Just like last quarter, all anyone wanted to talk about on Qualcomm's (QCOM 4.26%) earnings call last night was the mobile chip giant's expanding legal battle with Apple (AAPL 1.66%). The situation even overshadowed relatively strong earnings, as Qualcomm topped consensus estimates by putting up revenue of $6 billion with adjusted earnings per share of $1.34. Management said the automotive, networking, and Internet of Things (IoT) segments performed particularly well.

Heading into the release, there was concern that Qualcomm's results could be held back since Apple is interfering with royalty payments that its contract manufacturers owe to Qualcomm, which was one of the counterclaims in Qualcomm's countersuit against Apple. The whole situation is complicated because Apple's suppliers sit between the two dueling parties and are effectively getting caught in the crossfire.

Diagram showing convoluted payment web between Apple, Qualcomm, and Apple suppliers

Image source: Court filings.

Here are the relevant highlights from the call regarding the escalating litigation.

Qualcomm believes its direct license offers are fair

Over the years, Apple has tried to ink a direct licensing deal with Qualcomm, but has never found the offered terms consistent with fair, reasonable, and non-discriminatory (FRAND) principles. Qualcomm says its offers have been comparable with the terms it offers hundreds of other companies, according to Qualcomm President Derek Aberle:

The offers we have made to Apple for a direct license to Qualcomm cellular standard essential patents are consistent with the value of our patent technologies, established by these more than 300 arm's-length license agreements and are fully compliant with Qualcomm's FRAND commitments. It is unfortunate that Apple has rejected these fair and reasonable offers.

Apple has started withholding payments to suppliers, which owe Qualcomm

Since Apple's contract manufacturers pass along the royalty costs in full, which Apple is now disputing, Apple has simply started to withhold these payments from its suppliers. These suppliers, in turn, underpay what they contractually owe to Qualcomm. The difference is roughly $1 billion. Aberle again:

Despite Apple's claims against Qualcomm, Apple suppliers remain contractually obligated to pay royalties to Qualcomm under their license agreements with us, including for sales of iPhones to Apple.

In our fiscal second quarter, Apple interfered with the license agreements between Qualcomm and the Apple suppliers by actively inducing them to underpay the royalties they owed to Qualcomm for sales during the December quarter. Apple withheld payments to their suppliers for sales in the December quarter in an amount equal to what Apple claims Qualcomm owes to Apple under a separate cooperation agreement between the companies.

iPhone with Air Pods

Image source: Apple.

The underpayments didn't affect recognized revenue

Apple suppliers reported the appropriate amount of royalties owed during the quarter, but simply underpaid what was owed. As such, Qualcomm still recognized the full royalty revenue from these contractual agreements, so it's mostly a matter of cash flow. Net accounts receivable did increase sequentially by $2 billion, including the disputed $1 billion. This is offset on the balance sheet, with $1 billion held in liabilities while the dispute remains ongoing.

Here's CFO George Davis:

It is worth noting that fiscal second-quarter royalty revenues were not impacted by the underpayment because the suppliers reported the full royalties for the term of their agreement, and acknowledged they were due, but underpaid by the same amount that Qualcomm is withholding from Apple under the cooperation agreement.

Suppliers are still on the hook

As mentioned above, Apple suppliers are getting caught in the crossfire, since they still owe Qualcomm royalties due to their agreements irrespective of what Apple does. Apple withholding payments to suppliers because Apple has a beef with Qualcomm has no direct impact on what the suppliers owe. On the other hand, the suppliers don't want to pay out such large amounts. Here's General Counsel Don Rosenberg:

So just to be clear, the excuse that the contract manufacturers used was that Apple wasn't paying them and what Apple was saying was that they are holding back payment to them to match payments that they claim we owed them from the other agreement, the BCPA. No connection to the license agreement between us and our contract manufacturers.

So it was totally improper for the contract manufacturers to withhold. And we now look at what they're going to do going forward, and we say, well, even the excuse that they use before that is Apple claiming that they were making up for amounts that we didn't pay them, doesn't exist anymore. So there doesn't seem to be even an arguable rational reason for anybody to withhold the payments.

This is how Qualcomm still recognizes the full revenue

Normally, if an amount is disputed, it isn't recognized as revenue. But since the suppliers themselves have not formally disputed the payments, Qualcomm is still able to recognize the revenue in full, as mentioned above. Here's Davis:

Typically, if there's a formal dispute, then we would not take revenue until the dispute is resolved. And I'll let Derek or Don comment on what constitutes a formal dispute. But certainly, entry into arbitration or lawsuit is one case in the past. For the customer in the second quarter, the customer reported fully and underpaid and has not filed a formal dispute. And in that case, we take the revenue for the amount paid while we're working on collecting the balance owed from the customer. 

A major overhang

The legal battle is a major overhang, and -- unlike the FTC's suit -- probably isn't going away anytime soon. It's a small consolation for Qualcomm investors that the bulk of the dispute is in the rearview mirror. The Business Cooperation and Patent Agreement (BCPA) that's at the center of the dispute expired at the end of 2016. Rosenberg again:

While we disagree with [Apple's original complaint], obviously, the rationale for that no longer applies. As Derek said earlier, that BCPA contract is expired. So there are no more monies even arguably due from us to them and therefore, no basis or rationale to continue withholding from the contract manufacturers. 

Qualcomm is taking a conservative approach to guidance, factoring in numerous scenarios of royalty payments from Apple via its suppliers (not including a scenario where Apple suppliers pay nothing). The company expects fiscal third-quarter revenue to be in the range of $5.3 billion to $6.1 billion, with adjusted EPS of $0.67 to $0.92.