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Qualcomm's Monopoly And The Broader Chip Market

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Anti-trust Laws Violated

Qualcomm (QCOM - Free Report) took a hit today in the markets, plummeting over 10%, as some of the company’s practices are ruled illegal. US District Judge Lucy Koh made a ruling on the FTC’s Qualcomm case, saying they did violate US anti-trust laws. According to Judge Koh, "Qualcomm's 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." Qualcomm immediately appealed the ruling and is attempting to expedite the legal process so the adverse effects of the ruling don’t materialize on their balance sheet.

The Federal Trade Commission (FTC) charged Qualcomm with operating a monopoly back in January of 2017 on the grounds that they are charging unreasonable licensing fees and forcing customers like Apple (AAPL - Free Report) and Samsung to have exclusive contracts with them. Qualcomm has been making significantly more on its patent licensing than its chip products over the last decade. The charges finally came to fruition today with Judge Koh’s ruling.

The ruling is ordering Qualcomm to renegotiate licensing contracts with its customers to ensure that both buyers and other chip makers aren’t paying excessive licensing fees on QCOM’s patents. They are also being directed to end any exclusivity agreements they might have with customers such as their exclusive supplier deal with Apple which inhibits any competing chip makers from making a production bid.

Qualcomm just settled a lawsuit with Apple last month regarding licensing fees, claiming that Apple has been withholding these royalties. This case was settled when Apple caved and paid around $5 billion in “overdue” royalties. QCOM jumped 38% in the 2 days surrounding this settlement.

Even with the sharp decline in price today, QCOM is still up 23.5% YTD, outperforming S&P 500 by almost 9 percentage points.

As a shareholder or potential investor, we need to assess the chances of this ruling being reversed and if it is not reversed how negatively will this impact Qualcomm’s income statement. Considering that a significant portion of the firm’s profits are coming from licensing fees, I would speculate that if this decision isn’t reversed there will be a substantial material effect on QCOM’s bottom-line. This will not only decrease their immediate revenue base, but it will also increase competition in an already overly competitive space.

The Chip Industry

 

Above is a chart showing earnings growth over the last 2 years and expected earnings over the next 4 quarters. As you can see, the industry is extremely cyclical, as demand fluctuates with consumer trends. In 2017 a lot of growth was being driven by cryptocurrency miners that needed vast amounts of processing power in order to profit off of “mining” these coins. This industry has turned south, as the marginal costs increased and marginal profits decreased.

Cloud computing also spread its reach in 2017/2018, buying up as much processing power as possible to gain a competitive edge in this fast growing industry. I think the demand for this processing power has largely been met and only to be revitalized as the industry shifts to meet consumer needs.

The chip industry is also affected by smartphone demand, which has seen declines in the last year or so as the industry matures. Innovation in smartphones has also hit a speed bump as developers struggle to add new and exciting features to their phones to attract buyers.

Semiconductor Performance

Semiconductors (blue) have underperformed the market (red) over the past 52-weeks, with a massive dip in the last month.

 

The cyclical nature of the semiconductor business makes it very sensitive to economic factors. The escalated trade conditions between the US and China is the leading cause of these stocks taking a 16.5% haircut in the last 4 weeks.

If Trump is able to negotiate a favorable trade deal soon, I am confident that semi stocks like (MU - Free Report) , (AVGO - Free Report) , and INTC will see some positive returns.

Take Away

Be wary of investing in Qualcomm as the negative impact of the anti-trust violation comes to fruition. I believe that if this ruling stands, QCOM will have quite a bit more downside potential. The cyclical semiconductor industry is something to continue to keep an eye on, especially as US-China trade tensions ease. The industry is expected to have negative EPS growth throughout this year and turn positive again in 2020. This is all subject to change as economic conditions do.

 

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