Qualcomm: The Patent Empire Strikes Back (Building Leverage Against Apple)

Summary

• The battle between Qualcomm and Apple has turned into a high stakes chess match where each new week brings more news as each company lashes out at the other.
• The company filed a complaint with the U.S. ITC alleging that Apple engaged in the unlawful importation/sale of iPhones that infringe one or more claims of its six patents.
• The company alleges that each of the six patents at issue enables high performance in a smartphone while also extending battery life.
• The company notes that the technology of the patents at issue are central to the iPhone, but are not essential to practice mobile device standards/subject to a licensing commitment.
• The company’s infringement action against Apple is a strong positive and will be used as a bargaining chip to mitigate damage to its patent licensing stream in likely settlement talks.

The battle between Qualcomm (NASDAQ:NASDAQ:QCOM) and Apple (NASDAQ:NASDAQ:AAPL) has turned into a high stakes chess match where every new week brings more news as each company lashes out at the other in defense of or against QCOM's ubiquitous patent licensing strategy. QCOM's latest move, the initiation of a patent litigation against AAPL (to be discussed below), turns out to be a shrewd move on its part. When companies such as QCOM and AAPL fight to defend their most important business that is critical to their success (patent licensing royalties and iPhone revenues/profits respectively), each party makes chess-like moves to gain leverage over the opposing party. Think of it this way if a company was lashing out at your profit stream which accounts for about 80 percent of total profits, what would you do? Well, if you were QCOM you would strike back just as hard at the opposing company by targeting its dominant revenue/profit stream (which is AAPL's iPhone business). Over the past week. QCOM announced that it had filed a complaint with the U.S. International Trade Commission ("U.S. ITC") alleging that AAPL engaged in the unlawful importation/sale of iPhones that infringe one or more claims of six QCOM patents covering key technologies that enable features/functions in iPhones.

QCOM is requesting that the U.S. ITC institute an investigation into AAPL's infringing imports and ultimately issue a Limited Exclusion Order ("LEO") to bar importation of those iPhones and other products into the U.S. to stop AAPL's unlawful and unfair use of QCOM's technology. The company is seeking the LEO against iPhones that use cellular baseband processors other than those supplied by QCOM's affiliates. Additionally, QCOM is seeking a Cease and Desist Order barring further sales of infringing AAPL products that have already been imported and to halt the marketing, advertising, demonstration, warehousing of inventory for distribution and use of those imported products in the U.S. Upon the filing of such action, QCOM noted that its inventions "are at the heart of every iPhone and extend well beyond modem technologies or cellular standards." In particular, the company noted that the patents at issue represented "six important technologies, out of a portfolio of thousands, and each is vital to iPhone functions. AAPL continues to use QCOM's technology while refusing to pay for it. "Each of the six patents at issue enables high performance in a smartphone while also extending battery life. QCOM seeks damages/injunctive relief and it expects that the U.S. ITC investigation will begin in August 2017 and will be tried within a year.

According to QCOM, while the technologies of the patents at issue are central to the iPhone's performance, such patents are not essential to practice any mobile device standards or subject to a commitment to offer a license. The company notes further that iPhones not only use technologies covered by the patents at issue, but also thousands of additional QCOM patented technologies covering media streaming, social media interaction and basic communications. The technologies of the patents at issue are: 1) U.S. Pat. 8,698,558 - which extends battery life by building intelligence into the system so the antenna always uses the right amount of battery power to transmit; 2) U.S. Pat. 8,633,936 - which enables high performance and visual graphics for games while increasing battery life; 3) U.S Pat. 9,608,675 - which enables a mobile device to send high speed data from a phone by combining many lanes of traffic while prolonging battery life; 4) U.S. Pat. 8,838,949 - which enables a "flashless boot" which allows a smart phone to connect to the Internet quickly after being powered on; 5) U.S. Pat. 9,535,490 - which enables the smartphone applications to get their data to/from the Internet quickly/efficiently by acting as a smart "traffic cop"; and 6) U.S. Pat. 8,487,658 - maximizes smart phone performance while extending battery life by connecting high/low voltage circuits with efficient interfaces.

QCOM's U.S. ITC action should be one that is seen as a strong positive for QCOM investors. As noted above, we see such action as one designed to increase the company's leverage in likely settlement talks down the road. With AAPL attacking QCOM's main profit center (patent licensing royalties) and QCOM attacking AAPL's main profit center (iPhone profits), both parties will have a clear motivation to bargain for what they really want while also mitigating any losses to their profit centers. QCOM is using its patent arsenal against AAPL to minimize the damage to its patent licensing royalty stream while AAPL is employing U.S. laws to drive down its iPhone costs by reducing its licensing payments to QCOM. Do not be surprised then if news emerges within the next year or two that QCOM and AAPL settled their litigation and each party comes out a "winner" by AAPL reducing patent licensing costs while QCOM preserves much of but not all of its patent licensing stream. With our theory behind QCOM's recently instituted action in mind, the company continues to push forward for global government approvals of its acquisition of NXP Semiconductors (NASDAQ:NXPI). We continue to believe that the NXPI acquisition is critical to the future success of QCOM given the substantial global attacks on QCOM's licensing based profit model, which accounts for 80 percent of its profit.

QCOM's earnings estimates for 2017-18 have fallen significantly in recent months as AAPL has pushed its suppliers to stop paying QCOM royalties. To us, a steep fall in earnings estimates is a sign that the company is unlikely to overcome the various attacks on its wireless modem patent licensing model without substantive adverse results. Not only is QCOM facing European Union antitrust related pressures relating to the NXPI acquisition, but it is being pressured by: 1) slowing smartphone demand and 2) patent-licensing-related litigation instituted by U.S. FTC and AAPL (as noted above). Further, the company lost a motion to dismiss the U.S. FTC's antitrust case against it. (Commentators argue that QCOM's alleged anticompetitive behavior, if not controlled or punished, could have significant effects on the entire standards-setting system. For consumers, such commentators note that the company's unchecked behavior would mean higher prices and a proliferation of incompatible devices.) Although many investors have argued that QCOM has faced and withstood these attacks previously, we believe that this time such attacks may cause more damage than in the past. In our mind, however, QCOM's U.S. ITC action offers downside protection and insurance against overwhelming damage to its patent licensing royalty model.

We have noted that handheld wireless devices have become more common, and, therefore, such devices are becoming commoditized. Commoditized products tend to compete on pricing advantages rather than patent-protected technological advantages. When a product becomes commoditized, the manufacturers of such product are less able to charge premiums for technology-based advantages and are then forced to compete on a pricing basis. As wireless devices become commoditized, manufacturers of such devices search for cost reduction opportunities to decrease costs and increase profits. With this in mind, QCOM's patent licensing fees have become an obvious target for wireless device makers. As such, QCOM's U.S. ITC action is a clear attempt to protect/maximize its main profit center for as long as possible as it transforms. Attacks on the company's licensing model (and its overall profitability) ensure the importance of the EU antitrust regulator's approval of the NXPI acquisition. (Note that EU antitrust authorities have paused consideration of NXPI acquisition after the companies failed to comply with an information request.) The NXPI acquisition is a strategic positive as it allows QCOM to drive revenue/earnings growth through diversification of its product offerings and reduces/mitigates its dependence on its current royalty-based business model.

Our View

We see the QCOM instituted U.S. ITC patent infringement action against AAPL as a strong positive for QCOM. While we cannot discern the strength of QCOM's action given its technological complexity and our time limits (despite our background in patent litigation), we clearly see such action as a bargaining chip to mitigate the damage to its patent licensing stream resulting from AAPL's own litigation against it. As noted above, do not be surprised if both companies arrive at a settlement agreement in the next year or two resolving all litigation against each other in a way that benefits each party (and its investors). In other words, AAPL will benefit by obtaining reduced royalties being paid to QCOM and QCOM will benefit by minimizing the damages to its patent licensing stream to buy it time to transform through its NXPI acquisition (if it closes). As such, we are considering of a small investment in QCOM's shares if they remain in the $50 to $55 range in the near term (Note, we have used a QCOM insider's near million-dollar purchase at about $53 a share earlier in 2017 as a reference point as to when such shares begin to represent value). QCOM's shares will remain under pressure until it resolves its licensing disputes along with its attempts to close its NXPI acquisition.

The closure of the NXPI acquisition is critical to QCOM since such acquisition will allow QCOM to overcome slowing growth in the mobile market where products are being commoditized and volume growth is moderating. Such acquisition also allows QCOM: 1) to become a more diverse company that has the potential to participate in new markets and drive revenue/earnings growth; and 2) to target the IoT market, i.e., the addition of connections and computing power to products such as home appliances, vehicles and industrial equipment. Automotive and industrial IoT applications are a more profitable market for semiconductors and allow QCOM to transform toward such higher growth areas of automotive, IoT, security and networking. If the company can close the NXPI acquisition, it would establish its global leadership in integrated semiconductor solutions, expand its footprint across key growth market opportunities such as automotive, IoT, security and networking. The acquisition also would allow QCOM to expand into new industries and decrease its dependence on the slow growth smartphone market.

QCOM's forward price-to-earnings ratio is about 13.00 based on fiscal 2017 earnings estimates of $4.25, and about 14.20 based on fiscal 2018 earnings estimates of $3.89. Estimates for each year have fallen significantly in recent months. Near term, as the EU investigation of the NXPI acquisition continues and QCOM's regulatory/litigation disputes continue, investors are likely to have another chance to purchase QCOM's shares at a lower price. As noted above as well, we see QCOM's counter-striking U.S. ITC action against AAPL as a mitigating force in regard to QCOM's patent licensing strategy. Investors who understand the importance of the company's most recent action against AAPL will benefit from an investment in QCOM's shares. Over the long term, investors will benefit from share price appreciation, dividend increases, share buybacks and the transformative benefits from the company's NXPI acquisition (if it closes). Despite near-term adversities and uncertainties arising from the ongoing litigation and the pending NXPI acquisition, we believe that such adversities/uncertainties will fade in the long-term as QCOM benefits from its transformational NXPI acquisition towards growth market opportunities such as automotive, IoT, security and networking.

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Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.