Apple Locks Horns with Qualcomm over iPhone Chips

Files a $1-billion lawsuit against Qualcomm on January 20th, 2017

Technology giant Apple Inc. (NASDAQ: AAPL) has locked horns with its iPhone chip supplier Qualcomm Inc. (NASDAQ: QCOM) by filing a $1 billion lawsuit against the company on January 20th, 2017, as reported by Reuters. Apple’s move comes days after the US government accused the chip maker of resorting to anti-competitive tactics to maintain a monopoly over key semiconductors that are used in high-end smartphones.

San Diego, California-based Qualcomm, a leader in wireless chip technologies, is a major supplier to both Apple and Samsung Electronics Co. Ltd for modem chips that connect phones to wireless networks. The two companies together accounted for 40% of Qualcomm’s FY16 revenue of $23.5 billion.

In its lawsuit filed in US District Court for the Southern District of California, Apple accused Qualcomm of overpricing smartphone chips and refusing to pay some $1 billion in promised rebates. Apple also said that Qualcomm has withheld the rebates because of Apple’s discussions with South Korea’s antitrust regulator, the Korea Fair Trade Commission (KFTC). The complaint also challenged the validity of some key Qualcomm patents for wireless technologies. Apple asks the court to rule that, if the patents are upheld, that the royalty amount is significantly lower than what Qualcomm currently charges.

Qualcomm has patents for chips which include standard essential patents, a term used to describe technology that is required to be licensed broadly and on “reasonable” terms. However, Apple said that Qualcomm refused to license this technology to other manufacturers to prevent them from making the chips and thereby maintain its monopoly. Moreover, Apple was required to pay a separate licensing fee for the same chips, in a “no license, no chip” policy. In addition, Qualcomm pressured network carriers to not sell or support Apple devices made with Intel Corp.’s (NASDAQ: INTC) chipsets.

Meanwhile, Apple has been facing flak from investors after sales dropped in early 2016 following a decade of continuous growth. The biggest source of concern for Apple is its major dependency on its blockbuster product iPhone, which accounted for 66% of its FY15 revenue. Apple is facing pressure to squeeze more profit out of every iPhone after shipments fell 5% in Q4 FY16 compared to 48.04 million units sold in the year-ago period. Apple typically sources the same component from several suppliers, which helps secure lower prices by forcing the manufacturers to compete on price.

Qualcomm ducks several blows

Over the past couple of years, Qualcomm has been faced with many lawsuits regarding its patent licensing practices. In December 2016, KFTC fined Qualcomm $854 million for unfair patent licensing practices. In February 2015, Qualcomm paid a $975 million fine in China, while the European Union in December 2015 accused it of abusing its market power to thwart rivals. On January 17th, 2017, the US Federal Trade Commission (FTC) filed a lawsuit against Qualcomm, accusing the company of using its dominant position as a supplier of smartphone chips to call the shots with regard to supply and licensing terms on several cellphone manufacturers.

Qualcomm, the largest maker of mobile phone chips, has been under fire by regulators around the world for its patent licensing practices. Apple’s lawsuit is the first direct challenge by one of its biggest customers and threatens to upend how royalties are calculated by any owner of a patent on technology that underlies modern electronics. Qualcomm was the sole supplier of modem chips for Apple’s phones until the release of the iPhone 7 in September 2016, after which Intel started supplying about half of the modem chips for the newest models.

On its part, Qualcomm has stated that Apple has intentionally mischaracterized its agreements and negotiations, while encouraging regulators to attack Qualcomm in various jurisdictions around the world by misrepresenting facts and withholding information.

Patent royalties bone of contention

With its lawsuit, Apple is looking to reduce the patent royalties that Qualcomm charges with the support of regulators. While Qualcomm gets the bulk of its revenue from chip sales, most of its profit comes from wireless patents it licenses to the mobile industry. Earlier, the Company explored a plan to break up its chip business from its patent licensing unit after pressure from activist investor Jana Partners, but decided to remain whole. Its patents cover the fundamentals of cellular technology, allowing it to rake in billions in licensing fees. In other words, the chipmaker gets paid regardless of whether its chips are used in mobile phones or not.

One common thread in all of the cases is the contention that royalty rates should be calculated as a percentage of the price of the components in the phone that Qualcomm invents and sells, measured in tens of dollars. Currently, licensing is a percentage of the price of the entire phone, which is usually in the hundreds of dollars.

Moreover, companies usually collaborate to develop industry standards so that the devices can communicate with each other. Since they have the ability to ensure their inventions get included in the standards, they pledge to license on “fair, reasonable and non-discriminatory” terms. Apple has accused Qualcomm of breached that pledge by refusing to license its patents to Intel, which been providing some chips to Apple for the past year.

Qualcomm to acquire NXP for $39 billion

Qualcomm announced on October 27th, 2016, that it would acquire Netherlands-based NXP Semiconductors N.V. (NASDAQ: NXPI) for $39 billion to establish leadership in new growth avenues such as Internet-of-Things (IoT) and the automotive industry, an area where NXP has expertise and is already an established player. Qualcomm is also trying to reduce its dependence on the slowing smartphone market, which is weighing on its topline, and find ways to sell its modems and processors for other applications such as automotives.

NXP, ranked 7th in the semiconductor industry, supplies a much broader set of industries with chips, some of which are analog. Moreover, NXP also manufactures its own chips, unlike Qualcomm which has always outsourced production. NXP, an established player in chips for the IoT, automotive, and security applications industries, could prove to be a worthy asset to Qualcomm, helping it to gain a leg-up in an intensely competitive market and against rivals such as Intel and Nvidia Inc. (NASDAQ: NVDA).

For Qualcomm, it appears to be a sound decision in the light of the fact that it could take the Company years to develop such technological expertise on its own. The two companies, which will have combined revenue of more than $30 billion, will have products that are capable of winning sales in markets worth $138 billion by 2020, Qualcomm predicted. Two years after the transaction closes, Qualcomm forecast $500 million of annual cost savings.

Stock Performance

Apple’s stock stood at $121.88, gaining 1.59%, at the close on Wednesday, January 25th, 2017, having vacillated between an intraday high of $122.10 and a low of $120.28 during the session. The stock’s trading volume was at 32,405,629 for the day. The Company’s market cap was at $639.65 billion as of Wednesday’s close.

Qualcomm’s stock stood at $56.90, gaining 3.45%, at the close on Wednesday, January 25th, 2017, having vacillated between an intraday high of $56.98 and a low of $55.50 during the session. The stock’s trading volume was at 27,493,024 for the day. The Company’s market cap was at $86.12 billion as of Wednesday’s close.

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