Today Qualcomm announced that it has settled with the NDRC of China which has ruled that Qualcomm has violated their anti-monopoly law. The settlement had been close for some time, I posted about it two weeks ago, and despite some onerous terms, the stock traded up after-hours as the headlines certainly look similar to what the Street was expecting.
That being said, there is an enormous amount of detail and nuance in this agreement, with some potentially large implications. I have re-read the press release a few times and the accompanying presentation (which is just a power point version of the press release). I could not dial in for the conference call. Maybe someday I will track down the transcript, but life is short.
Overall, I think this is a positive development for Qualcomm, but it leaves a lot of questions unanswered, which makes me think there are still more developments to come. And in anything this complex there are always unforeseen effects.
I think today’s announcement also deserves attention because it sheds a lot of light on Qualcomm’s Technology Licensing (QTL) business which is usually shrouded in secrecy and confidentiality clauses.
First, Qualcomm has effectively admitted to being a monopolist, at least in China. In their slides, they claim this should have no impact on their business outside of China. In effect, Qualcomm has issued a self-criticism, which is an important part of China’s political system. In the US, if you admit to being a monopolist, you end up being burdened with a regulatory regime in perpetuity watching over your shoulders. This is not how it works in China, and if Apple is any example, a self-criticism can open the door to big sales.
Second, they have agreed to change their licensing practices in China. The press release’s coverage of this was so maddeningly obscure that it almost made me want to read the transcript in a false hope that they may have actually clarified this. Basically, they are making it easier to become a Qualcomm licensee in China. This is great news for China’s handset vendors, and seems to make their negotiating position a little bit easier. However, crucially it appears that Qualcomm still maintains the right to audit its licensees compliance with their contracts. This is a major advance for the company, as it has been impossible for them to enforce contracts without these.
A third key point is the headline figure of a reduction in royalty rates. For any device with 3G the rate is 5%, and 4G-only phones the rate is 3.5%. This is one area where you have to pay close attention, because it sounds like almost no change. Qualcomm’s global average royalty rate is something like 4.5%, and they have always said it would go to ~3% for 4G-only devices. So no big change, right? Not quite. To start, the company admits that it will only charge 65% of the full royalty. This is a sizable hit, but roughly in line with what I and the Street was expecting. However, there is one more wrinkle to remember. The headline rate of 5% (minus 35% discount) is actually a big step down. For years, Qualcomm has charged closer to 6% royalties, especially for smaller, newer handset vendors with no IP to cross-license.
Netting all this math out, the royalty rate goes from 6% to 3.25% (65% of 5%), which is a 46% reduction in their rate.
My Qualcomm model is not up to date, but I suspect this will end up being a significant hit to QTL earnings. On the positive side, they should be able to start charging royalties on many more handsets (more on this in a moment) but the rate comes down a lot. Moreover, they acknowledge that they will give added credit for companies with IP to license. This should be read as a direct benefit to Huawei, ZTE and Lenovo (incl. Motorola) – companies with significant IP. They already enjoy discounted royalty rates because of their IP, and reading between the lines, it seems likely that their royalty rate goes down further.
Of course, modeling all this out is going to be very hard, which is my fourth takeaway from today’s news. In their press release, they raised guidance very slightly. Essentially, the removed the legal expense. (To put this context, they raised EPS guidance by $0.10, which implies they were preparing to spend $160 million on legal fees in the next nine months!)
The main point is that revenue outlook is unchanged. And they say that it will take some time to update this because every customer in China now gets a chance to renegotiate their contract. The end result of all this is that no one will be able to model Qualcomm clearly for another year or so, until everything gets tied down.
I am going to make a prediction. At some point this calendar year, Qualcomm is going to change the timing of when they recognize QTL revenue. Currently, they recognize it one quarter in arrears, meaning that licensing revenue generated in the March quarter is not recognized until the June quarter. Over its history, Qualcomm has periodically changed this to report QTL revenue in the quarter they are generated. Every few years, the company switches from one to the other. This has made it impossible to fully gauge the impact of any big change in licensing, too many variables in the equation. They switched it when they shifted from largely CDMA licensing to largely WCDMA licensing. And I think they will switch again. I am not saying the company is gaming the system, these changes happen and QTL is hard to fully understand.
A fifth revelation is that Qualcomm will be able to charge royalties on ‘TDD’ phones. This matters as China claims ownership of most TDD related patents. So this is a major positive for Qualcomm.
One of the most interesting terms of the agreement center on how Qualcomm will improve its licensing practices in China. Case in point, under the new agreement, when they negotiate with companies in China, they will “provide patent lists during the negotiation process.” Let that sink in. It implies that in the past, they made companies sign patent licenses without specifying the patents.
Several years ago, I had the chance to read one of Qualcomm’s licensing agreements with a China handset vendor. It was a stunning document, with terms that would clearly be hard for that company to stomach. So while I was surprised that they did not include patent lists previously, I was not that surprised.
All in all, I think this opens a lot of doors for Qualcomm in China. There will be a near-term hit to earnings. But by removing some of the more onerous practices, this agreement may make it much easier for Qualcomm to business in China, opening new doors.