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Qualcomm Loses Antitrust Case: Is the Dividend Safe?

Shares of Qualcomm (QCOM) fell as low as $49 earlier this year as investors fretted over the significant legal risks the company's core licensing business faced. Simply put, the firm was accused by Apple and others of abusing its monopolistic position in wireless chips and charging excessive royalty rates.

Investors received good news in April when Apple agreed to drop all litigation against the company and signed a new licensing agreement, sending Qualcomm's stock surging more than 20%.

Qualcomm shares topped out at $89 in earlier this month (up more than 80% since February) but have since come crashing down.

The stock's initial tumble began in earnest on Monday following the White House's decision to ban U.S. companies from selling to Chinese telecom giant Huawei unless they receive government approval.

The order was driven by security concerns since Huawei is believed to have close ties to the Chinese government, and it's a clear escalation of the existing trade war between America and China.

Huawei is the second largest seller of cellphones in the world and generates over $100 billion in annual revenue, according to The Washington Post. Qualcomm said it would not supply parts to Huawei "till further notice."

It's unclear exactly how large of a customer Huawei is, but in its last quarterly earnings filing, Qualcomm noted it recorded $150 million of royalties "due under an interim agreement with Huawei" which represents "a minimum, non-refundable amount of royalties due for the second quarter of fiscal 2019 by Huawei while negotiations continue."

That payment accounted for 3% of company-wide revenue last quarter and 13.4% of sales recorded in Qualcomm's licensing segment. Royalty payments carry much higher margins, so it's quite possible Huawei historically generated over 10% of Qualcomm's annual profits.

Therefore, a drawn out battle with Huawei has good potential to weigh on Qualcomm's short-term results. However, this issue seems likely to eventually be resolved without affecting Qualcomm's long-term earning power.

Qualcomm's week got a lot worse late Tuesday evening, when a federal judge ruled in favor of the Federal Trade Commission's antitrust case against the company. Shares plunged over 10% in premarket trading this morning, reaching as low as $68 (down over 20% since May 3).

We warned about this risk following Qualcomm's price surge in April:

From a dividend safety perspective, Qualcomm's outlook has improved with business set to ramp back up with Apple, its largest customer. As we previously discussed, Qualcomm's dividend should once again soon be more than covered by the firm's free cash flow generation.

Meanwhile, the one-time payment from Apple to Qualcomm will ensure that the company has plenty of cash to maintain a very strong balance sheet and continue its share repurchase program. 

However, the FTC's antitrust case is a lingering concern. While the deal with Apple and Intel's withdrawal from smartphone modem chips suggest a potentially favorable outcome, Qualcomm could still be forced to pay a multi-billion dollar settlement or change its licensing practices...

For these reasons, along with our conservative approach to income investing, Qualcomm retains a "Borderline Safe" Dividend Safety Score for now, but its outlook has improved following the Apple deal. 

Foss Patents provided an excellent summary of the judgement delivered last night. The following remedies were ordered by the judge:

(1) Qualcomm must not condition the supply of modem chips on a customer’s patent license status and Qualcomm must negotiate or renegotiate license terms with customers in good faith under conditions free from the threat of lack of access to or discriminatory provision of modem chip supply or associated technical support or access to software.

(2) Qualcomm must make exhaustive SEP licenses available to modem-chip suppliers on fair, reasonable, and non-discriminatory ("FRAND") terms and to submit, as necessary, to arbitral or judicial dispute resolution to determine such terms.

(3) Qualcomm may not enter express or de facto exclusive dealing agreements for the supply of modem chips.

(4) Qualcomm may not interfere with the ability of any customer to communicate with a government agency about a potential law enforcement or regulatory matter.

(5) In order to ensure Qualcomm's compliance with the above remedies, the Court orders Qualcomm to submit to compliance and monitoring procedures for a period of seven (7) years. Specifically, Qualcomm shall report to the FTC on an annual basis Qualcomm’s compliance with the above remedies ordered by the Court.

Essentially, as the judge stated in her findings, "Qualcomm's royalty rates are unreasonably high" and its "licensing practices have strangled competition in the CDMA and premium LTE modem chip markets for years, and harmed rivals, OEMs, and end consumers in the process." Change is demanded on both fronts.

Qualcomm will undoubtedly appeal this ruling, though Foss Patents believes that "with such a rich and powerful body of evidence, it's going to be hard for Qualcomm to persuade the appeals court (the Ninth Circuit) that the facts are favorable to its defenses."

No matter how you look at it, this news is a big blow to a core part of Qualcomm's business. Prior to the royalty dispute with Apple, the firm's Qualcomm Technology Licensing (QTL) segment generated 75% of company-wide operating profits in 2016.

QTL's operating income shrunk from $6.5 billion in 2016 to $3.5 billion in 2018, due mostly to withheld royalty payments from Apple, but even still it accounted for just over half of the firm's total profits last year. 

Should Qualcomm lose its likely appeal, what will happen to the earning power of this business? How excessive are its current royalty rates? What impact will licensing some of its patents to rival chip makers have? Without being able to sign exclusive supply deals, how much more competition will the firm face?

Answering these questions is very difficult due to the wide range of potential outcomes Qualcomm faces. Making matters worse, The Wall Street Journal also notes that Qualcomm "faces a class-action lawsuit from consumers asserting similar antitrust claims and seeking billions in damages."

What could this all mean for Qualcomm's dividend? The good news is that the company continues to maintain an excellent balance sheet. 

Qualcomm holds $10.3 billion in cash and marketable securities, maintains a modest amount of debt (about $16.4 billion), and earns an A- credit rating from Standard & Poor's. The firm is also set to receive a one-time payment from Apple of around $4.6 billion sometime this quarter.

The harder part of the equation is forecasting Qualcomm's ongoing cash flow if it appeals the ruling and loses. If licensing profits fall far enough after renegotiating its royalty rates and making life easier for its rivals, then the current dividend could need to be rightsized. 

For context, Qualcomm's current dividend consumes about $3 billion per year. 

Qualcomm's CDMA Technologies (QCT) segment, which develops and sells chips for smartphones, generated average annual pretax operating profits of $2.5 billion over the last three years and is on pace to produce profits of around $2.2 billion this year.

In other words, the firm's more stable business segment following this antitrust ruling is not enough to cover the dividend on its own. The licensing business (QTL) is very important.

As previously mentioned, QTL's pretax operating income shrunk from $6.5 billion in 2016 to $3.5 billion in 2018 due largely to Apple withholding royalty payments.

Profits in this segment will rise this year with Apple back on board. Let's assume the licensing business eventually gets back to $6 billion in annual operating profit. If Qualcomm appeals and loses, and its licensing business gets cut in half, then the firm would have around $3 billion of profits from this segment going forward.

Combined with $2.5 billion in operating profits from QTC, Qualcomm's core businesses would potentially generate about $5.5 billion in pretax income. 

However, the firm also currently has around $2 billion in annual unallocated costs (R&D, interest expense, etc.) which would reduce its operating income to $3.5 billion. Taxes would shave a little more off, too.

In other words, in such a scenario there would be little room to cover Qualcomm's $3 billion dividend commitment, especially while leaving enough room for the firm to continue investing in its business for the future. 

How likely is that scenario? It's hard to say. Probably still unlikely, but it would now seem to be within the realm of possibilities following last night's ruling. 

Until more is known about Qualcomm's likely efforts to appeal the ruling, plus how severely a final adverse ruling would really hurt the firm's licensing business, Qualcomm retains its Borderline Safe Dividend Safety Score.

We will continue monitoring the situation, which seems likely to take many months to resolve. As outlined in past notes (see below), our personal preference remains to avoid companies that face challenges to their business models. Investors holding shares of Qualcomm should be comfortable with these uncertainties and size their positions accordingly.

Given the binary nature and unpredictability of trial outcomes, including the possibility of a settlement with U.S. regulators, Qualcomm's increasingly wide range of potential outcomes seems to make the stock a less ideal option for conservative income investors whose top priority is a safe dividend in all environments (and legal outcomes)...

As long as the worst-case scenario doesn't actually occur, the company's intellectual property, including a strong position in 5G wireless technology, means income investors will likely continue enjoying a safe and growing dividend going forward. However, as conservative investors our preference is to invest in simpler businesses whose futures don't hinge on low-probability, high-severity events.

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