Shares of Qualcomm (NASDAQ:QCOM) dipped 2% in 2017, woefully underperforming the Philadelphia Semiconductor Index's 38% rally. Qualcomm's decline would likely have been even uglier if Broadcom (NASDAQ:AVGO) hadn't tried to buy it for $105 billion.
So where did things go wrong last year for Qualcomm, the biggest mobile chipmaker in the world? The answer boils down to three main themes: regulatory crackdowns, clashes with OEMs, and an inability to close its $38 billion buyout of NXP Semiconductors (NASDAQ:NXPI).
Qualcomm's regulatory woes
Qualcomm generates most of its revenue from sales of its Snapdragon SoCs (system on chips). But most of its profits come from licensing wireless patents to smartphone makers. Qualcomm usually takes a 3% to 5% cut of the wholesale price of each smartphone sold worldwide.
Regulators in many countries are probing that practice for two main reasons. First, taking a cut of the entire phone's wholesale price seems excessive when Qualcomm's patents only cover the wireless components. Second, Qualcomm allegedly leveraged those patents to drive competing mobile chipmakers out of the market with unfair licensing fees.
Qualcomm's biggest markets are China, South Korea, and Taiwan, and it's been sued by regulators in all three countries. In 2015, it agreed to pay a $975 million fine in China and change the way it calculated licensing fees.
In early 2017, South Korean regulators fined Qualcomm one trillion won ($940 million) for similar reasons. Taiwanese regulators followed suit in October and fined Qualcomm $23.4 billion NT dollars ($790 million).
Qualcomm is appealing the fines in both countries, but it's doubtful that the fines will be completely dropped. It also faces similar probes in the U.S. and Europe.
Clashing with the OEMs
Smartphone makers were eager to pay Qualcomm licensing fees after Apple (NASDAQ:AAPL) sparked the modern smartphone revolution with the first iPhone in 2007. However, that market is now heavily commoditized.
Canaccord Genuity recently said that only three OEMs -- Apple, Samsung (NASDAQOTH: SSNLF), and Huawei -- actually make a profit from their phones. Other OEMs are selling their devices at a loss. That's why many OEMs want Qualcomm to lower its licensing fees.
Apple is leading that charge against Qualcomm. First, it sued the chipmaker last year over unpaid "rebates" for its exclusive use of Qualcomm modems in previous iPhones. Apple claimed that Qualcomm withheld those payments in retaliation for its cooperation with the South Korean FTC during its regulatory probe.
Apple then sued Qualcomm in the U.S. and China, claiming that its licensing fees were unfair, and ordered its suppliers to suspend all licensing payments to Qualcomm. The latter retaliated by suing Apple's suppliers and attempting to block iPhone sales in China.
These legal clashes will likely drag on, but Apple is already exploring ways to replace Qualcomm's components in future iPhones and iPads. To make matters worse, Apple's revolt has reportedly convinced a second major OEM -- possibly Huawei -- to also withhold its licensing payments.
An uncertain future for NXP
Qualcomm announced its intention to buy NXP, the biggest automotive chipmaker in the world, in late 2016. However, all of Qualcomm's regulatory problems and clashes with OEMs have cast a long shadow over that deal.
U.S. regulators approved the deal last April, but it remains in limbo in the EU. Qualcomm tried to appease regulators by offering to purchase NXP without some of its patents, but it could need to make additional compromises to seal the deal.
Even if the EU approves the deal, NXP's investors might reject it. Activist investor Elliott Management, which holds a 6% stake in NXP, has been pushing for a higher offer of $135 per share, compared to Qualcomm's original offer of $110.
Investors apparently agree with Elliott -- the percentage of tendered NXP shares fell from almost 15% last February to less than 2% in December. If Qualcomm fails to close the NXP deal, it will lose a crucial foothold in the connected and driverless car market, which it needs to diversify its top line away from mobile chipsets and wireless licenses.
The road ahead
Analysts expect Qualcomm's woes to continue, with its revenue and earnings falling 2% and 17%, respectively, this year. The deterioration of its bottom line could endanger its dividend as its payout ratio hits historic highs.
On the bright side, Qualcomm's stock could rebound on another Broadcom offer, successful appeals in South Korea or Taiwan, an amicable resolution with Apple, or the approval of the NXP acquisition. Therefore, I'm not bullish on Qualcomm at these levels, but I wouldn't bet against it, either.