The Federal Trade Commission (FTC) has filed a case against chip maker Qualcomm Incorporated (QCOM) in the Northern District of California. The allegations are serious. In its charges, the FTC states that the chip maker exploited its leadership position in baseband modem patents to force competitors out of the market. The FTC complaint essentially states that Qualcomm asked smartphone makers to use its chips or pay inflated royalties for its patents.
According to the FTC, Qualcomm struck a deal with Apple Inc. (AAPL) in 2011 and 2013 for the use of its chips Apple's smartphones. As part of the deal, Qualcomm paid Apple billions of dollars in rebates not to use competing modems from Intel Corporation (INTC) based on similar technology. "Qualcomm recognized that any competitor that won Apple's business would become stronger, and used exclusivity to prevent Apple from working with and improving the effectiveness of Qualcomm's competitors," the complaint reads. (See also: Qualcomm Unveils New Snapdragon Chip for IoT.)
The deal was also intended to throttle growth of WiMax technology, a wireless standard that competed with Long Term Evolution (LTE), during that time. This led to losses at Sprint Corporation (S), which had invested heavily in the technology.
For its part, Qualcomm stated that the FTC's complaint was based on "flawed legal theory, a lack of economic support, and significant misconceptions about the mobile technology industry." The company said that the FTC's central thesis was wrong and that the complaint was made to "advance the interests and bargaining power of companies" that were seeking to profit from Qualcomm's work in the field. (See also: Qualcomm's 3 Most Profitable Lines of Business.)
Will the FTC Complaint Affect Qualcomm's Business and Stock?
Qualcomm's use of patents to sell its chips has come under increasing scrutiny around the world. For example, the company paid a fine of $975 million in China toward the end of 2015, after regulators there brought charges similar to the ones alleged by FTC against it. Qualcomm also agreed to a slight modification in the formula that it uses to calculate royalty rates. Analysts had characterized the China fine as an overall win for Qualcomm, given its profits from the country. However, China's action set a precedent for similar action by South Korean authorities and, now, American regulators. (See also: South Korea Hits Qualcomm With a $854 Million Fine.)
The most important consideration in these cases is a disruption to the company's business model. Of Qualcomm's profits, 80% are derived from royalties for its patents. Any attempt by the authorities to force Qualcomm to stop linking sale of its modems to patent royalties or to drastically rework the company's royalty charges will result in a decline to Qualcomm's profits.
But that may not happen. There is a strong possibility that the company might reach a settlement with the FTC similar to the one it worked out with Chinese authorities. The reason for this is that a disruption to the company's business model may disturb market dynamics for other products. The company's modems are widely used in the industry and are among the fastest. For example, Apple, which has begun sourcing modems from Intel, is reportedly intentionally slowing down the speed of its Qualcomm chips to bring them on par with Intel's chips. (See also: Is Qualcomm's Royalty Revenue at Risk?)
This may be the reason that investors have reiterated their faith in the company. In response to the charges, Qualcomm's shares dropped by 4% in after-hours trading. However, they recovered Wednesday and ended the day approximately 1.5% higher at $65.13.