If Qualcomm (NASDAQ:QCOM) loses its legal battle with the U.S. Federal Trade Commission, it could be forced to drastically change its business practices. The mobile chip giant's financials have already been deteriorating amid its separate dispute with Apple, and Qualcomm's dividend could even be put at risk if the situation doesn't improve.

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: 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.

Evan 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 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.

Dylan Lewis owns shares of AAPL. Evan Niu, CFA owns shares of AAPL. The Motley Fool owns shares of and recommends AAPL. The Motley Fool owns shares of Qualcomm and has the following options: long January 2020 $150 calls on AAPL and short January 2020 $155 calls on AAPL. The Motley Fool recommends NXPI. The Motley Fool has a disclosure policy.