Qualcomm (NASDAQ:QCOM) stock continues to be volatile. Since mid-April, QCOM stock has moved from $55 to $88, to $65 to $70, before settling in at a current price above $76. But while the recent shifts are larger than usual, QCOM stock has seen big moves for several years now.
For the last five years, Qualcomm stock has mostly moved sideways — the stock was actually down 6% over that period — but with a number of peaks and valleys along the way. QCOM stock has been a trader’s darling for two key reasons.
First, Qualcomm is a leader in chips used for smartphones. Key customer Apple (NASDAQ:AAPL) has seen its stock significantly outperform QCOM. But it, too, has seen a few sharp moves. Investor attitudes toward Apple have risen and fallen along with the company’s product cycle — and QCOM in some cases has gone along for the ride.
Second, Qualcomm’s business model has been under various forms of attack for most of that period. And it has been the effectiveness of those attacks, and the threat of new ones, that has driven investors in and out of Qualcomm stock.
That hasn’t changed in 2019. If anything, the debate over Qualcomm’s model has intensified. Understanding that debate is essential to understanding QCOM stock.
Antitrust Concerns Are Nothing New
Regulators have had their eyes on Qualcomm for years. The European Commission, driven by complaints from Ericsson (NASDAQ:ERIC), Nokia (NYSE:NOK), and others, began its initial antitrust probe back in 2005. The investigation was eventually canceled in 2009 after the complaints were withdrawn.
One reason those complaints were withdrawn, however, was that the suppliers managed a win in South Korea. In 2009, South Korea’s Fair Trade Commission fined Qualcomm $207 million (the figure was reduced by about 18% this year) for unfairly using its dominance in mobile phone chips. With customers moving on to new chips, the changes driven by South Korea’s action and the resources used in Europe led the claimants to move on.
Regulators in Asia and Europe weren’t finished, however. In 2015, Qualcomm paid $975 million to settle antitrust litigation in China — the largest fine in that country’s history. The next year, South Korea hit the company again, this time for $853 million.
A new investigation in Europe ended with a $1.2 billion levy in 2018. Another fine reportedly is on the way. Taiwan got $774 million last year as well. All told, Qualcomm has paid nearly $4 billion in antitrust fines worldwide.
What Regulators Are Saying About QCOM
The fine print of the allegations vary modestly from country-to-country, but the basic complaint is the same: Qualcomm is using its patent power to cement its monopoly. As EU Commissioner Margrethe Vestager put it last year:
“Qualcomm illegally shut out rivals from the market for LTE baseband chipsets over five years, thereby cementing its market dominance. Qualcomm paid billions of dollars to a key customer, Apple, so that it would not buy from rivals.”
The problem in regulators’ view is that Qualcomm charges for its chips — but it also charges to license the associated patents. It then provides rebates that are conditioned on exclusively buying Qualcomm products. Regulators argue that those rebates, in particular, keep potential rivals — among them Intel (NASDAQ:INTC) — out of the mobile baseband chip market.
The problem for Qualcomm here is twofold: First, it risks more fines in new jurisdictions. Second, this system is quite profitable for Qualcomm. As Apple has termed it, Qualcomm is “double dipping” in gaining both product and licensing revenue. Losing that ability would hurt Qualcomm revenue and profits.
Most notably, the company’s licensing revenue is extremely high-margin. In fiscal 2017, pre-tax profit margins (not gross margins — operating margins, essentially) in the licensing business were 80%. Every dollar of licensing revenue lost suggests, even after taxes, close to 70 cents of lost net income. It’s not a surprise, then, that investors showed caution toward Qualcomm stock as antitrust questions piled up.
Apple Takes on Qualcomm
What really got investor attention, however, wasn’t a regulator, but a customer. Apple sued Qualcomm for $1 billion in early 2017, kicking off a bruising legal battle. QCOM stock dropped 12% on the news, as Apple accused the company of inflating royalties. Qualcomm countersued. Apple instructed contract manufacturers like Foxconn Technology (OTCMKTS:FXCOF) to withhold royalties, which hammered Qualcomm profits.
Qualcomm stock would hit a 20-month low later in 2017. A takeover attempt by Broadcom (NASDAQ:AVGO) spiked the stock — but in March 2018, President Donald Trump quashed the deal, and QCOM stock hit the lows again. Another rally would fade along with a sell-off in semiconductor stocks. By February of this year, QCOM was back below $50.
Apple’s efforts hurt Qualcomm earnings and putting pressure on QCOM shares. Then, out of nowhere, Apple settled. The risk of a loss in that case — which could color antitrust sentiment worldwide — came off the table. Billions of dollars in back payments were set to flow into Qualcomm’s coffers.
QCOM stock gained 23% on the first day and kept rising. It would barely clear $90 in May, if briefly. At that point, Qualcomm stock had risen almost 60% in just a couple of weeks. Over that span, Qualcomm added nearly $40 billion in market value.
It appeared as if the worst was over. Antitrust issues overseas had been largely settled. Apple (including its contract manufacturers) and Samsung combined generated 40% of revenue in fiscal 2016 — and Qualcomm was apparently on good terms with both key customers. 5G was on the way. The naysayers had been proven wrong. After years of volatile and sideways trading, Qualcomm was set to jump-start growth.
The U.S. Gets Involved With QCOM Antitrust
A lot of news surrounded Qualcomm from 2017 to 2018. There were antitrust fines in Taiwan and Europe. Broadcom was trying to buy Qualcomm, while Qualcomm was trying to buy NXP Semiconductors (NASDAQ:NXPI) in a deal that eventually broke after some 20 months of effort. The Qualcomm-Apple battle garnered headlines. And there were the arguments about the fate of smartphone unit growth — a key source of pressure on Apple stock — and the timing and size of the opportunity in 5G.
Amid all that action, investors somewhat forgot that the U.S. Federal Trade Commission (FTC) had decided to get in on the antitrust action. The FTC charged Qualcomm with anticompetitive behavior in January 2017. Two days later, the Apple suit was filed. Headlines surrounding that battle somewhat displaced the FTC effort.
And as the case dragged on, its relevance seemed minimal. Qualcomm stock had not been very impacted by past antitrust settlements; even a U.S. effort would be much the same. Settlement talks were held last October, suggesting the pending removal of yet another headwind to QCOM stock.
That analysis turned out to be wrong, however. QCOM stock had one more big move in it.
A Monopoly Ruling, and QCOM Stock Tumbles
On May 21, U.S. District Court Judge Lucy Koh ruled in favor of the FTC. Qualcomm stock already had been struggling amid the Huawei blacklist and generally weak sentiment toward semiconductor stocks. It would fall 11% in trading the day after Koh’s ruling.
Koh found that Qualcomm’s “no license, no chips” policy was anti-competitive. The judge cited three reasons:
First, Qualcomm refused to allow rivals licenses to standard-essential patents (SEPs). That meant that end customers like Apple or Samsung had to license those patents from Qualcomm even if they used chips from another customer.
Second, the rates it charged for those SEPs were “unreasonably high,” as the judge wrote in her opinion. On occasion, Koh wrote, Qualcomm charged higher licensing fees when manufacturers used other chips — in a clear effort to prevent those customers from doing so.
Third, the rebates and market share discounts offered by Qualcomm further harmed competition, allowing Qualcomm to use its existing market share to prevent competitors from entering.
Koh clearly had the famous Microsoft (NASDAQ:MSFT) antitrust case in mind; she cites that case liberally in her decision. From a broad standpoint, her argument is much the same: Smartphone manufacturers need Qualcomm modems just like PC manufacturers needed the Microsoft operating system. And, like Microsoft in the 1990s, Qualcomm has capitalized on that need to generate more revenue than it would have otherwise — and to keep its competitors from having a piece of the market.
The Importance of SEPs and FRAND
Particularly in the context of Apple settling with Qualcomm, Koh’s argument appears quite thin at first glance. As the patent holder, isn’t Qualcomm entitled to monetize the IP which it spent — and still spends — billions of dollars developing? Why, exactly, can the government decide what licensing rates are “unreasonably high”?
It’s because of the importance of SEPs. The standards created in tech industries, in particular, generally are set by standard-setting organizations, or SSOs. These efforts are hugely important to ensure that an iPhone can call a Samsung, and vice versa. Without agreed-upon industry standards, interoperability would be significantly hampered — causing harm to consumers and businesses alike.
As Koh notes on page 125 of her decision, the Microsoft case is instructive. The Ninth Circuit held that “SSOs requir[e] members who hold IP rights in standard-essential patents to agree to license those patents to all comers on [FRAND] terms (emphasis in original).”
As part of those SSOs, Qualcomm agreed to abide by those rules. It can’t charge whatever it wants for licensing. It can’t coerce or entice customers to exclusively use its chips. FRAND (fair, reasonable, and non-discriminatory) pricing prevails.
This is the case antitrust authorities have made against Qualcomm in so many overseas jurisdictions. It’s the argument Apple made as well. A U.S. judge has taken their side, which projects an enormous impact on Qualcomm’s business model.
What That Means for Qualcomm Stock
Make no mistake: Koh’s ruling will be trouble for Qualcomm if it is upheld. Licensing revenue would take a hit — and that’s a problem. Going back to fiscal 2016, before the Apple battle led to lower licensing revenue, the importance of licensing is apparent.
Qualcomm’s QCT (Qualcomm CDMA Technologies) unit generated $15.4 billion in revenue, down 10% year-over-year as shipments fell. Its pre-tax margins were 12%. Segment profit was $1.81 billion.
QTL (Qualcomm Technology Licensing) revenue came in at $7.6 billion — less than half that of QCT. But margins were a staggering 85%. That business generated profit of $6.53 billion.
In other words, licensing accounted for 78% of total earnings. Even in FY18, with Apple’s suppliers withholding billions of dollars in revenue, QTL still generated 54% of the company’s profit. Those total profits, at the segment level, unsurprisingly were 22% lower than they were two years ago — in large part due to Apple’s withdrawal.
Licensing revenue is massively important to QCOM’s bottom line. But Koh’s ruling could suggest that Qualcomm can’t license its patents and sell its chips to the same customer for the same reasons. That would lower sales and reduce licensing revenue, the most profitable revenue Qualcomm has — and in fact the most profitable revenue pretty much anyone in tech has.
Qualcomm might have to lower its rates for other customers. The company would also have to license its technology to rivals, potentially allowing Intel and others into the baseband modem space. Given that Intel’s weakness appears to be the key reason why Apple settled in the first place, that suggests more competition as well.
Lower sales, lower margins, and more competition: it’s a tough combination for Qualcomm.
A Short Seller Highlights the Risk to Qualcomm Stock
Back in January, Kerrisdale Capital released its short case for QCOM stock based on the prediction that Qualcomm would lose in court. The firm estimated a revenue loss of $2.7 billion: 12% of fiscal 2018 sales. It projected that such a hit would lead EPS to plunge to $1.64 annually, due, again, to the impact on margins.
As such, Kerrisdale concluded, QCOM stock potentially could fall as far as $21. That’s not far off from back-of-the-envelope calculations that assume a roughly 13x P/E multiple broadly in line with the likes of INTC and AVGO.
That seems too bearish at this point. The Apple settlement changes the calculations, though it’s possible Apple could look to renegotiate should the FTC prevail. And it’s unwise to simply take a short-seller’s word for it: Kerrisdale had some big wins, but it famously erred with Straight Path Communications, acquired by Verizon (NYSE:VZ) after a bidding war with AT&T (NYSE:T).
That said, Kerrisdale’s broad point still holds — and the firm is not alone in making it. Several Wall Street analysts cut their targets after Koh’s decision to adjust for the new risk. An antitrust loss will irrevocably change Qualcomm’s business model, hurting both revenue and earnings. Investors can — and will — argue about the exact impact going forward, but there will be an impact.
Can Qualcomm Win on Appeal?
Of course, that assumes that Qualcomm winds up losing for good — which is not guaranteed. Last week Koh refused a request to stay the decision. Qualcomm said in response that it will ask the Ninth Circuit Court of Appeals for an appeal, a process that could take a year or more on its own.
And it’s possible Qualcomm will win. More than a few legal experts have criticized Koh’s logic. Most notably, an FTC Commissioner writing on her own behalf in the Wall Street Journal said the decision “radically expanded a company’s legal obligations to help its competitors.” Even the Department of Justice has taken a notably different stance from its fellow regulatory agency.
Other legal experts argue that Koh overreached. USC law professor Jonathan Barnett criticized the decision in an op-ed in The Hill on that basis. Barnett made a point echoed elsewhere: if Qualcomm’s behavior was so anti-competitive, why have smartphone prices generally declined (at least outside of the iPhone)?
It’s exceedingly difficult to argue that end smartphone customers are somehow being deprived. Prices in many cases (particularly for Asian manufacturers) are declining. Innovation is proceeding at a breathtaking pace.
Meanwhile, as others have pointed out, Apple — the company likely most reliant on Qualcomm — switched its baseband modem business to Intel. It’s not Qualcomm’s fault that effort failed. If anything, it highlights the fact that Qualcomm’s R&D efforts are substantial — and successful. It makes a better modem than Intel could. Should Qualcomm be punished for that?
Where QCOM Sits Now
It’s worth noting that, at the moment, QCOM stock sits only modestly below where it traded before Koh’s decision was released. That doesn’t necessarily mean that the market thinks the decision will be reversed.
But there is a case that investors are being a little too sanguine relative to the antitrust risk. Qualcomm stock isn’t necessarily expensive, at about 15x FY20 EPS estimates. Apple revenue should help growth beyond that as well. But 15x for a chip stock isn’t cheap, even if a 3.2% dividend yield does help the case. INTC is at 11x CY20 EPS estimates, and AVGO at about 12x.
Qualcomm stock is getting a premium — and litigation risk aside, maybe it should. 5G is a bigger driver for Qualcomm than anything Intel has. Qualcomm has no competitors along the lines of Advanced Micro Devices (NASDAQ:AMD) or Nvidia (NASDAQ:NVDA). Broadcom thought Qualcomm was worth $82 per share — and Qualcomm itself didn’t believe that was enough. For the current business model, QCOM stock might be attractive at these levels (though it was more so at $65 just a few weeks ago).
The Antitrust Risk
To own Qualcomm stock here, an investor has to have some faith that the antitrust case won’t be a big deal. That seems too optimistic. It’s easy to say that Microsoft weathered its own antitrust suit well, given that it is again heading toward a trillion-dollar market cap. But MSFT stock spent over a decade in the metaphorical desert after the resolution of its suit and the collapse of the dot-com boom.
The FTC represents a very real threat to Qualcomm — not just in terms of another potential fine. The business model that has cemented the company’s dominance and driven some of the highest margins in the industry is at stake. Whatever the true financial impact of a permanent change would be, it will be significant. And investors, at the very least, need to understand that risk.
As of this writing, Vince Martin has no positions in any securities mentioned.