While Qualcomm (QCOM) - Get Reportis hardly the only tech company to have significant patent-licensing revenue streams, the company's 3G/4G patent licensing business has long been an outlier. That's true both in terms of its size, and the way it strengthens a large complementary business (mobile processor/modem sales).
The $853 million fine just levied against Qualcomm by South Korea's Fair Trade Commission (KFTC) over its licensing practices is the latest sign this business, though at no risk of going away, is losing its luster. And that, in turn, strengthens the argument for lowering Qualcomm's dependence on licensing revenue via its pending $47 billion deal to buy Dutch chipmaker NXP Semiconductor (NXPI) - Get Report.
The fine comes 13 months after the KFTC first charged Qualcomm, and relates to the links between the company's mobile chip and licensing businesses. The agency, which resides in Samsung (SSNLF) and LG's home country, alleges that Qualcomm refused to give rival chipmakers the same access to its massive patent portfolio that it has given phone makers, and required chipmakers to share business information as part of licensing deals.
It also claims Qualcomm refused to sell chips to phone makers who didn't accept its licensing terms, and also required them to license patents they don't need and to make their own patents available to Qualcomm for free.
Qualcomm has denounced the ruling as "an unprecedented and insupportable decision relating to licensing practices that have been in existence in Korea and worldwide for decades." It insists the KFTC hasn't shown any proof that Qualcomm's practices harm the competition, and promises to appeal.
Qualcomm shares were trading down 1.7% in the early afternoon Wednesday, compared to the Nasdaq's decline of 0.8%.
In 2009, the KFTC fined Qualcomm $226 million for allegedly granting lower royalty rates to phone makers that bought Qualcomm chips; an appeal remains pending. The EU is also probing Qualcomm over such practices, as well as over claims the company engaged in predatory chip pricing to drive Nvidia's(NVDA) - Get Report now-shuttered Icera 4G modem chip unit out of the market.
U.S. and Taiwanese regulators also have probes underway, with the U.S. investigating whether Qualcomm has been honoring its commitment to license patents under fair, reasonable and non-discriminatory (FRAND) terms. And in early 2015, the company settled a Chinese antitrust probe by agreeing to pay a $975 million fine and provide favorable licensing terms to Chinese phone makers.
The revised Chinese terms, together with a soft high-end smartphone market and delays in striking licensing deals with certain Chinese phone makers, led revenue at Qualcomm's licensing division (QTL) to drop 4% in fiscal 2016 (ended in September) to $7.66 billion. Its chip division (QCT), pressured by weak iPhone 6S sales and growing competition, saw revenue fall 10% to $15.4 billion.
And though QCT accounted for nearly two-thirds of Qualcomm's fiscal 2016 revenue, QTL, owing to its high-margin business model, was responsible for 3.6 times as much operating income. This is admittedly a historically high ratio -- it narrowed to 2.3x in the September quarter -- but regardless, QTL has a long track record of producing over half of Qualcomm's profits.
The many regulatory probes Qualcomm is facing over QTL's practices raise the possibility of further restructurings of its deals with phone makers. And the gradual expiration of a number of Qualcomm's 3G patents -- many of them were obtained in the 1990s -- could hurt its negotiating position in such talks.
In addition, the fact that Qualcomm gets a lower royalty rate on sales of 4G-only devices (typically 3.25%) than on sales of multi-mode 3G/4G devices (up to 5%) could become a headwind in the coming years, if major carriers decide 4G coverage has improved enough to sell 4G-only phones to customers. And there's still some uncertainty about the royalty rates Qualcomm will get on 5G-only devices; the company has a substantial 5G patent portfolio, but so do Nokia (NOK) - Get Report, Ericsson (ERIC) - Get Reportand InterDigital (IDCC) - Get Report.
QCT might also be stung by the probes, as they could lead Qualcomm to license more of its intellectual property to rivals and refrain from tying licensing deals to chip sales. The business has already been pressured by several developments, including tough low-end competition from Taiwan's MediaTek, Apple's (AAPL) - Get Report decision to partly rely on Intel(INTC) - Get Report modems in the iPhone 7 after years of solely using Qualcomm's and the use of home-grown app processors and/or modems by the likes of Apple and Samsung.
All of this increases the appeal of buying a well-diversified chipmaker doing over $9 billion in annual sales and providing ample opportunities for cost synergies -- especially when the purchase is being financed in part via offshore cash. Together with Qualcomm's existing efforts to diversify into markets such as automotive chips, RF front-end modules and server CPUs, the NXP deal gives Qualcomm a much better chance to deliver healthy profit growth in the coming years than if the company opted to just keep focusing on its core businesses.