FTC scrutiny thwarts Qualcomm’s lucrative licensing model

Bloomberg

Qualcomm Inc. built itself into the world’s biggest and most profitable smartphone chipmaker by using a simple formula: selling billions of dollars worth of semiconductors while raking in fat profits from licensing fees tied to the underlying technology.
That lucrative model is under siege on a growing number of fronts — most recently this week when the US Federal Trade Commission accused Qualcomm of using its dual businesses to thwart competition in the $100 billion market for phone chips. The regulator alleged that Qualcomm forced partner Apple Inc. to use its chips exclusively in return for rebates, or kickbacks, on license fees, a strategy that makes it hard for rivals to take business away from the chipmaker.
The accusation is the most serious leveled against the San Diego-based company so far in a series of regulatory investigations spanning three continents and could push Qualcomm to consider separating its licensing business from its chip division.
Qualcomm’s revenue has more than doubled since 2010 as it made its technology and chips essential to the smartphone explosion. Its growth and leadership have been driven by a virtuous cycle in which its chip unit generates patents that it licenses to phone makers, who pay Qualcomm a percentage of the price of every phone they sell, regardless of whether they use its chips. The profit is then funneled back into industry-leading spending on research and design.
The company argues this has served the industry well, driving innovation available to everyone. Now, as growth slows in the smartphone market, some of Qualcomm’s customers may have enlisted regulators to try to help them break out of deals their lawyers have failed to unwind.
The success of the unit has made what the FTC called “the Qualcomm tax” a target. In its last five fiscal years, Qualcomm has turned $37 billion of licensing revenue into $32 billion of pretax profit.
According to the complaint, Qualcomm offered Apple “billions of dollars in conditional rebates” on license fees if it exclusively used Qualcomm baseband processors in the iPhone from 2011 to 2016. The company denies the accusation and said it will fight the FTC’s complaint, which it said is based on flawed legal theory and seeks to advance the interests and bargaining power of mobile-phone manufacturers.
The case isn’t the only one facing the chipmaker’s legal team. Last month, South Korea, home to two of Qualcomm’s largest customers, fined the company 1.03 trillion won ($890 million) and described its practices as monopolistic. Qualcomm has said it will appeal the decision. The chipmaker is also being investigated by the European Union and Taiwanese authorities.
For analysts and investors, regulatory scrutiny raises, again, the possibility that the divisions might be better off apart. Qualcomm rejected calls by activist investors to split the businesses in 2015, but it may need to reconsider a breakup to secure antitrust approval for its pending acquisition of NXP Semiconductor NV, the chip industry’s largest-ever transaction. A breakup could also appease FTC regulators accusing the company of wrongdoing. “Would you force Qualcomm to operate these two businesses more independently now?” said RBC Capital Markets analyst Amit Daryanani. “Given they’ve got the NXP transaction coming up, it might force them to evaluate what they have.”
Jana Partners LLC, which had encouraged Qualcomm’s board to consider a split and other changes after taking a stake in the company, sold its holdings in the first part of 2015, according to a filing last May.

LEGAL SUCCESS
Qualcomm isn’t showing any signs of backing down, and it has honed a formidable legal team through years of patent tussles. The company has fought challenges to patents covering the basics of how modern phone systems work since the 1990s. That Qualcomm has been paid so much money over the years demonstrates just how successful it has been at fending off legal attacks from one-time dominant companies such as Nokia Oyj and Texas Instruments Inc.
When the FTC unveiled its suit Tuesday, the company remained defiant, arguing the rush to file was politically motivated ahead of the incoming administration of President-elect Donald Trump.