Quick Thoughts: QCOM – How Many Shoes are There to Drop?

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November 18, 2015

Quick Thoughts: QCOM – How Many Shoes are There to Drop?

QCOM traded off 9.4% on Wednesday after revealing that the South Korean government had opened an antitrust inquiry into the company’s patent licensing practices in the country. As we have seen with Qualcomm’s protracted negotiations with the Chinese government, even a positive outcome may not entirely immunize the company from hangover effects on its ability to collect against its intellectual property rights. Given that 73% of Qualcomm’s EBT derive from its royalty agreements, investors are obviously squeamish about any issue that might impede its ability to collect, particularly from Korean manufacturers who make up a reasonable share of Qualcomm’s addressable market. While we believe that Qualcomm is very likely to weather this investigation without substantial long term damage to its potential royalty streams, there is likely to be no closure for several years, during which time, investors may continue to seriously discount the company’s value. We expect FY16 to bring positive news for QCOM, with improved royalty flow from China and share gains driven by the Snapdragon 820 SoC. Still, the upside from these catalysts will likely be muted because of this ongoing overhang. Because of this, QCOM at $48 is a trade rather than an investment.

Qualcomm shareholders took another blow on Wednesday, as the company announced that staff members of the Korean Fair Trade Commission (KFTC) had issued a report alleging that Qualcomm had violated the country’s anti-competition laws, and recommending that the full commission impose a fine and require changes to the company’s licensing practices. This is the second time that the KFTC staff has made such allegations, a similar report in 2009 resulted in no actions from the commission, and it is not at all clear the recommended actions in the current case would threaten a significant reduction in the value of Qualcomm’s licensing business. Still, the market was merciless in the 9.4% sell off.

This highlights the risk in Qualcomm. Nearly three quarters of its current profits derive from royalty payments for use of its massive portfolio of patents. The value of this intellectual property has been long established through negotiated agreements with nearly every important vendor of mobile devices, requiring a percentage royalty on the first few hundred dollars of value for the rights to Qualcomm’s entire portfolio, including both standards essential and non-essential, but highly valuable implementation patents. Qualcomm’s initial agreements concerned the CDMA technology that it championed two decades ago, leading many investors to concern that the company’s claim on more modern wireless standards may be less certain, despite massive R&D investments and obvious technical contributions.

The Chinese and Korean antitrust investigations are tests of those claims. Qualcomm settled the Chinese inquiry earlier this year, emerging with a paper victory of a reasonable fine and a national schedule of fair royalty rates within range of the status quo. Unfortunately, the very process of the investigation emboldened numerous Chinese manufacturers to withhold or underreport royalty obligations, weighing heavily on FY15 earnings and placing an onus on Qualcomm to negotiate collection, something that has proven much harder than had been expected.

Like China, Korea is an important market for Qualcomm, with Samsung and LG amongst its biggest global royalty payers. We don’t believe that the Korean manufacturers are likely to withhold payments on contracts already negotiated, but the specter of government intervention with the intention of reducing royalty rates is a serious potential downside. If the KFTC picks up the investigation this time, resolution may take years, during which time investors may choose to discount a very negative outcome, and perhaps, assume a contagion that could spread to other governments. If investors are unwilling to assume significant value for Qualcomm’s patent licensing operations out a decade from now, they will likely remain very cautious about the stock, even at nearly 40% below its 52 week highs.

We believe that Qualcomm shares are worth more than $75, but are fearful that these unanswerable questions about the future value of its IPR will continue to dog it, particularly as the Korean investigation drags on. At $48, we see QCOM as an excellent trade, but perhaps no more than that until the crystal ball gets a lot clearer.

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