How Apple's lawsuit threatens Qualcomm's business model

Qualcomm's (NASDAQ: QCOM) licensing business is a profit-making machine. Almost every time a smartphone is sold, the chipmaker gets a cut, because of its patents on communications standards.

Investors love it. Qualcomm is among the world's biggest tech hardware companies, and one-third of its revenue — or almost $8 billion in 2016 — comes from high-margin licenses. Over the past five years, the company has traded for an average of close to 18 times profit, compared with about 13 times for chipmaker Intel, according to FactSet.

But Apple's $1 billion lawsuit filed against Qualcomm on Friday shows the risks of that dependence, sending the stock down 13 percent Monday.

Apple (NASDAQ: AAPL) claimed that Qualcomm has been "charging royalties for technologies they have nothing to do with." That followed a lawsuit from the U.S. Federal Trade Commission earlier last week and investigations launched in 2015 by South Korea and Taiwan, all questioning whether Qualcomm's charges are fair and reasonable.

"The licensing business is under attack on multiple fronts, from both governments and now Qualcomm's own customers," said Stacy Rasgon, an analyst at Bernstein Research who recommends holding the shares. "Nobody likes to pay royalties, but most held their noses and did. Now they seem less likely to pay those rates, and are fighting back."

A Qualcomm spokesperson called Apple's claims "baseless" and said in an e-mailed statement that Apple "intentionally mischaracterized our agreements and negotiations, as well as the enormity and value of the technology we have invented, contributed and shared with all mobile device makers through our licensing program."

Nevertheless, Romit Shah, an analyst at Nomura, downgraded Qualcomm shares to neutral from buy on Monday, citing the piling up of lawsuits and investigations.

Last year, Qualcomm agreed to buy chipmaker NXP Semiconductors (NASDAQ: NXPI) for close to $40 billion, in what would be the biggest ever deal in the semiconductor industry. Shah said the regulatory hurdles to completing that transaction have risen substantially of late, because it requires clearance in the countries where Qualcomm is under investigation.

"Recent rulings and lawsuits are stronger and broader than anticipated," he wrote.

The Apple suit stems from an investigation by Korean authorities into Qualcomm's potentially anti-competitive practices in how it charges royalties. Apple cooperated in the probe, which ultimately led Korean regulators to fine Qualcomm $854 million in December for unfair trade practices.

Apple's business agreement with Qualcomm has included rebates from the chipmaker for exclusive use of its products. In last week's lawsuit, Apple alleged that Qualcomm withheld payment of $1 billion as a retaliatory measure for helping Korean authorities.

Whether Apple is ultimately successful is now a matter for the courts to decide, but win or lose it illustrates the mounting pressure on Qualcomm's business. Apple and its suppliers along with Samsung (Korea Stock Exchange: 593-KR) account for about 40 percent of the chipmaker's revenue.

Qualcomm's licensing model dates back to early days of cellphone connectivity, when standards developed by the company were essential for linking phones to voice and data networks.

The modern smartphone is loaded with technologies that Qualcomm had nothing to do with creating. Apple said security, payments and camera features that it developed result in more money for Qualcomm, which "believes it is entitled to collect its `tribute' on every such improvement."

Even as Qualcomm fights back, the company recognizes the risks to investors. In its annual report, Qualcomm said its business can be hurt by "attacks on our licensing business model, including current and future legal proceedings or actions of governmental or quasi-governmental bodies or standards or industry organizations."

And here's the bottom line for shareholders, also spelled out in Qualcomm's filings:

"A significant portion of our business is technology licensing, which is a high-margin business, and as such, Qualcomm typically has higher market capitalization and profit than companies with similar revenues."

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