Qualcomm's Legal Problems Loom Large (QCOM)

By Hans Wagner | August 06, 2007 AAA

Qualcomm (Nasdaq:QCOM) is entering a critical litigation time frame with its legal troubles involving Broadcom (Nasdaq:BRCM) and Nokia (NYSE:NOK). The company's guidance going forward suggests investors should expect higher litigation costs over the next two to four quarters. And this guidance also assumes unconstrained chip imports for the rest of 2007, something that might not take place, as the customs service is already enforcing a ban.

Investors considering Qualcomm should think carefully before jumping in.

Imports Banned
On June 7, 2007 the U.S. International Trade Commission decided to ban the import of certain chips that are made or designed by Qualcomm. The ITC found that Qualcomm violated a Broadcom patent to conserve battery power in phones when they are outside the range of their network.

This ruling comes from a patent dispute where Broadcom accused Qualcomm of illegally using Broadcom's wireless technology in Qualcomm's chips. Qualcomm sought a veto from the White House which was denied on August 6.

The company is seeking to have the ruling overturned by a Federal Appeals court, though that could take awhile. Also, Qualcomm claims to have developed a work-around that will overcome the problem.

According to the company, this work-around has been available to its customers for several months and there seems to be a high degree of acceptance.

Verizon Contract with Broadcom
Meanwhile, the phone manufacturers and carriers that use Qualcomm chips are scrambling to find other solutions, as they do not want to miss out on the up-coming holiday selling season. Verizon Wireless (NYSE:VZ) and Sprint are highly dependent on phones with Qualcomm chips, as are phone manufacturers Samsung and LG Electronics. AT&T Mobility (NYSE:T) is less dependent on Qualcomm chips and is rumored to have completed a deal with Broadcom to supply its chips.

Verizon, the No. 2 U.S. service provider, decided to stop
participating in the effort to reverse the ITC decision when it announced an agreement with Broadcom. The agreement requires Verizon to pay $6 for each handset it sells with Broadcom chips, up to $40 million per calendar quarter and a maximum of $200 million for the life of the deal.

The fact that Verizon has concluded an agreement with Broadcom raises suspicion about the acceptance of the Qualcomm work-around. It looks like Verizon wants to be sure it has a solution that is acceptable for the peak selling season.

Of interest, in Verizon's filing with the SEC, the company stated, "Given the limits of the payments under the agreement, Verizon does not expect that there will be a material effect on Verizon Wireless's annual results." This makes one wonder if Verizon intends to seek payment from Qualcomm to help defray the costs of the Broadcom agreement.

Also, in Qualcomm's third-quarter conference call on July 25, 2007, management stated that it believed the cost of the chip was no more than $1 per phone. Sounds like Qualcomm was posturing to deal with a threat from AT&T.

On the other hand, analyst Matthew Hoffman from Cowen & Company believes the Verizon decision actually helped Qualcomm in the appeals process despite being widely considered a negative read on Qualcomm's bargaining leverage at the time. It established that Broadcom can be remunerated for its patents and that it would not be irreparably harmed if Qualcomm continues to ship.

A settlement would help most everyone; however, so far Qualcomm and Broadcom have not been able to find common ground to generate a deal. Any settlement would have to take place in the very near future so the manufacturers and carriers can produce the phones in time for this year's holiday season.

Broadcom Litigation
On Monday, August 6, U.S. District Judge Rudi Brewster, in a ruling between Qualcomm and Broadcom stated that Qualcomm waived its rights to enforce two patents for compressing video signals. The judge wrote that Qualcomm deliberately concealed them from an industry standard-setting group suggesting "extremely foul play".

This finding uncovered "a carefully orchestrated plan and the deadly determination of Qualcomm to achieve its goal of holding hostage the entire industry". Not a very good conclusion for Qualcomm.

The judge also said that Qualcomm did not share more than 200,000 pages of important documents with Broadcom until after the jury trial ended. This is another black mark against Qualcomm with the judge writing that Qualcomm participated in "constant stonewalling, concealment and repeated misrepresentations" throughout the trial. Qualcomm must also pay Broadcom's attorney fees.

This is another situation where Qualcomm comes out on the wrong side and will likely harm its future sales.

Nokia Arbitration
In another important action, Qualcomm and Nokia are arbitrating the continued use of Qualcomm's patents in Nokia's CDMA wireless phones. The prior agreement expired after April 9, 2007 and Nokia has continued to use the Qualcomm chip design implying Nokia intends to extend the agreement.

Qualcomm is claiming that Nokia is obligated to pay the same royalties as specified in the original agreement. Nokia stated in its announcement that it expects the royalties due to Qualcomm will be substantially less.

The result of the arbitration panel that is just now being formed will not be known for several months.

The Bottom Line
All these legal troubles come at a key time when the wireless industry is making the transition to 3G, where Qualcomm has a significant presence with its WCDMA products growing rapidly. In fact, as reported in the company's third-quarter earnings release and conference call, UMTS chipset (3G) shipments were up 79% quarter-over-quarter and 127% year-over-year. This growth is threatened by the current legal issues Qualcomm faces.

Of note Mark McKechnie, an analyst at American Technology Research, believes the import ban will produce a 2% to 3% earnings reduction in the current quarter and a 5% hit in the quarter ending in December. Not a good sign for a company positioned to take advantage of the rapid move to 3G wireless. Investors considering Qualcomm should carefully weigh the company's legal woes before making a commitment of capital.

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