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The value of cellular communications starts at $400 per unit

What a tangled web we weave

Apple’s 2QF17 earnings, just out, are an illustration of the company’s faltering grip on the mobile phone business. At this point, more than 80% of its profit comes from a single product, the iPhone. And in the context of that precarious reliance, I got to thinking further about Apple’s suit against Qualcomm. Increasingly, that legal action looks to me like a play to lower costs (royalty payments) in the face of slowing revenue growth. The company can still squeak out a few more quarters of earnings increases if it hammers suppliers on costs, even if revenue growth stalls and Apple can’t find a new large product-market to take up where the iPhone left off.

In its counterclaim, Qualcomm denies most of Apple’s allegations, asserting that Apple’s contentions are baseless. The bulk of the document involves “factual allegations,” detailed points that, if proven true to a jury’s satisfaction, would persuade them to find in Qualcomm’s favor.

To set some background, the reader is surely aware that Apple has been highly successful in the mobile handset business. From the introduction of the iPhone in 2007 until today, year in and year out, Apple has garnered the lion’s share of profit in the smartphone industry, sometimes north of 90%, its take dwarfing all competitors as well as suppliers like Qualcomm. And yet, the value of Apple’s iPhone has depended heavily on Qualcomm’s intellectual property. In a previously published article, I noted that the differential in price between an iPod Touch and an iPhone — essentially an iPod Touch with a cellular connection — is at least $350 (it’s up to $400 now), value Apple derives from Qualcomm’s intellectual property (see graphic at top).

At the heart of Apple’s wide ranging complaint against Qualcomm is the contention that Qualcomm is making too much money on its intellectual property licensing. But because Apple’s case is weak (given that it makes much more money on that same intellectual property than Qualcomm does), it has resorted to a multi-front campaign of legal attrition hoping to wear out Qualcomm and bring it to the table to renegotiate on terms more beneficial to Apple. In addition to filing suits in the United States, Japan, and China, Apple has promoted legal actions by public authorities in South Korea and the United States. Apple is using its muscle to squeeze a supplier, a standard feature in Apple’s playbook (to wit: the treatment of Imagination and Dialog). You don’t get to be the most profitable company in the world through mindless generosity.

Nominally, behind all the claims and counterclaims is about $1 billion that the companies are tussling over. Apple calls the amount is a “rebate” due from Qualcomm. Actually, even though the named sum is $1 billion, the long-term battle is over much more than that. Qualcomm’s recent earnings revision indicates that the value of Apple’s royalty payments to Qualcomm are $500 million per quarter. A billion here, a billion there, Apple is after bigger fish.

Qualcomm contends that the amount Apple thinks it is owed was supposed to be payment under terms governed by a “cooperation agreement” both parties signed in 2013, that Apple is in breach of this contract, and that Qualcomm no longer owes this payment.

Qualcomm is also saying that Apple has made material false statements in various contexts, and that these misrepresentations have harmed both Qualcomm and consumers. High on the list is an allegation made to the Korea Fair Trade Commission that Qualcomm has never offered Apple reasonable access to its patents, characterizing Qualcomm as some kind of patent zombie, all this at a moment in time when the KFTC was considering action against Qualcomm. In other words, Apple was putting a thumb on the scale in Korea. This kind of behavior — called “incitement” — is explicitly forbidden by the cooperation agreement. By inciting, Apple has breached the contract and, Qualcomm says, is no longer owed the payment.

Also, Apple has interfered with third parties, in this case the contract manufacturers that make iPhones. If Qualcomm is actually holding back $1 billion in payments potentially owed to Apple, then Apple is able to get back at Qualcomm by causing the contract manufacturers to withhold their payments to Qualcomm. Qualcomm has done business with the four contract manufacturers that make iPhones (Foxconn, Pegatron, Wistron, and Compal) since before the iPhone was introduced, and these companies have for the most part paid their licensing royalties in full. Despite Qualcomm’s having offered Apple a direct patent license at various points, Apple has continued to procure iPhones from contract manufacturers that maintained the licensing arrangements. In retaliation for Qualcomm’s withholding payment, Apple simply underpaid its suppliers by the amount it thinks it was owed by Qualcomm, forcing them to further withhold the same amounts from payments made to Qualcomm. At first, it looked like Apple was only going to hold back the disputed $1 billion. But since in the last week of April, Apple indicated that it will continue to withhold payments until the dispute is resolved, pointing to the much larger amount really under contention.

Apple has been buying iPhones from Foxconn for nine years, and paying the negotiated price. Now, Apple is unilaterally declaring the amount it will pay a key contract manufacturer for its product, even if that amount is less than what it costs Foxconn to make the product.

For Qualcomm, a spot of particular soreness is Apple’s insulting mischaracterization of the performance differential between Qualcomm’s modem chips and those of Intel, which supplies modems for some of the iPhone 7 family. According to Qualcomm, Apple throttled Qualcomm’s modem by not making use of advanced features — specifically, 256-QAM and 4x4 MIMO — that increase data rates by 33%. Despite this maneuver, which made Intel’s modem look better, the Qualcomm modem still outperformed the Intel part. To add injury to insult, Apple attempted to keep Qualcomm from discussing this result through threats to future business.

Qualcomm believes that its wireless implementations are superior, that these capabilities were created through multi-billion-dollar investments, and that Apple has benefited greatly from them. In a saturated and slowing smartphone market, Apple wants to increase its margins by squeezing its suppliers by, apparently, any means. It is absurd on the face of it that Apple asserts it is being bullied when it is the 800lb gorilla.

But it may have tried to grab the lunch money of the wrong kid. Qualcomm, while not as large or profitable as Apple, has its own deep war chest, lots of intellectual property lawyers on staff and retainer, and vast experience in venues around the world dealing with intellectual property licensing issues. If Apple wants a better deal, it should negotiate in good faith directly, not light brush fires everywhere.

If Apple is bluffing, Qualcomm is not falling for it. The wireless technology provider is ready to present — no, relishes the prospect of presenting — its case to a jury. Apple’s politics of bullying in the shadows will not do well in the glare of public scrutiny. Apple may be a master at choking its supply chain partners, but that strategy is more a sign of weakness than strength. With nothing to replace the iPhone, Apple can’t see where its next meal is coming from and is thus turning to desperate methods.

Written by

Technology Analyst

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