The U.S. Federal Trade Commission says Qualcomm (NASDAQ:QCOM) has abused its market power and undermined competition in the cellular modem industry for years. The case, which is similar to a separate suit filed by prominent customer Apple (NASDAQ:AAPL), went to trial this month. Qualcomm is trying to defend its business practices from regulatory scrutiny, but the federal court will have the final say.
In this segment from Industry Focus: Tech, host Dylan Lewis and Fool.com contributor Evan Niu discuss the chipmaker's legal woes.
A full transcript follows the video.
This video was recorded on Jan. 25, 2019.
Dylan Lewis: There's been plenty of news ahead of this earnings release, and that's we're going to be spending a lot of our time talking about today.
Evan 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 non-discriminatory 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 non-discriminatory 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 out 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 five times 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 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.
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 has a disclosure policy.