We closed out the remaining positions in Qualcomm for all accounts in the AMM Dividend Growth Strategy*. One of the main reasons we sell a position is when a fundamental change occurs to the underlying business model. Qualcomm’s very profitable licensing business, the toll booth to the cellphone age is undergoing a fundamental change.
Qualcomm has two business divisions, QTC and QTL. QTC designs and builds computer processing chips. QTL is a licensing business. Qualcomm owns the CDMA technology built into the modem chips that go into every cell phone. Qualcomm has always earned a licensing fee based on the overall price of the phone not just simply for the price of the broadband chip it sold. The justification from Qualcomm is that original equipment manufacturers (OEMs) like Foxconn/Apple and Samsung get access to all of Qualcomm’s book of patents, essential patents and non-essential. Qualcomm’s rate is 5% of the price of the phone.
Smartphones are more expensive on average than the old traditional cell phones. As smartphones took off the cash flow that Qualcomm earned through its QTL business soared too. QTL accounts for over 50% of Qualcomm’s profits even though it only generates around 20% of Qualcomm’s revenue.
Qualcomm’s licensing business and the majority of its profits and cash flow are under attack from regulators, competitors, and its customers. Qualcomm once used its superior processing chips as a tool to get OEMs to pay the high licensing fees. If you didn’t the implication was you would lose access to the premium processing chips. Competitors’ processing chips are now as good and sometimes better than Qualcomm’s.
Regulators in South Korea, the E.U., and the U.S. are in the process of reviewing Qualcomm’s licensing business for unfair practices. The biggest case is in the U.S. The FTC is arguing a case that Qualcomm’s licensing business is violating FRAND, “Fair, Reasonable, and Non-Discriminatory”, doctrine. Arguments in front of the judge ended January 29.
If Qualcomm loses the case it will have to license its patent to competitors and renegotiate its licensing agreements with all its customers. No longer will Qualcomm be able to charge the 5% royalty rate per the price of the phone. Qualcomm’s patent rights would be “exhausted” after licensing its modem technology to a competitor. Qualcomm can no longer legally demand additional license fees on the price of the phone once the initial license is granted to the competing chip company.
The loss of QTL’s royalty structure would mean that Qualcomm will be more dependent on its Chip business that is low margin, high competition, and cyclical. Not the business that originally attracted us to Qualcomm.
We invested in Qualcomm because of QTL and its toll booth like business. Since this business appears to be fundamentally changing for the worse we have decided to sell the position in all dividend strategy accounts*.
*Some clients may continue to hold QCOM due to restrictions related to capital gains realization, individual requests to hold the position, and/or because the client holds shares in a different portfolio strategy (i.e. outside of the AMM Dividend Strategy).