Quick Thoughts: AAPL takes a swing at QCOM

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  • AAPL’s $1B suit is the latest in a contentious history with QCOM, which believes it has been the instigator of anti-competitive investigations in Korea and the Obama FTC
  • QCOM is the largest holder of both essential and non-essential patents for all 3G and 4G standards, and has licensed its IP to OEMs as a single package for more than 22 years.
  • AAPL has refused a bundled license, paying only via its OEM’s QCOM contracts. Its lurid claims look to end QCOM’s patent bundling, putting 84% of QCOM profits at some risk.
  • QCOM has 22 years of success defending its licensing model in court. This precedent and its legal experience are powerful assets that make the likelihood of a damaging outcome very low.

On Tuesday, January 17, 2017, the Obama FTC in a 2-1 decision accused QCOM of antitrust violations. Dissenting Commissioner Maureen K. Ohlhausen crafted a strongly worded dissenting opinion that the complaint is “… based on a flawed legal theory (including a standalone Section 5 count) that lacks economic and evidentiary support, that was brought on the eve of a new presidential administration, and that, by its mere issuance, will undermine U.S. intellectual property rights in Asia and worldwide.” The FTC complaint alleges QCOM three violations of the FTC Act including a “no license, no chips” policy, refusal to license standard-essential patents to competitors, and extracting exclusivity from AAPL in exchange for reduced royalties. With the likely appointment of new Republican commissioners within the next several months, we do not expect the FTC to pursue this investigation. We note that QCOM’s licensing practices, established more than 20 years ago and essentially unchanged, have been challenged many times in legal venues around the world. While the company has paid fines in a few cases, its basic right to license its IP on an “all-or-nothing” basis has been affirmed.

Enter the AAPL suit, filed 3 days after the FTC’s defiant lame duck filing. We believe that the timing of these actions is far from coincidental, given the FTC’s heavy reliance on AAPL’s complaints in its own, and, perhaps, both the FTC and AAPL had been counting on an easier path forward under a Clinton administration. AAPL presents a more detailed and complex case against QCOM comprised of 25 counts accusing QCOM of overcharging for chips and seeking remuneration for nearly $1B in accrued rebates it has claimed over the past year.

AAPL is not a direct QCOM licensee, but indirectly pays the royalties via its contract manufacturers (“CMs”). AAPL and QCOM maintain a Business Cooperation and Patent Agreement (“BCPA”) that expressly caps the royalties that AAPL pays to QCOM via its CMs and provides for rebates back to AAPL to manage the cap. AAPL claims that $1 billion of these royalty rebates were withheld because of its cooperation with investigators from the Korean Fair Trade Commission (KFTC), a serious allegation that QCOM denies. At first glance, it seems unlikely that QCOM’s experienced legal team – which oversees any such contractual disputes – would have allowed the rebates to be used in this way. We note that the amount of any rebate payment in question would still have been allocated for financial purposes, and thus would not represent an unaccounted obligation for future earnings.

In addition to seeking out compensation for the rebates, AAPL’s lawsuit is asking to unbundle the way QCOM licenses its patents, redefine specific patents as non-essential, and formally define the license royalties related to the smallest saleable unit of a device rather than a retail price. QCOM has long resisted this unbundled licensing model, arguing that with more than 10,000 relevant patents and thousands of licensees, an a la carte approach is impractical. AAPL argues that the “all-or-none” program violates the terms of various standards bodies, which require all “essential” IP be licensed to all members on a fair, reasonable and non-discriminatory (FRAND) basis. QCOM, which has faced and won FRAND challenges for decades, maintains that the long record of voluntary bilateral agreements with licensees is strong evidence that its program meets the requirements of the standards bodies.

Ultimately, AAPL’s complaints will be evaluated by the US District Court for the Southern District of California, with a high likelihood that any outcome would be automatically appealed. The possible stakes are high – a full AAPL victory could cut QCOM’s royalty income (which accounts for 84% of its profits) dramatically. Still, we think the likelihood of such an outcome is very low given QCOM’s extraordinary litigation history. Moreover, it is not likely that there will be a definitive conclusion for years, unless there is a negotiated settlement between the two companies. Meanwhile, we see many reasons to like QCOM’s business prospects right now – chip share gains and improved royalty collections chief amongst them. As such, we see today’s sell off as a considerable buying opportunity.

©2017, SSR LLC, 225 High Ridge Road, Stamford, CT 06905. All rights reserved. The information contained in this report has been obtained from sources believed to be reliable, and its accuracy and completeness is not guaranteed. No representation or warranty, express or implied, is made as to the fairness, accuracy, completeness or correctness of the information and opinions contained herein.  The views and other information provided are subject to change without notice.  This report is issued without regard to the specific investment objectives, financial situation or particular needs of any specific recipient and is not construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Past performance is not necessarily a guide to future results.

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