Qualcomm, the largest player in the cellphone chip market, makes most of its money selling cellular modems and other components. But the company's biggest profits come from its patent licensing business. Phone manufacturers pay Qualcomm for access to its patents, which it claims covers all the fundamentals of modern cellular communications. Royalty fees depend on an end product's final sale price.
Both customers and international regulators in recent years have accused Qualcomm of unfair licensing practices, adding to the upheaval in its most profitable business. Qualcomm has never had to overhaul its business model despite a spate of legal challenges. One of its biggest triumphs came when Qualcomm resolved its legal battle with Apple, which has started paying royalties after a prolonged boycott.
But the company suffered a major setback last week that could force it to adjust its patent licensing practices. United States District Judge Lucy Koh said that the company had illegally limited competition in the modem market, siding with the Federal Trade Commission in its antitrust case against Qualcomm. She ruled that Qualcomm had leveraged its leadership to extract excessive royalties from phone makers.
She wrote in a 233-page ruling that the company’s licensing practices “strangled competition” in the $20 billion baseband modem market. She said that Qualcomm had to change how its business operates. It also needs to renegotiate its existing licensing deals at more reasonable rates. Qualcomm, which holds over 40% market share, must also submit to monitoring for seven years to make sure it follows the rules.
The decision also directs the San Diego, California-based company to start licensing its industry-standard patents to other chip suppliers, which it previously refused to do. Judge Koh argued that hoarding those patents made it much more difficult for other vendors to challenge Qualcomm’s dominance. The verdict also forbids Qualcomm from entering exclusive licensing deals with its customers to shut out rivals.
Confronting a slowdown in the smartphone market—global shipments slumped 4 percent in the first quarter of 2019, according to Strategy Analytics—Qualcomm said it would attempt to delay the order and appeal the decision. "We strongly disagree with the judge’s conclusions, her interpretation of the facts and her application of the law,” Don Rosenberg, general counsel at Qualcomm, said in a statement last week.
The decision came more than two years after the Federal Trade Commission accused Qualcomm of holding a monopoly in modem chips. The agency alleged that Qualcomm supplies its modem chips only to phone manufacturers that agree to its disporportionately high royalty rates. Withholding its supply of modem chips, software and technical support makes it easier for Qualcomm to exact more favorable terms.
This requirement reduces competition and reinforces Qualcomm's monopoly power, the FTC said. Qualcomm has long been the leader in the market for modem chips, which are used to connect smartphones to wireless networks. Many of the largest phone manufacturers can't afford to lose access to Qualcomm's chips, so they agree to pay steeper prices than the patents themselves are worth, the FTC said.
This "no license, no chips" policy was at the center of the FTC's case against Qualcomm. The practice is considered a form of double-dipping, with Qualcomm charging for the same intellectual property in its patent licensing fees and in the selling price of its silicon. The FTC also argued that the the practice pushed phone manufacturers to pay Qualcomm unfairly high licensing rates for using rival modem chips.
Qualcomm has amassed a sweeping portfolio of patents central to 3G, 4G and 5G communications. Many of these technologies are part of industry standards, which is why they are referred to as standard essential patents (SEPs). As a result, phone manufacturers have to pay Qualcomm fees whether or not they're using its chips. That makes cellular modems sold by rivals much less attractive, according to the FTC.
Steve Mollenkopf, the chief executive of Qualcomm, has long argued that its patents are vital to making modern smartphones work. That's why it demands Apple and others pay royalties based on the selling price of an end product, not the modem chip inside. But some customers have complained that the device-level licensing allow it to profit off software, hardware and other technologies not covered by its patents.
The San Diego, California-based chip supplier said in 2017 that the allegations were grounded in "a flawed legal theory, a lack of economic support and significant misconceptions about the mobile technology industry." The $83-billion behemoth stressed in the same statement that it had "never withheld or threatened to withhold chip supply in order to obtain agreement to unfair or unreasonable licensing terms."
The legal dispute played out inside a San Jose, California, courtroom in January. Competition in the modem chip market is still cutthroat, Qualcomm argued. adding that its overall market share has slipped in recent years. Customers—including Apple, Samsung and Huawei—implement its modems because they're the best, the company argued. They transfer data faster and consuming less power than rival modems.
Judge Koh said lots of companies have pulled out of the modem chip market because Qualcomm made it too hard to win customers. The companies left have been harmed by Qualcomm's pricing practices, she said. Intel, which called out Qualcomm last year for weaving a "web of abusive patent and commercial practices," recently halted its 5G modem development. The company could not see a path to profitability.
The decision has the potential to drive up demand for modems sold by Samsung, Mediatek and other chip suppliers. Bruce Hoffman, who leads the FTC's competition department, said in a statement last week that it's "is an important win for competition in a key segment of the economy." He added that the FTC would "remain vigilant in pursuing unilateral conduct by technology firms that harms the competitive process."
The verdict poses the latest threat to Qualcomm's business model. Qualcomm, the No.6 player in the global semiconductor industry, has clashed with antitrust authorities around the world. China ordered Qualcomm to pay $975 million in penalties in 2015, while South Korea slapped it with $850 million of fines in 2016. The European Union charged it $1.2 billion in 2018 for arranging an illegal chip supply deal with Apple.
Qualcomm has weathered other thorny legal threats. The company's accord with Apple ended a bitter legal battle over the semiconductor supplier's patent fees. As part of the deal, Apple plans to pay Qualcomm $4.5 billion to $4.7 billion for unpaid fees and other costs related to the legal hostilities, which resulted in Apple purging Qualcomm's 4G modem chips from the iPhone last year and replacing them with Intel's.
Qualcomm also agreed as part of the deal to supply modems to Apple, which could be used in future iPhones. The company's 5G modems are considered the most advanced in the world, which may have pushed Apple to make peace with Qualcomm, previously its primary modem chip supplier. Apple also agreed to a six-year licensing deal that analysts estimate will pay Qualcomm between $7 and $9 per device.
Whether Judge Koh's verdict will invalidate Qualcomm's settlement with Apple remains unclear. Qualcomm's shares had soared around 50 percent since the deal with Apple was announced last month. With the legal conflict closed, the company projects its profits to swell by $2 per share as shipments of Apple's iPhone and other devices increase. Its share price plunged 10 percent after the decision last week.
"To permit Qualcomm to continue to charge unreasonably high royalty rates would perpetuate its artificial surcharge on rival chips, which harms rivals, OEMs, and consumers," Judge Koh wrote. "There is sufficient likelihood that Qualcomm will hold monopoly power in the 5G modem chip market such that exclusive dealing agreements for the supply of modem chips could foreclose competition in that emerging market."
Qualcomm has started to loosen its patent licensing terms in an apparent attempt to prevent more legal conflicts. Last year, the company lowered the cap on patent royalties it charges phone manufacturers. Qualcomm set the selling price of a smartphone for the purpose of calculating its cut at $400, even if the device sold for double that. The company also agreed to prune its licensing fees for 5G technology.
If the verdict stands, Qualcomm may be forced to fundamentally change how it calculates it royalties. Licensing its industry-essential patents to rivals means Qualcomm may have to move from device-level to chip-level licensing rates, That could severely cut into its profits. The company funnels most of these profits into its research and development efforts, which has helped bolster its early lead in 5G cellular chips.
How much money Qualcomm could lose over the long run is still unclear. The company's licensing business reported $1.1 billion of revenue in the second quarter of 2019, down 8% over the last year and up 10% compared to the first quarter. Second-quarter operating profit came to $674 million. Qualcomm expects to earn $1.275 billion in patent royalties in the current quarter, down 11% from the year-ago quarter.
The decision could also face scrutiny from the Trump administration, which has long regarded Qualcomm as important to competing with China for dominance in 5G technology. Last year, the administration blocked Broadcom’s proposed buyout of Qualcomm, pointing to the potential damage to American 5G leadership. 5G networks are projected to be at least 10 times faster than current 4G LTE, industry analysts say.
The Justice Department has also waded into the legal conflict, calling for the court not to impose penalties that could adversely affect the market for 5G. Around 1.395 billion phones are set to be shipped in 2019, with 5G unit shipments projected to be around 0.5% of the total, according to market researcher IDC. By 2023, 5G smartphones will represent 26 percent of all shipments in the 1.542-billion-unit market.