Qualcomm plunged to a four-year low on Nov. 19 after being hit by antitrust charges in South Korea. Qualcomm announced that an "examiner's report" from the South Korean Fair Trade Commission declared that its licensing practices were anti-competitive and violated Korean law.
View from Samsung C&T's Dongdaemun Design Plaza, Seoul. Source: Author
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Through its CDMA licenses, Qualcomm earns a 3% to 5% cut of the wholesale price of every smartphone shipped worldwide. The commission opposes that cut, stating that Qualcomm should collect royalties based on the value of the components that its patents cover, instead of the wholesale value of the entire handset. Qualcomm has declared that it will "vigorously defend" itself against those charges.
We've been down this road beforeQualcomm has had problems in Korea before. Back in 2009, the same Fair Trade Commission took issue with Qualcomm reducing CDMA royalties for OEMs which installed Qualcomm chips. That probe wasn't settled until 2013, when the Korean government finally slapped Qualcomm with a $208 million fine.
The new charges which Qualcomm faces in Korea are similar to the ones it faced in China during a 14-month probe, which ended this February witha $975 million fine. Under that settlement, Qualcomm agreed to only apply royalties to 65% of the net selling price of a handset, which is slightly lower than the wholesale price. But despite that agreement, Qualcomm claims that many top Chinese handset makers still underreport shipments to pay lower license fees.
During fiscal 2015, 53% of Qualcomm revenue came from China and 16% came from South Korea. Last quarter, lower license fees and non-compliant OEMs in China caused Qualcomm's QTL (licensing) revenues to dip 1% to $1.8 billion while operating profit slid 3% to $1.5 billion. A similar ruling in Korea could cause even more pain as leading smartphone makers like Samsung and LG pay Qualcomm lower royalties. That would hurt its bottom line growth, since the QTL business generated 86% of its pre-tax earnings last quarter.
Is this a protectionist play?Canaccord Genuity recently estimated that Appleswallows up 94% of all smartphone profits worldwide while controlling just 14.5% of the overall market. This means that most of Apple's Android rivals are selling their phones at paper-thin margins. Canaccord estimates that the ASP of iPhones during the quarter was $670 with an average operating margin of 37%, while Samsung had an ASP of just $180. The firm didn't estimate Samsung's margins, which vary widely due to its large range of devices.
Samsung's mobile unit firmed up last quarter, but it only brought in 32% of the company's operating profits -- a five-year low for the once-dominant division. To diversify away from smartphones, Samsung started beefing up its chipmaking facilities to challenge Qualcomm. To cut costs, Samsung started replacing Qualcomm's silicon with its own chips in its flagship devices -- a move which caused Qualcomm sales to fall 5% annually in fiscal 2015.
Many of Samsung and LG's devices use Qualcomm processors. Source: Qualcomm
Samsung is so big that its revenue is equal to nearly a fifth of South Korea's entire GDP. Since the Asian financial crisis in the late 1990s, South Korea's GDP has grown at an average of just 1.1% on a quarter-over-quarter basis. Therefore, the South Korean government might be forcing Qualcomm to lower royalties so that handsets from Samsung and other Korean OEMs can be sold at higher margins. Doing so would also help Samsung and LG compete more effectively against cheaper Chinese rivals which already benefit from Qualcomm's lower licensing fees.
However, South Korea and China aren't the only countries investigating Qualcomm. A year ago, the U.S Federal Trade Commission started investigating allegations that Qualcomm had breached its patent licensing agreements. This summer, EU antitrust regulators started probing allegations that Qualcomm was using illegal strategies to shut out rival chipmakers.
Should Qualcomm investors be worried?Regardless of the motivations behind the South Korean probe, it highlights two serious flaws in Qualcomm's business model. First, claiming a 3% to 5% cut of the wholesale price of all smartphones really hurts OEMs which are already operating at paper-thin margins. Second, charging OEMs royalty fees based on the wholesale price of the entire handset might be unreasonable when Qualcomm doesn't manufacture all the components.
If Qualcomm can't address these problems soon, the bullish notion that stable QTL profits will offset weaker sales of processors and wireless modems should be thoroughly reexamined.
The article Qualcomm Inc. Faces New Problems in South Korea originally appeared on Fool.com.
Leo Sun owns shares of Qualcomm. The Motley Fool owns shares of and recommends Apple and Qualcomm. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
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