Qualcomm (NASDAQ:QCOM) has been racking up headlines for years for its controversial business practices. This week, things are getting serious -- an upcoming FTC decision could completely destroy the business model the company has relied on for decades.

In this week's episode of Industry Focus: Tech, host Dylan Lewis and Motley Fool contributor Evan Niu explain in depth how Qualcomm's business model works, why it's infuriated so many customers and governments around the world, what's at stake for the company in the next few weeks, when we'll find out what happens next, and why investors should probably not try to catch this falling knife before the big decision comes out.

A full transcript follows the video.

This video was recorded on Jan. 25, 2019.

Dylan Lewis: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It is Friday, January 25th. We're talking about the big bad Apple (NASDAQ:AAPL) supplier that's grabbing headlines. I'm your host, Dylan Lewis, and I'm joined on Skype by Fool.com's Evan Niu. Evan, what's up?

Evan Niu: Not much, getting ready for earnings season.

Lewis: Earnings season, one of our favorite four times of the year! It's so nice that we get it quarterly instead of once a year, like some of the winter holidays, huh?

Niu: Yeah. It's about to start getting pretty busy. 

Lewis: Actually, Qualcomm, the company that we're going to be talking about today, should be reporting in the next week, week and a half or so. But there's been plenty of news ahead of this earnings release, and that's what we're going to be spending a lot of our time talking about today.

Niu: Yeah, they've been at trial all month with the FTC. It's a pretty big trial, a lot of interesting information coming out. A lot of salacious headlines. 

Lewis: Before we get into that news, this is a company that we've discussed plenty on the show. But typically when we've done it, we've talked about it because they're an Apple supplier. Almost all those conversations have funneled up into a larger conversation about Apple. Today, we're going to focus specifically on Qualcomm. There's a lot going on with this company, and I think that the state of this business could really change in the next year or so depending on how some upcoming decisions go.

Before we do all that, though, why don't we do a little rundown on who they are, what they do? I'm sure there's some people that maybe know the name and not much else, Evan.

Niu: As a quick primer, Qualcomm has been one of the big pioneers of cellular technology. They develop all these connectivity solutions. For example, 3G was a big one for them for CDMA. But also, 4G LTE, and all these cellular standards, they had a big part in developing the technology. They license those patents out. They also sell chips, predominantly modems that help these cellphones connect to cellular networks. Just about every cellphone in the world has some level of Qualcomm technology inside, in which case they earn a royalty on it. So, they have a very unique business model that gives them incredible power in the cellular industry. 

They have a very controversial policy called "no license, no chips" that has only strengthened their market power. They basically would not sell you chips unless you agreed to a licensing agreement, which typically had really onerous terms, really high royalty rates. They have all this necessary intellectual property known as standard-essential patents, and they also make the best modems. So, if you're a smartphone maker, you don't have much of a choice other than to do business with both sides of this company. 

If you have standard-essential patents, you're obligated to license them out at fair, reasonable, and nondiscriminatory terms, but they're not doing that. And that's at the heart of a lot of these legal challenges. They also charge royalties that are based on a percentage of the smartphone's total price. They're not the only one that does that, but that's another controversial aspect of this business. 

Lewis: You threw out a couple of different terms there that I think we'll probably loop back to at different points in the show. I just want to explain those acronyms quick that we'll be using later. Standard-essential patents, like you said, this is IP that's related to a standard that has been set. This is the stuff that Qualcomm holds and winds up licensing out to other companies. The fair and reasonable and also nondiscriminatory is also known as FRAND. You might hear us refer to it that way. Basically, if you have a technology that is adopted as the "standard for an industry," you need to make it available to people that participate in that industry because the standard has to apply at a somewhat reasonable price for all the players that are participating. 

Niu: Right. The idea is, you don't want one company to be able to have a lock hold on the entire industry. If they need your intellectual property and you refuse to license it, you could bring the entire industry to a halt. 

Lewis: Without this type of dynamic, there wouldn't be much of an incentive for a standard to be set at all, because by doing that, you'd be creating these de facto monopolies. 

Niu: Right. There's also a lot of debate over how essential these patents are to these standards. It's kind of a self-proclaiming thing. Qualcomm says these are necessary, but there's not an actual body that agrees and validates that these are, indeed, necessary. That's a whole other debate. We don't have time for that. [laughs] 

Lewis: That's all to say, though, the reason we're having this conversation is because Qualcomm's business approach and everything that they provide to the smartphone industry has become so indispensable for so many of these businesses. This business model, though, has caused the company to come under a lot of scrutiny lately because of the standard-essential patent FRAND dynamic in particular.

Niu: Right. Regulators all around the world have been filing complaints and lawsuits against Qualcomm for over a decade. I think it starts back in 2007 or somewhere around that time frame in the European Union. In the years since, Japan, China, South Korea, now the U.S. China hit Qualcomm with a $1 billion fine in 2015. South Korea did $850 million in 2016. Those are the precursors to the current battles that Qualcomm is having with Apple and the U.S. Federal Trade Commission. Both of those complaints were filed simultaneously but separately two years ago in January 2017. This stuff's been going on for a long time. 

Apple was always a major customer. It's not every day that you hear of an Apple supplier that can bring Apple to its knees, which is exactly what Qualcomm did for many years. Typically, the power dynamic is the opposite. Apple has all the power, usually, with most of its supplier relationships. But, because it has no choice but to work with Qualcomm and pay these royalties that it's now called "extortion-level and exorbitant," and out of desperation for royalty relief, they've agreed to all these terms and contracts with Qualcomm, including exclusivity with buying only modems from them for a period of time in exchange for rebates that reduced how much they had to pay overall. It's been a big mess. 

Lewis: Listeners might remember, in a past episode when we were talking about some recent Apple woes, that they had sales of certain iPhones blocked in certain markets in Europe. That's all related to this dispute that we're talking about here. The scope for Qualcomm, though, could really get quite a bit larger. What we're seeing with Apple is what we're seeing, really, with their entire distribution relationship, and all of the people that they supply to, because it is a core business model discussion. It's not just the relationship with one supplier. 

Niu: Right. As far as the FTC trial is concerned, which is what's been playing all month, the FTC has presented a really strong case that Qualcomm's behavior has really undermined competition in the cellular industry and modem markets. The whole point is to prove that they hurt competition and hurt markets and therefore consumers. Of course, Qualcomm has its experts testify that they did not hurt competition. That's what's up in the air. The case is set to conclude next week, but then, of course, the judge will probably take some time to really put together a decision. 

There's a lot going on. The FTC basically wants Qualcomm to license its technology at reasonable rates, which could have drastic impacts on its business, as well as to drop this whole "no license, no chips" policy that's been so controversial.

Lewis: To give a sense of how this plays out with the supplier relationships they have, we got some testimony from Apple COO Jeff Williams in this case. He's saying that Apple pays about $7.50 per device after rebates, which is about 5X the $1.50 per device that the company initially thought was a fair rate for the components that they were getting. You can imagine that not only is that something that Apple feels, but industrywide, if everyone's paying that, that's something that probably gets passed along to consumers at some point.

Niu: Right. If you apply it to Apple unit volumes, if you look at how many iPhones they're selling on an annual basis and apply that $7.50, in 2011, that means they were paying somewhere about $465 million a year to Qualcomm. But, as Apple's business grew and iPhone units grew, that climbed to about $1.1 billion in 2015 and 2016. It's also worth noting that Williams said in 2013, when the two companies were trying to renegotiate a contract, Qualcomm wanted to add another $8 to $10 per device on top of that $7.50, which would more than double its royalties. That's an extra $1 billion a year, when Apple already felt it was overpaying. [laughs] So, you can see, Apple's not very happy about this whole situation.

Lewis: And I'm sure they're not the only one. Evan, when you look at how Qualcomm's top line works, the licensing segment, which they refer to as QTL, doesn't seem like that much money. But you need to think about the margins for these different businesses that they have. We're talking about something that's the breadwinner for this overall business.

Niu: Right. IT's super high-margin because they're just licensing the technology. Whereas on the chip side, of course, it's a hardware business, so inevitably you're going to have much lower margins there. The two sides of this company go very well together, as we've seen over the past decade.

Lewis: I think the actual numbers, the licensing business does currently about $1 billion in revenue per quarter. You go back over the past 12 months, Qualcomm has done about $23 billion in sales. So, licensing looks like a drop in the bucket. You look at the margins, though, licensing is near a 60% earnings-before-taxes margin. The other side of the business makes much more revenue but has an EBT margin in the high teens. So, anything that will impact this part of the business will have an outsized impact on the financials for this company. 

Niu: Right. The licensing business has been under a lot of pressure over the past couple of years in part because of these legal challenges. For example, licensing revenue total in fiscal 2018 was about $5.2 billion. That's down from $6.4 billion in fiscal 2017 and $7.7 billion in fiscal 2016. So, that business has been under a lot of pressure. They've been trying to make concessions to try to appease all these people that are upset with how they do business. For example, in late 2017, they reduced the percentage rate that they're asking. In early 2018, they also lowered the cap of both the value of the handsets, since they charge based on the total value of the phone, but they cap it. They lowered that cap from $500 to $400. They're trying to make these concessions to appease these people that are upset, and that's also weighing on the business. 

Lewis: It seems like the market is starting to take notice of the fact that this is a pretty big risk for this business. Earlier this week, we saw an official short note out from Kerrisdale Capital about this company. It was tied to the fact that they didn't think that this business model was sustainable and they were worried about what this company might look like if they're not able to charge the current margins that they are on a lot of their products.

Niu: Right. Kerrisdale was pretty damning in their estimates. They argued that Qualcomm's only worth $21 a share if they lose all of these battles. They estimate that they would be losing out on $2.7 billion of licensing revenue compared to their fiscal 2018. That's over half of revenue in that business for the last fiscal year. That's a massive cut. They're predicting the stock is going to fall by 60%, assuming that they're going to lose these battles, and that's why they have a short position. 

Lewis: Yeah. Even if you're not predicting a huge haircut for this stock, you look at the type of company that this has been over the last couple of years, this business has bought back a ton of stock, they pay a pretty solid dividend, about a 5% yield right now. It's hard for me to imagine that those types of policies, that type of capital allocation program, is going to continue if they aren't able to command the same premiums on their stuff that they have in the past.

Niu: I definitely agree. They've generally been pretty good about capital returns historically. They did a massive $30 billion buyback last year after the NXP deal fell apart. In general, they've been increasing these dividends very regularly. But, yeah, the sustainability of that dividend will be seriously called into question if they lose these legal battles. If you look at their adjusted earnings per share, last year, they did about $3.69. I think they paid out $2.30 in dividends. The payout ratio is about 65%, which theoretically says that maybe they have some wiggle room. But if you look at free cash flow, which is what pays dividends, free cash flow last fiscal year was $3.1 billion. Dividend payments were $3.5 billion. They paid out more in dividends than they brought in in free cash flow, and that's not a good sign.

Lewis: No, it's not what you want to see from a dividend payer. I look at all of this -- some people might see a big decision like this and think, "There might be some upside potential for this stock, possibly a chance to buy before we see something that could meaningfully change the thesis," try to get ahead of that news. I don't want any part of this business anytime soon, Evan.

Niu: I actually sold back in 2015, and that turned out to be a good time. [laughs] Obviously, I didn't know that this relationship with Apple was going to implode so spectacularly. But at the same time, there were a lot of risks around customer concentration. Apple is the biggest modem customer by far, and it's been pretty obvious that they've been developing their own modem for a few years, even though it could be still more years before they're ready to actually ship their own modem. On top of that, they have a massive debt load. They've been trying to pay down their debt. Right now, it's about $16 billion in total term debt. That's down from $22 billion from fiscal 2017. But even with the debt, the interest expense last year was more than operating income. That's another sign that these financials are deteriorating. They paid $770 million in interest last year, but they only generated $740 million in operating income. They're already at this precarious position. As we mentioned, if these legal battles go against them, it's just going to get a lot worse. 

Lewis: I think as an investor, you want things that are relatively easy and relatively simple to predict. This reminds me a bit, it's not quite on par with the binary outcomes that you see in the biotech space, in the healthcare space, but this is maybe as close as we get in the tech world. One decision will very meaningfully impact the trajectory of a business for the next year or two. In this case, I don't want to have to pay to have a seat to watch that happen. I'd rather just watch from the sidelines and see. This could be something that really changes the dynamic of this business and what they're able to do in terms of rewarding shareholders, and also what they're going to have in terms of cash on hand to be able to plow into R&D and anything else that they want to do over the next couple of years.

Niu: I agree. There's so many risks facing Qualcomm right now. I'm very glad to not be in it. I'll be with you on the sidelines watching them. Right now, it seems like most experts feel like the FTC has a pretty strong case. The federal judge, Lucy Koh, handles a lot of these high-profile tech cases, has already issued a preliminary ruling last year tentatively siding with the FTC and saying, "Yes, Qualcomm should change its licensing practices." Of course, that's not a finalized decision. But I think there's indications that it's not going to go in Qualcomm's favor. 

Lewis: Yeah. It's not necessarily that we're going to go back to a period of them basically wiping this business segment. It might be that it's more reasonable, but even at that, if this is the engine that's driving this company and any element of it is taking a haircut, it's going to be problematic for investors.

Niu: It also has implications for other players. There are something like 10 or 12 companies that are similar to Qualcomm in the sense that they develop these standard-essential patents for the cellular industry and then license them out. Almost all of them do charge based on the total price of the smartphone. If that practice gets shot down, that has implications for a bunch of other companies like Nokia, Ericsson, a bunch of other players, too. This is going to be a pretty big trial that will have a lot of impact on the industry.

Lewis: For people that are following this story, we should have an update when? When are they going to be actually releasing a decision?

Niu: I don't know if they've set a timeline for that. I know that the trial is supposed to conclude next week. But then, the judge is going to make a call. It's not a jury trial. Lucy Koh will have to take some time to form her opinion, because those opinions tend to be super long and detailed. She'll have to have a lot of good rationale for her decisions. I don't know exactly how long to expect on that, but it's going to be a big one whenever it drops. 

Lewis: We'll have some update on the business when they report earnings, but a far more important update on the business whenever that decision is finalized and we get a sense of what this company will look like over the next couple of years.

Evan, thanks for hopping on and talking about it with me!

Niu: Thanks for having me!

Lewis: Listeners, that does it for this episode of Industry Focus. If you have any questions, or if you want to reach out and say hey, you can shoot us an email over at industryfocus@fool.com, or you can tweet us at @MFIndustryFocus. If you want more of our stuff, subscribe on iTunes or check out all of our videos from this podcast over on our YouTube channel. As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear. Thanks to Austin Morgan for all his work behind the glass! For Evan Niu, I'm Dylan Lewis. Thanks for listening, and Fool on!

Dylan Lewis owns shares of Apple. Evan Niu, CFA 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 recommends NXP Semiconductors. The Motley Fool has a disclosure policy.