In its April 19 earnings report, Qualcomm (QCOM - Get Report) warned that it couldn't say for sure whether Apple's (AAPL - Get Report) iPhone contract manufacturers would keep paying royalties. On Friday, markets learned that worst-case scenario is indeed transpiring. What might not be fully grasped is the degree to which further escalation could occur on both sides.
About three months after Apple sued Qualcomm and made a slew of allegations regarding its licensing practices, and three weeks after Qualcomm countersued Apple and made numerous allegations of its own, Apple has informed the company it's withholding payments to contract manufacturers such as Foxconn and Pegatron that the manufacturers used to pay the per-unit royalties they owe to Qualcomm for manufacturing hardware for Apple that contains Qualcomm's 3G and 4G patents. It adds Apple "has indicated that it will continue this behavior until its dispute with Qualcomm is resolved."
As a result, Qualcomm is cutting the June quarter guidance it issued with its earnings report. It now expects revenue of $4.8 billion to $5.6 billion (down 7% to 21% annually) and adjusted EPS of $0.75 to $0.85 (down 27% to 35%), down from a prior outlook for revenue of $5.3 billion to $6.1 billion and adjusted EPS of $0.90 to $1.15. The initial guidance had only assumed full royalty payment from contract manufacturers at the high end of the guidance ranges, but did assume some lesser level of payment at other points.
Qualcomm opened sharply lower on the news. But with many investors having already feared the worst, shares gradually moved higher and closed up 1%. They're still down 18% on the year, thanks in no small part to legal worries.
Qualcomm mentioned in its earnings release that the contract manufacturers had withheld $1 billion in royalty payments during the March quarter, on account of Apple withholding from them the same amount. But it also pointed out that this figure was only equal to the $1 billion in rebate payments--related to an agreement that expired in 2016--that Qualcomm had withheld from Apple. Apple has accused Qualcomm of withholding these funds due to its cooperation with a South Korean probe of Qualcomm, but an FTC complaint against Qualcomm indicated that the company was making payments in exchange for the exclusive use of Qualcomm modems within iPhones, something that ended last year.
Regardless of the specifics for what happened before, Apple telling its contract manufacturers to stop paying Qualcomm any royalties, and in the absence of any withheld payments from Qualcomm, represents a clear escalation of their dispute. One that could be a sign that Apple is ready to fully sever its business relationship with Qualcomm for the time being, but also pave the way for Qualcomm to more aggressively retaliate.
Since Apple's suit was launched, and to some degree before that, there has been speculation that Apple could rely solely on Intel (INTC - Get Report) for the modems going into the iPhones expected this fall. Unlike the Intel XMM 7360 modem used in some iPhone 7 units, Intel's XMM 7560 modem, expected to enter mass-production in the coming months, supports the cdma2000 3G networks used by Verizon (VZ - Get Report) , Sprint (S - Get Report) and a handful of international carriers. That raises the possibility that Apple won't need Qualcomm to do a global iPhone 8 launch, and given how bitter the companies' legal battle has become, the odds seem to be good that Apple will stop relying on Qualcomm if it can.
On the other hand, if Qualcomm feels it has little to lose financially--either in terms of royalty payments or chip sales--by further escalating its dispute, the company could do a lot more than what it's attempting in its countersuit, which merely seeks monetary damages and for existing agreements to be honored. One potential move, as pointed out by tech analyst Patrick Moorhead, is for Qualcomm to seek injunctions (in the U.S., and perhaps elsewhere) on the importing of iPhones and 3G/4G-capable iPads made by Apple's Asian contract manufacturers.
There is some precedent for such an action: In 2013, Samsung won an ITC import ban on the importing of the iPhone 4 (launched in 2010) and certain iPads, on accounts of their infringement of a mobile data patent. But the Obama administration vetoed the ban a few months later.
There's a good chance that the political fallout of a total iPhone import ban--both due to the number of U.S. workers affected in some way, and the consumer backlash--would prevent such a ban from going into effect. On the other hand, the Qualcomm IP used by iPhones goes well, well beyond one patent, and Qualcomm has some experience of its own with political lobbying. And even a partial ban--for example, on older iPhones, or on 3G/4G iPads--would do real damage, and perhaps motivate Apple to resume payments until its lawsuit, which alleges Qualcomm's royalty rates for both Apple and others are excessive, plays out.
Another possibility: Since the payments being withheld from Qualcomm are technically owed by contract manufacturers that produce 3G/4G devices for both Apple and others, Qualcomm could sue the manufacturers and try to prevent their sales of 3G/4G devices in general. This might require Qualcomm to stop taking payments in general from the manufacturers while its suit unfolds, but it's quite likely that such payments are smaller than the iPhone royalties Qualcomm is losing out on.
Ultimately, Apple's decision not to take a direct patent license from Qualcomm the way that most other big smartphone OEMs have in favor of having its contract manufacturers make payments--this was done to lower Apple's per-unit royalties--could result in a more compromised legal position. Both because the manufacturers have licensing deals that often aren't due to expire for a while, and because they have non-Apple business that could be put at risk during a drawn-out legal battle.
One could argue that it's not in Qualcomm's interests to severely escalate the dispute, since the company presumably wants to remain a long-term supplier to a company that ships over 200 million smartphones per year. But with Apple both challenging the foundations of a licensing business that still accounts for a majority of Qualcomm's profits, and now halting the flow of royalties related to its smartphone sales, it's easy to see the gloves coming off.
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