Apple is likely to lose its royalty feud with Qualcomm

Qualcomm has been forced to adjust its guidance for the coming quarter after being informed by Apple that it would not be receiving any royalties for the foreseeable future.

According to Qualcomm (as Apple has made no statement), Apple has ceased payment as it finds the contract terms unacceptable, even though it does acknowledge that some payment is warranted.

Qualcomm’s new FQ3 16 guidance is for revenues / EPS that will be $500 million to $800 million (midpoint $650 million) and $0.15 – $0.30 lower than the guidance given at the recent FQ2 16 results.

Although the issues that Apple has with Qualcomm’s business model are very similar, if not the same as the issues that Nokia had back in 2006, the circumstances are completely different.

First: Contract validity. The dispute that arose between Nokia and Qualcomm in 2006 occurred because Nokia’s contract had come to an end and the companies were unable to reach agreement on terms for the renewal. Nokia stopped paying Qualcomm as it had no idea how much to pay, and instead accrued an estimate of the cost in its balance sheet.

The contracts upon which Apple has ceased payments have not expired and I can’t see any real contractual grounds upon which to cease making payments. As a result, I do not think that it will not be difficult to show to a court that Apple is acting in bad faith and to win an enforcement order.

Second: Third party suppliers. Apple does not pay Qualcomm directly – the payment is made by its manufacturing partners who make its products. This means that Apple is getting involved in contracts that are in place between entities that have nothing to do with Apple other than it is the end buyer. I do not think it will be difficult to argue that Apple has no real grounds to be involved in these contracts and is acting in bad faith.

Apple’s intentions are clear in that wants a lower rate from Qualcomm and, unlike Nokia, is not prepared to wait until current contracts expire before launching its proxy war via its suppliers.

Apple’s royalties are calculated on the wholesale price of the device, which in this case will be the price at which the supplier sells the finished device to Apple. I calculate that the supplier is paying Qualcomm 2.8% of the price of the device from making the following assumptions:

• Qualcomm’s FQ3 17 royalty revenues from Apple would have been from calendar Q1 17 as royalties tend to be paid one quarter in arrears
• Apple shipped 52 million units in calendar Q1 with an ASP of $650, giving iPhone revenues of $33.8 billion, upon which it made gross margins of 45%. This means that suppliers sold the devices to Apple with an ASP of $448 for a total revenue of $23.3 billion.

There are a number of caveats to these assumptions:

1. Price cap: There is a price cap above which no royalties are paid. This cap was originally meant for products like laptops with modems, but premium smartphones are now so expensive that they often hit this cap. I have estimated that this cap is somewhere around $500, but if it is as low as $400, then the rate I calculate paid by Apple goes up to 3.1%.
2. Pay up front: There is a pay-up-front option (which Nokia took advantage of) which allows the vendor to pay a lower rate going forward. It is not clear whether contracts with the iPhone suppliers have made use of this option or not.

The net result is that I calculate that Apple is paying somewhere around 3% to Qualcomm which I think is at least on par with many other vendors.

The problem with patents as there is no real way to determine what should be paid to for them. I have long believed that patents are worth either (1) what an entity is prepared to pay for them, or (2) the present value of the cash flows that the patent generates.

This is why historical precedent is so important when it comes to patent licensing, and here Qualcomm has a huge advantage. Qualcomm has hundreds of agreements and more than 20 years of history as evidence that its agreements have not damaged the mobile industry, in fact, quite the reverse.

Furthermore, Apple’s intransigence on this issue and ceasing payments that it has already agreed to in writing, plays enormously to Qualcomm’s advantage. Courts look poorly upon a refusal negotiate and acting in bad faith, and Apple has done more harm than good to its case here.

Hence, I think Qualcomm’s chances of prevailing against Apple are better than they were against Nokia, which is all the more reason why it should fight tooth and nail to preserve its business model.

This article was first published on RadioFreeMobile