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Apple's Legal Battle Is Wrecking Qualcomm's Licensing Business in More Ways Than One

Mobile chip giant Qualcomm (NASDAQ: QCOM) reported fiscal third-quarter earnings last night, and the company's licensing business expectedly took a major hit due to the ongoing and escalating legal battle with Apple (NASDAQ: AAPL). Qualcomm had previously warned investors of the expected financial impact, reducing its revenue guidance by $500 million in April; Apple's decision to withhold all royalties caught Qualcomm off guard, and Qualcomm updated its outlook as soon as it realized that the iPhone maker would be playing hardball.

The numbers for the Qualcomm technology licensing (QTL) segment speak for themselves:

QTL

Fiscal Q3

Change (YOY)

Sequential Change

Revenue

$1.2 billion

(42%)

(48%)

Earnings before taxes (EBT)

$854 million

(51%)

(56%)

EBT margin

73%

(13 percentage points)

(14 percentage points)

Data source: SEC filings.

Ouch.

There's probably more where that came from

The hit is particularly painful since QTL is normally incredibly profitable, often bringing in more EBT than the Qualcomm CDMA technologies (QCT) chip business, and on a smaller revenue base, to boot. For example, in the fiscal first quarter (before the Apple dispute kicked off), QTL contributed $1.5 billion in EBT on $1.8 billion in revenue (85% EBT margin), compared to QCT's $724 million in EBT on $4.1 billion in revenue (18% EBT margin).

Image source: Getty Images.

It gets worse. Apple's high-profile lawsuit has broad implications for Qualcomm's fundamental licensing model, which is why other Qualcomm licensees are watching so closely. They would also like to pay less if possible, and Apple's suit appears to be emboldening them to defy Qualcomm as well. On the April earnings call, which was largely dominated by discussion of the Apple situation, Qualcomm disclosed an additional dispute with another licensee. This unnamed other licensee is not related to Apple or the iPhone, and translated into a $150 million hit:

The fiscal second quarter revenue and operating profit results for QTL, which were largely in line with our prior guidance, were negatively impacted by a dispute with one of our licensees. This dispute resulted in the licensee underpaying royalties of more than $150 million for sales during the December quarter. We are working to resolve this dispute, but we expect the licensee, which is not one of the suppliers of iPhones to Apple, to continue to underreport its royalties until the dispute is resolved and therefore, have factored that into our guidance for the third quarter of fiscal 2017.

Qualcomm's guidance for the fiscal fourth quarter includes no royalty revenue from Apple or the other licensee. QTL revenue in fiscal fourth quarter is expected in the range of $1 billion to $1.3 billion, down 31% to 47% year over year.

This is what I meant when I called the Apple suit a "fundamental" and "existential threat to Qualcomm's licensing business." All licensees pay a percentage-based royalty, and all licensees would highly prefer not to. But Qualcomm has historically wielded tremendous leverage and market power, particularly since its business practices forced many rivals out of the baseband market. Not only have Apple's and the FTC's respective legal complaints shined some light on potentially unscrupulous practices, but other licensees are now coming out of the woodwork.

There's probably more where that came from.

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Evan Niu, CFA owns shares of Apple. The Motley Fool owns shares of and recommends Apple. The Motley Fool owns shares of Qualcomm. The Motley Fool has a disclosure policy.