Apple's Legal Assault on Qualcomm Is Part of Phone Margin Grab

Apple is piling onto lawsuits that attack the way Qualcomm licenses technology for mobile phones in a widespread effort to rake back profits in a slowing market.

The latest suit by Apple, filed Friday, alleges that Qualcomm has unfairly used the power of its patents, which cover the fundamentals of phone systems, and its chip business to prop up its dominant position in the industry. Apple's legal actions follow regulatory investigations and fines on three continents, including a lawsuit announced last week by the Federal Trade Commission.

"It feels like another coordinated attack on Qualcomm," said Mike Walkley, an analyst at Canaccord Genuity. The mobile phone business is "a mature industry, they've got to get their margins higher."

Underpinning the government actions is a drive to shake loose Qualcomm's grip on the smartphone business. In its last five fiscal years, Qualcomm has turned $37 billion of licensing revenue into $32 billion of pretax profit. Its gross margin, or the percentage of revenue remaining after deducting the cost of production, is 61 percent and is predicted by analysts to widen.

Contrast that with Apple's gross margin of 39 percent in its most recent fiscal year, a number that's predicted to narrow in 2017. Samsung Electronics, the biggest maker of mobile phones ahead of Apple, also had a margin of 39 percent in its most recent fiscal year.

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Apple, Samsung and LG Electronics are part of an increasingly competitive smartphone market in the midst of slowing growth. Handset shipments likely increased 0.6 percent to 1.45 billion units in 2016, according to researcher IDC. As recently as the second quarter of 2015, the market was growing in double-digit percentages.

Samsung and LG are based in South Korea, where antitrust regulators announced in December a record KRW 1.03 trillion ($880 million) fine against Qualcomm for violating antitrust laws and called for the chipmaker to change its business practices.

In China, the biggest mobile phone market, antitrust regulators accused Qualcomm of abusing its dominant position. Rather than risk being locked out, Qualcomm in February 2015 paid $975 million to settle the case and was given the right to charge handset makers licensing fees, at a lower rate, for phones sold in the country.

Apple on Friday added its weight to the growing call for a change in the way licensing revenue is calculated. Now, the handset companies pay Qualcomm a percentage of the total selling price of the phone - a sum measured in hundreds of dollars - regardless of whether they use Qualcomm chips or not. The phone makers, backed by regulators, want a change that would force Qualcomm to charge the fees on the price of its components -- an amount based in the tens of dollars.

Qualcomm said Apple has been "actively encouraging" the government actions by "misrepresenting facts and withholding information" from regulators.

"We welcome the opportunity to have these meritless claims heard in court where we will be entitled to full discovery of Apple's practices," Don Rosenberg, Qualcomm's general counsel, said in a statement.

For Apple investors, any means necessary to bring down the iPhone maker's costs is the right move.

"Strategically if your enemy is somewhat wounded it's not terribly surprising that they'd be that much more aggressive," said Erick Maronak, chief investment officer at Victory Capital Management in Brooklyn, Ohio, which holds Apple stock among its $55 billion under management. "Any time they can reduce costs, whether it be legally, operationally or through new technologies, they've always been happy to pursue those."

Sales of the iPhone fell 8.3 percent to 212 million handsets in the 12 months through September, the first annual decline since the smartphone was introduced in 2007. The average selling price of its iPhones declined from a 2015 peak of $687 to $619 in the most recent fiscal quarter as it has introduced lower-cost handsets to fend off the threat from Chinese competitors such as Huawei, Xiaomi and Oppo.

Qualcomm has been a two-fold threat. Its patent position has taken a chunk of the sale price of each phone and the cash generated from that has helped the chipmaker fund industry leading research and development into better processors.

Apple generally uses two or more suppliers for any given component, creating competition and forcing down prices. But Apple had relied exclusively on Qualcomm's base-band chips - parts that connect the phone to networks - until the introduction of the iPhone 7 last year, when it switched some versions to modems from Intel Corp.

Ultimately a straight-up legal fight will take years to play out, according to Canaccord's Walkley. Apple would much more likely want to settle the case in return for lower rates.

That's a better bet given that the San Diego-based chipmaker has been fighting similar legal battles for more than two decades, and winning.

"This is Apple's posturing to get a lower rate going forward," Walkley said. "Apple is trying to overturn 20 years of history which, if they do, Qualcomm is in real trouble because then everyone else will then want their money back."