laughs], but it doesn't help when the they're facing these pretty big costs on their end, too, that they just don't think are fair. From Apple's perspective, it was more about principles, like, this is not right. And of course, the FTC is more like, this is just straight-up illegal, you're violating a bunch of antitrust laws. 

Lewis: All right. Why don't we get specifically into Judge Lucy Koh's decision, now that we've laid the context? We've been waiting on this for a while, and she pretty much ruled the way we thought she would.

Niu: She ruled in favor of the FTC on basically all counts. It's a 233-page decision. I haven't read all of it. I was perusing it, going through the important parts of it. But the conclusion is, she's imposed an injunction on Qualcomm that has a lot of big consequences. First of all, she's saying they cannot require chip customers to have licensing agreements. You can't threaten to withhold chip supply in order to pressure people into these licensing agreements. Basically taking apart this "no license, no chips" policy. And at the same time, she's ordering Qualcomm to renegotiate the existing licenses. She's obviously saying this policy is not right to begin with, so it doesn't make sense to let them keep some of the agreements that are already in place, some of which are very long-term, some are perpetual. She's saying they have to go and renegotiate all these.

She's requiring them to license their standard-essential patents on FRAND terms. They can't enter exclusivity agreements. If you think about it, the cellular modem market already has extremely high barriers to entry because the R&D is so capital intensive, so technically challenging, and it takes so many years to develop. The last thing you need are even greater barriers like exclusivity agreements. 

Another piece is that they cannot interfere with customers communicating with government agencies. This refers to how Qualcomm, a couple of years ago, entered into a settlement agreement with Samsung, trying to silence Samsung from making antitrust complaints to South Korean regulators. On a related note, Qualcomm also tried to penalize Apple for cooperating with antitrust regulators around the world, which it is required to do by law. There's a lot of pieces going on here. 

And then the last one is just a compliance monitoring report that they have to submit to the FTC every year for seven years, just saying, "Hey, we're keeping up with and complying to the court order."

Lewis: Evan, I have not read the full decision, either. We've been trading back some excerpts on Slack and chatting. I will say, I think, yes, the business practices were there. What was particularly damning about this, to me, was some of the cross-examination, you could say, basically taking whatever management was saying throughout the proceedings that this case has gone through, and then comparing that with evidence that they have, whether that be emails or messages. That seemed to really show that they were very aware of what was going on. 

Niu: [laughs] Right. Lucy Koh, the judge here, was not happy about that. She mentioned multiple times in this decision how these executives, some of which have left the company since -- basically these executives were testifying, saying, "Oh, no, we didn't know. This was not happening." And then it turns out, like you mentioned, tons of evidence comes out -- documents, emails, presentations, all sorts of evidence, saying, yes, these executives absolutely knew about the shady practices, and were basically directly contradicting their own testimony. It just doesn't add up. They obviously knew these things were happening. At the very high level, the CEO had emails about the "no license, no chip" stuff, and he's also turning around and denying any knowledge of it. She was not happy about that. 

Lewis: Like all things legal, this case is far from over. All right, Evan, Qualcomm is going to be appealing this decision, and they've requested an immediate stay of the injunction. We don't have the firmest sense of what this means for the company yet. We have very little idea what it means for the companies they supply to. But I think it's easy to say this is going to create some problems for Qualcomm. 

Niu: Right. At face value, it looks really bad. Of course, it's going to take a while for it to all shake out with the courts and legal system and the appeals. That stuff always takes forever. But, again, at face value, Koh basically threw Qualcomm's entire business model in the trash. Qualcomm's model has always been to have these two highly complementary segments. You have licensing, you have chips, and they play off each other and are linked in such a powerful way. But now it's becoming clear that those ways are illegal. To be clear, if you were to separate these segments, there's still great businesses. But it's just that they shouldn't be able to generate nearly as much revenue or have the same level of earnings power that they have, if you split them up within that way. 

Just to put some numbers to it, for example, activist short seller Kerrisdale Capital, earlier this year, put out a short thesis. They are short the stock, at least as of January. They basically were running some numbers based on this assumption that the FTC was going to win this trial. And they have. According to their estimates, Qualcomm's licensing revenue could get basically cut in half. In fiscal 2018, they did a little over $5 billion in licensing revenue. According to Kerrisdale's estimate, if you adjust that to FRAND levels, reasonable levels, they would have lost $2.7 billion of that revenue. Again, it's a good business, you can bring in quite a bit of revenue, but just not nearly as much as they have been. 

Lewis: One of the things that I've been most curious about with this whole saga is, we had pretty much concurrent cases going on, Apple and the FTC. You had to think that Apple, reading the tea leaves and knowing exactly what was going to be happening with FTC and Qualcomm, would say, "We don't need to be doing anything too quickly with this supplier. We can wait and then use whatever that decision is as leverage for a future agreement." That's not what happened. They wound up striking a deal earlier last month. 

Niu: Right. Last month, Apple and Qualcomm announced a surprise settlement. In their case, literally the same day that their trial started. It was just hours after the opening arguments. It took everyone by surprise. Like, whoa, you guys have been fighting relentlessly, trashing each other in the press for two years. And all of a sudden, you just settle? Now we're finally understanding what happened more in the month since. Apple had been banking on Intel delivering a competitive 5G modem, but Intel was having trouble and could not do it. They were getting hit with delays, a lot of technical challenges, could not keep up on the technological side, to the point where Apple basically had no choice, since Apple needs to come out with a 5G phone sooner rather than later. With the timeline being threatened by Intel not being able to deliver, that's what forced Apple's hand here. They're probably going to release this 5G iPhone -- it's too late for this year, since design cycles take quite some time. Next year is when they're expected to have a 5G iPhone with a Qualcomm modem. But it ironically just goes to show how good Qualcomm's underlying technology is. It's pretty clear at this point that Apple hates doing business with Qualcomm, but it just has no choice. 

When this all started, I actually predicted that Qualcomm would end up settling with the FTC and that the Apple case would do more damage, in part due to political stuff that was happening around the time, with the incoming Trump administration and the changing political composition of the FTC commissioners. For example, the only Republican commissioner on the board at that time wrote a really strongly worded dissent against the case. Obviously, I was 100% wrong. It's probably a good thing I'm not a lawyer. 

Lewis: [laughs] But you know what, Evan, you have to own your mistakes. You have to be accountable. At the Fool, we talk about that all the time. We have our scorecards, we have our holdings. They're public, people can see them. And we keep all these episodes available. If anyone wants to listen to the January episode, it's there. We might have gotten some predictions there wrong as well. But I think it's good that you're acknowledging that you were wrong. 

Niu: I probably went into the right line of work, not being a lawyer.

Lewis: [laughs] Yeah, you and me both. We are no Nick Sciple. 

Before we wrap up, I want to talk a little bit about what this means for Qualcomm's business. The stock is down roughly 10% since this news came out, understandably. This is a big hit to their business model. But you have to look at what's been going on with this company over time. This stock changes quite a bit because they had these very complementary business segments -- like you said, they had this high-margin licensing revenue, and then relatively low-margin chip sales. This seems to compromise that. And they've already been dealing with a shrinking top line.

Niu: Right. The stock jumped on the Apple settlement. You settled this thing with this enormous customer, you got this new chip supply agreement with Apple. But then the FTC comes and just trashes your business model. [laughs] The stock has been all over the place based on these developments that have been happening in the courts. Yeah, the licensing business, like you mentioned, has always been super high margin, and really been the bulk of their operating profits. Whereas on the hardware side, on the chip sales, it's profitable, but not nearly as much. I think the market is worried because this is a huge risk. But again, it's going to take a while to see how this shakes out, in terms of the appeals and all this stuff, and whether or not they actually have to do these things that the judge has ordered. 

Lewis: Yeah, and as you might imagine, a company that does a lot of supply work for the smartphone industry is somewhat reliant on the tailwinds or headwinds that that industry is experiencing. We've seen that a lot of unit shipments have been slowing down. Companies like Apple have had a little bit more trouble with longer upgrade cycles. All these things. This business is already facing some issues. This is just compounding that. It's worth talking about here with this company, they have over a 3% dividend yield. They're one of those companies that come up on tech dividend screeners. I would say I'm a little worried about that dividend payment medium to long-term because this is not a business that's flourishing right now. They're being told their business model needs to be rethought a little bit. And you look over at the last 12 months, they've paid out just under $2.50 per share in dividends, and they've pulled in just under $2 in earnings per share. Their payout ratio is over 130%. They have $10 billion in cash on the balance sheet, but they also have $15 billion in long-term debt. This is not a company that is necessarily built to sustain that dividend for the next decade, the way that they may have been in the past. 

Niu: Right. That dividend could absolutely be at risk if they're forced to change their business model in the ways we've been talking about. 

Another thing that is happening in the broader smartphone market that you mentioned is, we're in at the beginning of transitioning to 5G. The judge was very much like, with 5G being such a big thing that's happening, the last thing that we want is for Qualcomm to be able to do the same thing with 5G that they've done with 4G. It hurts consumers in the form of higher prices and all these negative effects of not having good competition. She's really looking out for consumers and saying, as we go to 5G, we need a more robust ecosystem of innovation and technology. That's good for the overall market, too. That's going to be a pretty big -- massive -- shift in the mobile world. 

Lewis: And that could be the trend that kick-starts Qualcomm again. But for my money, it is not a stock that has been on my radar, and I think things could get worse before they get better. Evan, how are you feeling about it? 

Niu: It's funny, I bought them a long time ago. Two or three years ago, I sold them because the stock was underperforming and they had too much reliance on Apple and Samsung, which at that time were about 50% of the total revenue, just massive. And at the same time, there were all these questions. These antitrust investigations are not new. They've been being investigated by antitrust regulators all around the world for many, many years. So, for me, I actually got out, again, two or three years ago, because I just saw some cracks in the thesis. And it turns out, those have been coming to fruition, even though at the time they were still paying a good dividend and all these things. But there was just a lot of risk factors that I saw that I didn't think were going to play out very well. Turns out, they didn't. So, I was right to sell at that time. I wouldn't touch the stock just because it's so volatile with all these risks going on with what's going to happen with the underlying model... It's just too much for me to handle. 

Lewis: Well, you were being hard on yourself earlier being wrong. You got that one right. 

Niu: There you go! You win some, you lose some.

Lewis: Yeah, you win some, you lose some. Thanks for hopping on today's show, Evan!

Niu: Thanks for having me!

Lewis: All right, listeners, that does it for this episode of Industry Focus. If you have any questions, or you want to reach out and say hey, you can shoot us an email over at industryfocus@fool.com, or you can tweet us @MFIndustryFocus. If you want more of our stuff, subscribe on iTunes, or you can catch the videos from this podcast over on YouTube. As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear. Thanks to Dan Boyd for helping out behind the glass today. For Evan Niu, I'm Dylan Lewis. Thanks for listening and Fool on!

Dylan Lewis owns shares of Apple. Evan Niu, CFA owns shares of Apple. The Motley Fool owns shares of and recommends Apple. The Motley Fool owns shares of Qualcomm and has the following options: long January 2020 $150 calls on Apple and short January 2020 $155 calls on Apple. The Motley Fool has a disclosure policy.