Why Apple was so upset with Qualcomm — and why it finally had to give in

Key Points
  • Over half of Qualcomm's operating income comes from licensing, not selling chips.
  • It holds core patents that any technology company needs to license to connect to cellular networks.
  • Before settling with Qualcomm, Apple fought with it over licensing terms and pricing. 
Steve Mollenkopf, chief executive officer of Qualcomm Inc.
Patrick T. Fallon | Bloomberg | Getty Images

Qualcomm and Apple have settled a bitter legal battle over billions of dollars in royalties and licensing fees just as it went to trial this week in San Diego. As part of the settlement, all legal action worldwide between the two companies will be dropped, and Apple will buy Qualcomm chips again.

The dispute centered around modem chips, which allow the iPhone and other computers to connect to cellular networks. Apple buys modem chips from companies like Qualcomm and Intel.

Qualcomm and Apple reach settlement—here's what four experts say it means for the companies' stocks
Qualcomm and Apple reach settlement—here's what four experts say it means for the companies' stocks

As part of the companies' deal for those chips, Qualcomm forced Apple to pay licensing fees for the rights to use some of the core cellular technology Qualcomm had patented — a practice Apple hated. Apple felt Qualcomm was abusing its position as one of a limited number of companies that hold patents on critical cellular technology.

Qualcomm's stock spiked on the announcement of the settlement. Over the past two days, the stock is up more than 38%.

Apple's stock, in contrast, was up about 1% , in line with the broader market.

The market reaction suggests a clear vindication of Qualcomm's business model, which is highly reliant on patent licensing. Apple has objected strongly to how Qualcomm conducts this business. But in the end it had no choice but to swallow its pride and go along.

It comes down to FRAND

Licensing patents is a critical revenue stream for Qualcomm. The fees from patent licensing were only 23% of Qualcomm's revenue in its 2018 fiscal year, but made up a majority of Qualcomm's operating income.

Specifically, Qualcomm's chip division, QCT, reported more than $17 billion in revenue, but only $3 billion in operating income. Qualcomm's licensing division, QTL, reported $5.1 billion in revenue at a 68% operating margin, which works out to $3.5 billion in profit.

Watch CNBC's full interview with Qualcomm CEO Steve Mollenkopf
Watch CNBC's full interview with Qualcomm CEO Steve Mollenkopf

A specialized agency of the United Nations called the International Telecommunication Union ultimately defines what people in the industry call "standards" — or the official technical specs for telecom networks so that devices can work across borders and carriers. Qualcomm has a lot of patents that fit into these standards.

"Standards bodies have been informed that we hold patents that might be essential for all 3G standards that are based on CDMA," Qualcomm wrote in an SEC filing last November.

Thanks to these patents, Qualcomm has licensing agreements with more than 300 companies.

Patent holders are supposed to license necessary patents at a reasonable price and on equal terms to everybody, or what's sometimes called fair, reasonable, and non-discriminatory (FRAND) licensing.

But technology companies and governments often have different ideas about what constitutes fair and reasonable.

Apple's main objection was that Qualcomm forced it to license these patents even though it was already a big customer for Qualcomm's chips.

"The issue that we have with Qualcomm is that they have a policy of no license, no chips. This is, in our view, illegal," Apple CEO Tim Cook said in January.

Apple also objected to Qualcomm's pricing scheme, where it used the total sales price of an entire device to figure out what to charge, instead of the sales price of a modem chip. Eventually, the two companies settled on a royalty price of $7.50 per device, which Apple still thought was too high.

As Cook put it: "They have an obligation to offer their patent portfolio on a fair, reasonable, and non-discriminatory basis and they don't do that. They charge exorbitant prices."

Apple isn't the only party that's had problems with Qualcomm's business practices.

In 2009, South Korea's antitrust agency, protecting local companies like Samsung and LG, fined Qualcomm $200 million for abusing its market position in radio frequency chips, saying in a statement more recently that a "monopolist enterprise's abuse of its market position cannot be tolerated." The KFTC later fined Qualcomm again in 2016 for $854 million for what it said were unfair business practices.

In 2015, Qualcomm paid a $975 million fine in China to resolve another complicated antitrust dispute. As part of that agreement, Qualcomm was required to lower its royalty rates in China for handset makers like Xiaomi and Huawei.

Perhaps the biggest threat to Qualcomm is a battle with the U.S. Federal Trade Commission, which ended in a trial earlier this year. The verdict has not yet been released.

But Apple had little choice

On Tuesday, Apple put all these objections aside and bought the patent license it was fighting for six years as part of the settlement.

Shortly after the deal between Apple and Qualcomm was announced, Intel said it would exit the 5G chip market, leaving Apple with one fewer option it could buy the part from. After the announcement, Nikkei and Bloomberg both reported that Apple had long been concerned that Intel could not meet demand for the parts.

The uncomfortable truth for Apple: Qualcomm is still the leader in wireless technology, and with next-generation 5G networks currently being built, Apple had little choice.

So Apple will make a one-time payment to Qualcomm, and will buy chips from it again. The companies have not yet disclosed how much Apple will pay and Qualcomm CEO Steve Mollenkopf told CNBC he would not disclose the amount.

"The energy of the companies right now is let's figure out how to ramp up as quickly as possible," Mollenkopf said Wednesday. "That's where the focus is, that's what we are excited about."

Qualcomm has indicated it will stand strong on its licensing policies when 5G networks start ramping up.

"We have informed standards bodies that we hold patents and pending patent applications that are potentially essential for 5G technologies and have committed to offer to license our essential patents for these 5G standards consistent with our commitments to those bodies," Qualcomm said in a filing last year.

WATCH: Intel was unlikely to come through for Apple

Intel was unlikely to come through for Apple, says Wolfe Research's Milunovich
Intel was unlikely to come through for Apple, says Wolfe Research's Milunovich