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Morningstar | Qualcomm Remains Shrouded in Uncertainty With Unfavorable Ruling; Negative Moat Trend Validated

On May 22, The Wall Street Journal reported that U.S. District Judge Lucy Koh ruled that Qualcomm unlawfully suppressed competition in the market for smartphone chips (particularly baseband processors) and used its dominant position to extract excessive licensing fees. The antitrust lawsuit was brought against Qualcomm in January 2017 by the U.S. Federal Trade Commission. We note this ruling comes roughly one month after the firm reached a settlement with Apple in a dispute with similar concerns as the U.S. FTC. While Apple was likely forced to settle due to the need for Qualcomm’s 5G technology, Judge Koh directly attacked Qualcomm’s business model by noting the firm has charged unreasonably high royalties for its patents related to 3G/4G and other technologies, consequently hampering rivals. She also challenged the firm’s practice of collecting royalties on the full price of the device.

Remedies include requiring Qualcomm to negotiate or renegotiate license terms with customers, make licenses available to modem-chip suppliers at fair and reasonable prices, no longer enter exclusive agreements to supply chipsets, while submitting to compliance and monitoring procedures to the U.S. FTC for seven years. We fully expect Qualcomm to appeal this ruling and try to get the injunctive remedies put off. We don’t believe Qualcomm’s recent licensing agreement with Apple is at risk, yet. That said, we are lowering our fair value estimate for narrow-moat Qualcomm from $80 to $72 and increasing our uncertainty rating to very high as we believe there is too much up in the air related to this ruling and the ongoing Huawei-related issues.

At this juncture, it is difficult to triangulate how severe the situation is likely to get for Qualcomm’s licensing model. Our bear-case fair value estimate is now $42 per share. In this downside case, Judge Koh’s ruling is upheld, which ultimately results in Qualcomm’s royalties being based on a lesser base, as the firm must license its patents to other chip suppliers. Our bear case also assumes lower chip sales as Qualcomm concedes some market share to these other chip suppliers as competition opens up with the remedies in place.

Apple remains tethered to Qualcomm for 5G modems for the foreseeable future, as we don’t think it will be able to develop its own modem for at least four years (if not longer). We don’t expect this ruling to alter Intel’s decision to exit the 5G modem business, and we don’t anticipate Apple utilizing a modem from another non-Qualcomm supplier (such as Mediatek), particularly as Qualcomm may be in a more vulnerable position such that Apple can obtain better pricing on chipsets.

Additionally, this ruling may reanimate other lawsuits around the world that Qualcomm was able to thwart, and the current U.S.-China tensions may exacerbate a potential scenario in which Chinese OEMs begin withholding royalties (beyond Huawei). All in, we think there are more attractive opportunities within the semiconductor space and would steer investors to wide-moat Intel in lieu of Qualcomm.