Should You Sell Qualcomm After Apple's $1 Billion Lawsuit?

Shares of Qualcomm (QCOM -2.36%) plunged 13% on Jan. 23 after the chipmaker was sued for $1 billion by one of its biggest customers, Apple (AAPL -1.22%). The lawsuit is related to the FTC's separate lawsuit against Qualcomm, which alleges that the chipmaker leveraged its portfolio of critical wireless patents to force its baseband competitors out of the market. Let's take a closer look at this tangled mess, and see if Qualcomm shareholders should sell their shares.

Image source: Apple.

Why is Apple suing Qualcomm?

Back in 2008, Sprint deployed its first WiMax network, a 4G standard which wasn't heavily dependent on Qualcomm's patent portfolio. Intel (INTC -2.40%) championed the use of WiMax chips, but Qualcomm opposed WiMax in favor of its upcoming LTE standard -- which it could generate more licensing fees from.

At the time, Apple considered launching an iPhone for WiMax networks. Realizing that the move could hurt its LTE ambitions, Qualcomm agreed to pay Apple "rebates" for sticking with its baseband modems and waiting for its LTE standard instead. Those rebate payments were dependent on Apple doing two things --  exclusively using Qualcomm's chips (from 2011 to 2016), and not instigating any litigation which accused the chipmaker of unfair licensing practices. The FTC claims that Qualcomm essentially "bribed" Apple with those rebates to prevent it from switching to competing chipsets.  

Over the past two years, Qualcomm was hit with antitrust probes worldwide, which all allege that it charges unfair licensing fees for its 3G/4G technologies. It was fined $975 million in China, another $854 million in South Korea, and could face up to $3 billion in additional fines in Europe and Taiwan. Apple claims that because it cooperated with authorities in Korea during the investigation, Qualcomm retaliated by withholding $1 billion in rebate payments -- which it's now suing to recover.

The outcome is anyone's guess...

The battle between Qualcomm and Apple will be a long and nasty one, since it's dependent on many shifting variables. First, the FTC lawsuit could be dropped if commissioner Maureen K. Ohlhausen, a Republican who voted against charging Qualcomm that was just appointed the acting chairwoman by the Trump Administration, chooses not to follow through. If the case is dropped, the rebates should remain a valid business arrangement; but if it isn't, the rebates could be invalidated as "bribes" -- which may hurt both companies.

 Regardless of what happens with the FTC case, Apple needs to prove that it didn't violate the two main conditions of its rebate agreement by using Intel modems or aiding the Korean FTC during its investigation. Apple doesn't deny aiding the KFTC at all -- it recently told CNN that it was merely "responding truthfully to law enforcement agencies" instead of "instigating" litigation against Qualcomm.

Meanwhile, Qualcomm must justify many of its opaque licensing practices. Qualcomm charges royalties based on a device's entire value, instead of just the chips in the device -- a practice that was already blocked by Chinese regulators. It also charges licensing fees on 3G/4G handsets which don't use any of its chips, since  those devices still rely on its wireless technologies -- although Apple argues that some of Qualcomm's licensed patents don't actually cover those core technologies. This means that Apple still pays Qualcomm fees on iPhones using Intel modems (and also the Infineon modems it used in the past), and that those fees are likely higher due to the lack of rebates.

Understanding the risks to Qualcomm

If Qualcomm loses its cases against Apple and other regulators, it could be forced to change its entire licensing model. That move would cause the QTL (licensing) business' margins to wither and crush its earnings since the business generates the lion's share of its profits.

It could also jeopardize Qualcomm's planned acquisition of NXP Semiconductors (NXPI -1.93%), which would make it the largest automotive chipmaker in the world while expanding its patent portfolio. If Qualcomm doesn't close that deal this year, its top line will remain heavily exposed to the commoditization of the smartphone market and seemingly endless challenges against its licensing business.

But should you sell Qualcomm?

Qualcomm faces plenty of legal headwinds, but I believe that the sell-off is a knee jerk reaction that has knocked the stock down to irrational levels. Qualcomm now trades at 14 times earnings, as opposed to the industry average of 22. It also pays a forward yield of 3.4%, which is easily supported by a payout ratio of 53%.

As a Qualcomm shareholder, I'm certainly disappointed with recent developments. But I don't plan to sell my shares unless the litigation either derails the NXP deal or forces Qualcomm to dramatically reduce its licensing fees. Until then, I'll still consider Qualcomm a cheap (albeit riskier) dividend play with solid growth prospects in adjacent markets like connected cars, drones, and Internet of Things gadgets.