Since the advent of smartphones Qualcomm (QCOM, Financial) has been the best bet for investors in the tech space. Qualcomm holds most of the smartphone architectural patents and earns not only from component and technology development but also from royalties on smartphone sales running on their technology. For a very long time, it has been a hot investment pick in its sector due to its advantage from technology patents. This almost made Qualcomm the unchallenged monopolist of the sector. But of late it hit the roadblock of coming under the scanner of several regulatory bodies across the globe and now the tech giant has to rework its licensing strategy. Let us take a dig at what is happening with Qualcomm in the licensing deck and how to react to it as an investor.
Qualcomm’s Licensing Scenario
Anti-trust probe into Qualcomm is likely to intensify global scrutiny of the firm’s highly profitable patent licensing business, and may even call into question its worldwide contracts with smartphone makers such as Apple (AAPL, Financial) and Samsung (SSNLF, Financial). China’s National Development and Reform Commission (NDRC) is moving to wrap up its 13-month investigation into the U.S. chipmaker as soon as possible, the regulator said in a statement on Friday, which would conclude one of the high voltage probe case Beijing into a western company’s proceeds.
Going but the tech reports from China Qualcomm are faced with a regulatory storm in China. Under its current patent policy if Qualcomm strikes any deal with any Chinese handset maker it might be hit by a record-breaking fine, as well as changes to how Qualcomm licenses its technology.
China is not the isolated case with the patent policy of Qualcomm. Anti-trust probes in Europe and by the U.S. Federal Trade Commission (FTC) is also stocked up high against the company and has been threatening the monopolistic technology patent policies of Qualcomm.
“It’s not an overstatement to say they’re under attack,” said Thomas Cotter, a patent expert and professor at the University of Minnesota Law School. “Nobody knows how it will play out, but the fact that there is an FTC investigation tells you something.”
Though the Qualcomm officials are tight lipped about the whole scenario but something serious is cooking up at the regulatory body’s end against Qualcomm’s policies and might bring about a sea change in the patenting policies of Qualcomm in the near future which would also effect its financial equations adversely.
Royalty equations and probable changes
As discussed earlier Qualcomm is the market leader in technology patent holdings amongst smartphone makers, including many that form industry standards like CDMA and LTE. Royalties based on the smartphones’ selling prices, even those made with competitors’ chips but running on the technology patented by Qualcomm, earned more than half of its $8 billion net income in 2014.
After the smartphone demand peaked out in the developed western markets all the smartphone makers turned their focus to China to gain mileage which was evident from Xiaomi’s success run of claiming the third position in the world smartphone sales by doing business in China alone. The rollout of LTE technology is driving the demands in China, and it is also the manufacturing hub for the majority of the world’s smartphones.
The NDRC, one of China’s anti-trust regulators, has said it suspects Qualcomm of overcharging and abusing its market position in wireless communication standards.
Going by the street whispers Qualcomm is considering options to restructure its royalty policies on phones sold in China, which will certainly have an adverse effect on its bottom line and financial numbers from business in China which is the fastest growing and most significant market of the tech giant.
Qualcomm earned about half of its global revenue of $26.5 billion from its China business for the fiscal year ended Sept. 28.
Renowned patent lawyers also pointed out that the lowering of royalty rates in China would mean that the contractual relationships will be affected not just with local manufacturers such as Huawei, Lenovo (LNVGY, Financial), ZTE (ZTCOY, Financial) and Xiaomi, but also with the large global players that make and sell phones in China, such as Apple and Samsung.
Though a royalty rate lowering by Qualcomm looks evident across China and in all probabilities across the globe since most of the phones are manufactured in China however in an analyst meet last November, Qualcomm President Derek Aberle shied away from answering a question about the time frame by when the chipmaker’s largest licensees’ contracts would be due for renegotiation, or how those renegotiations would be worked out with potential concessions in rates by Qualcomm in China.
“If Qualcomm comes to an agreement with China’s government to materially reduce its royalty rates, then what happens with their agreements with LG (LG, Financial), Samsung and Apple?” said Ascendiant Capital analyst Cody Acree. “It becomes a snowball that’s really hard to see the end to.”
Qualcomm on investigation radar
The Chinese anti-trust probe is not the first such episode for Qualcomm but the latest and perhaps the most impacting one since China is also the largest potential market for the chipmaker. But prior to this incident Qualcomm had faced such investigation in other regions as well, it was hit with a $20 million fine in South Korea in 2009 and was forced to renegotiate licensing agreements with Nokia and others by the European Commission in 2007.
According to industry experts the latest decisions by the apex US court of law to tighten the software patents procedure, as well as the possibility of a renewed initiative by Washington for patent reform, now have the San Diego based company held up at a tight spot even in their home turf.
The FTC’s probe concerns patents on technology used in industry standards and might require Qualcomm to change its licensing practices, according to a company filing.
“Qualcomm has more problems than just in China,” said Donald Merino, who advises companies on patents in Asia. “They have a problem in the US as well because the US is devaluing the patent system.”
Qualcomm's future
Whatever might be the workings, a royalty rate cut looks imminent from Qualcomm in order to stay in business, not just in China but the effect will cascade across the globe due to China’s strategic global position in the smartphone business both from sales and manufacturing aspects. The rate cut will certainly affect the business numbers of the chipmaker and will reduce its earnings to a great aspect. 2015 does not look very promising for the tech giant and its investors. For an investor it would be best not to add any position in the chipmaker as of now before royalty rate equations are worked out. Due to the possibilities of rate negotiations the threat over the business bottom lines looms large and might adversely affect the investors fund value.
