The U.S. Federal Trade Commission recently filedan antitrust lawsuit against Qualcomm (NASDAQ: QCOM), claiming that the mobile chipmaker leveraged its portfolio of crucial wireless patents to force competitors out of the market. The Commission claims that Qualcomm charged its baseband modem competitors higher license fees for its wireless patents, making it more expensive for smartphone makers to use rival modems.
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Image source: Qualcomm.
At the center of this case is Apple (NASDAQ: AAPL), which once considered launching an iPhone for the 4G WiMax networks championed by Intel (NASDAQ: INTC) and Sprint (NYSE: S). Qualcomm opposed WiMax, since it generated much lower royalties from that standard, and supported the LTE standard instead.
The FTC claims that to prevent Apple from launching a WiMax iPhone after Sprint deployed its first WiMax network in 2008, Qualcomm "agreed to rebate to Apple royalties" received from the iPhone maker's contract manufacturers "in excess of a specified per-handset cap." In other words, Qualcomm allegedly let Apple pay lower royalties to secure a long-term spot in the iPhone, lock rivals out of the baseband market, and deal a fatal blow to the WiMax standard.
The consequences of that deal
That alleged deal certainly helped Qualcomm, which remained Apple's exclusive supplier of baseband modems until the iPhone 7, which uses both Qualcomm and Intel modems. Qualcomm's biggest baseband modem rivals -- Texas Instrumentsand Broadcom -- both retreated from the market as Qualcomm's market share rose. The death of WiMax dealt a devastating blow to Sprint, which had invested billions in a dying standard and was forced to invest billions more in LTE networks.
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The FTC didn't outline any specific penalties against Qualcomm, butordered it "to cease its anticompetitive conduct and take actions to restore competitive conditions." But with the iPhone 7's modem production already split between Qualcomm and Intel, Qualcomm could easily argue that "competitive conditions" have been restored.
Furthermore, Qualcomm could note that Intel's payment of "contra revenues" (discounted chips, co-marketing agreements, and financial assistance in redesigning logic boards) to OEMs in exchange for using its mobile Atom chips was similar to its rebate agreement with Apple.
The sound and fury (probably) signifies nothing
Most importantly, a Republican-led FTC probably won't prosecute Qualcomm. The FTC voted2-1 to charge Qualcomm -- with two Democrats supporting the lawsuit and one Republican, Maureen K. Ohlhausen, voting against it, declaring that there was "no robust economic evidence" of anticompetitive effects from the deal.
One of those Democrats has already resigned, and the other commissioner's term will expire soon. President-elect Trump is expected to name Ohlhausen asthe acting chairwoman, and the new vacancies could be filled with Republicans who will likely support Ohlhausen's argument. Therefore, Qualcomm could simply receive a slap on the wrist without any serious fines.
But the antitrust drama isn't over yet...
Even if the FTC lawsuit fades away, Qualcomm still faces billions of dollars in overseas fines. Chinese regulators hit Qualcomm with a $975 million fine and forced it to lower its licensing fees in 2015, South Korea fined it $854 million at the end of 2016, and it could face up to $3 billion in additional fines in Europe and Taiwan -- which are both currently investigating the company for anticompetitive practices.
These lawsuits could all hurt Qualcomm's QTL (licensing) business, which generates the lion's share of its profits and offsets the lower margins of its QCT (chipmaking) business. With margins declining across the heavily commoditized smartphone market, more OEMs and regulators will likely revolt against Qualcomm's 3G/4G licensing fees -- which canequal up to 5% of a device's wholesale price. That could put tremendous pressure on Qualcomm's earnings over the next few quarters.
Should investors worry about these lawsuits?
The lawsuits against Qualcomm reveal how badly the commoditization of the smartphone market hurts the company. Its QCT revenues are falling due to fierce competition from cheaper ARM licensees like MediaTek, but its QTL revenues are also being weighed down by desperate OEMs which hope lower licensing fees can help them squeeze out more profits per handset.
These antitrust lawsuits won't sink Qualcomm, which is expected to generate nearly $24 billion in revenues this year. But they represent a dangerous paradigm shift in the market, and explains why the chipmaker is aggressively diversifying into adjacent markets like connected cars, drones, wearables, and Internet of Things devices.
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Leo Sun owns shares of Qualcomm. The Motley Fool owns shares of and recommends Apple and Qualcomm. The Motley Fool has the following options: long January 2018 $90 calls on Apple and short January 2018 $95 calls on Apple. The Motley Fool recommends Broadcom and Intel. The Motley Fool has a disclosure policy.