Qualcomm's (NASDAQ:QCOM) stock plunged on Wednesday after the U.S. Federal Trade Commission won its five-month antitrust case against the mobile chipmaker. The U.S. district court ruled that Qualcomm "strangled competition" with "unreasonably high" royalty rates, unfair business strategies, and exclusive partnerships.
Judge Lucy Koh stated that Qualcomm could no longer offer exclusive deals to original equipment manufacturers (OEMs), withhold chips from OEMs that don't license its technologies, or penalize customers for cooperating with regulators. Qualcomm will also be required to license its technologies to rival chipmakers at lower rates, renegotiate existing contracts to meet those conditions, and be monitored for seven years to ensure its compliance.
That ruling suggests that Apple's lawsuits against Qualcomm, which were abruptly settled in April, were justified. Qualcomm's stock previously rallied after Apple dropped its lawsuits and signed a six-year licensing agreement, but the latest court ruling indicates that the chipmaker's legal problems are far from over.
The case against Qualcomm
Qualcomm is the world's largest maker of wireless modems and mobile SoCs (system on chips), which bundle together a CPU, GPU, and modem on a single module. It also holds the largest portfolio of wireless patents in the world, which entitles it to a cut of each smartphone sold worldwide.
Most of Qualcomm's revenue comes from its lower-margin chipmaking (QCT) business, but it generates most of its profits from its higher-margin patent licensing (QTL) business. The QTL unit's average royalty rate once hovered at about 5% of a device's selling price (although the price used in that calculation was capped at $400).
Smartphone makers, many of which operate at thin margins, argued that Qualcomm should only take its cut from the wireless components instead of the phone's sale price. That controversial business model sparked regulatory probes in the U.S., Europe, China, Taiwan, and South Korea.
The plaintiffs in these cases argued that Qualcomm leveraged its dominance of mobile chips and wireless patents to secure exclusive deals. In 2003, Qualcomm offered Huawei a royalty rate of 2.65% if it exclusively used its modems, but that rate would rise to 5% to 7% if it used a rival's chips.
Between 2011 and 2016, Qualcomm paid Apple billions of dollars in rebates to prevent the iPhone maker from using another chipmaker's modems. Rival chipmakers also argued that the licensing fees made it impossible to match Qualcomm's prices and margins. All of those moves likely locked competitors out of the market and ensured that Qualcomm would dominate the mobile chip market.
What's at stake for Qualcomm?
Qualcomm was already fined in China, South Korea, and Europe, and the new FTC ruling could take a big bite out of its U.S. profits. In early May, Qualcomm stated that the Apple settlement would nearly double its third-quarter GAAP revenue annually with a one-time payment between $4.5 billion to $4.7 billion.
On a non-GAAP basis, which excludes that payment, Qualcomm expects its third-quarter revenue to decline 2% to 16% annually, and for its EPS to fall 21% to 31%. Qualcomm expects its QTL revenue to fall 10% to 16% due the softness of the smartphone market and a tough comparison to the prior-year quarter, which included a $500 million gain from a settlement with an unnamed licensee.
Qualcomm desperately needs its QTL business to keep growing since it accounted for 62% of its pre-tax earnings last quarter. If Qualcomm renegotiates all of its existing contracts with OEMs -- including giants like Apple, Huawei, and Samsung -- its QTL profits would inevitably tumble and dent its earnings.
What's Qualcomm's next move?
Qualcomm plans to appeal the ruling, so the case could drag on for months as it keeps generating licensing revenue from its existing agreements. Qualcomm will also likely argue that it already lowered its licensing fees over the past few years, and that it would be unfair to punish the company for earlier deals.
Qualcomm claims that the QTL unit currently takes a 2.275% cut of the selling price of single-mode 5G handsets, and a 3.25% cut of the selling price of multimode (3G/4G/5G) devices. Both figures are much lower than the 5% cut that's often cited in cases against Qualcomm.
Nonetheless, Qualcomm now faces an uphill battle, and the FTC case could spark a fresh rebellion among OEMs, who could halt their licensing payments until the deals are renegotiated. In other words, Qualcomm's legal troubles won't end anytime soon.
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Leo Sun 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.