Qualcomm vs. Apple – Black Magic pt. II

Apple fails to graduate from Hogwarts.

• It looks like Apple is giving up on its attempts to design an in-house 5G modem which is a big benefit to Qualcomm not for modem sales but because Apple will not be able to start another fight over royalty rates when its current contract expires in 2026.
• If Apple is unable to reopen hostilities with Qualcomm, then this increases the chance that no one else will either, putting Qualcomm’s patent business in the most secure position that it has been for many years.
• Rumours from Apple’s supply chain (see here) indicate that Apple is in the process of winding down its cellular modem activity which if true, means that it will have to source modems externally indefinitely.
• Given that Apple operates almost exclusively in the high-end, it will require only the best modems which puts Qualcomm in pole position given its long-term technology leadership in modems.
• MediaTek is also a contender to supply Apple but given the majority of its business is not in the high-end, the fit is not as good.
• The problem is relatively simple in that the cellular radios are very difficult to make and take years of practice to perfect which Qualcomm has pretty much been doing since 1985 when it was founded as Quality Communications.
• The general assumption on the street is that because Apple is arguably the best processor maker in the world, it should have no trouble replicating the chips that control cellular communication.
• Anyone who has been around for a while understands that when it comes to cellular radios simply being good at designing chips is not nearly enough.
• Dealing with analogue radio systems, moving standards and a dizzying array of different radio frequencies is fiendishly difficult where often experience is more important than raw engineering talent.
• This is what Apple failed to understand when it acquired the second-rate radio modem business from Intel in 2019 which originally came from Infineon and had been floundering for years.
• Solving these kinds of problems is often referred to as a black art and when it comes to this school of wizardry, Apple has failed to graduate and seems to be giving up.
• At first glance, this is a positive for Qualcomm as it will likely now be supplying modems to Apple indefinitely, but it is the strategic position that this affords Qualcomm where the real benefit lies.
• In 2018 Apple made the decision (wrong in my opinion) that it had to have 5G in its 2020 iPhone 12 which meant that its US products had to support millimetre wave frequencies and Qualcomm was the only supplier that could deliver it.
• At the time, Qualcomm was embroiled in the biggest patent dispute since its legendary fight with Nokia in 2007 with Apple which Apple thought it could win before it needed to source the 5G modems.
• Things didn’t work out this way and it was Apple’s need to buy 5G modems from Qualcomm for the iPhone 12 that caused it to give up on its fight (see here) and sign a 6-year patent (extendable for 2 years) license on the same terms as before.
• The length of this contract is unusual in that most patent licenses are for 10 years or more.
• In this case, I have long believed that 6 years was the amount of time that Apple thought it would take for it to design a modem as good as Qualcomm’s putting it in a position to resume hostilities over patents as soon as the license expired.
• However, Apple has gotten almost nowhere with its modem and giving up means that if it starts fighting over patents again, Qualcomm will stop supplying it with chips which is a risk that Apple simply cannot take.
• If Apple is getting out of the modem business, then there is no point in time where it will be in a position to resume the fight over royalties without putting its iPhone business at risk.
• This is why I believe that by far the biggest benefit to Qualcomm from Apple’s exit (if proven) is the added security that this provides to its licensing business.
• This will also make it harder for others to have a go at breaking the Qualcomm licensing model which has been a regular feature of the mobile phone industry for over 20 years.
• In my opinion, this puts Qualcomm Technology Licensing in the most secure position in terms of challenges to its business model than it has been for many years.
• Greater security and reliability mean a higher multiple as the stock market values consistency and reliability above pretty much everything else.
• As a substantial contributor to Qualcomm’s profit and cash flow, this means an upgrade to the multiple and further upside on the shares.
• I have a position in Qualcomm and am very happy to sit tight.