Apple Goes to Court to Protect its Profits
When people or companies say a fight that spills into court "isn't about the money," you know that means it's entirely about the money. Lawsuits are motivated by self-interest.
That's an important principle to keep in mind when reading about the legal back-and-forth between two of the world's largest companies. Apple Inc. in January sued Qualcomm Inc., contending that the maker of smartphone computer chips abuses its control over essential mobile phone technology to overcharge Apple and others. Companies including Apple 1 pay Qualcomm a percentage of each phone's total sale price for the chipmaker's patented wireless technology, whether they buy Qualcomm's chips or not.
Qualcomm struck back late Monday by saying Apple misled government regulators to spur them to crack down on Qualcomm's business practices, including how the company calculates its royalty fees.
By the looks of the litigation so far, this promises to be a nasty fight. Apple is seeking $1 billion from Qualcomm and billions of dollars more to compensate for years of overcharging. And if Apple wins, Qualcomm's highly profitable business model is potentially at risk.
Apple is not alone in its complaints about how Qualcomm calculates the fees for its technology. A crucial question, however, is why Apple is picking this moment to press the issue. Qualcomm's model has been in place for a couple of decades.
It could be that Apple reached a breaking point with Qualcomm. Apple may also be piggybacking on work of regulators in places like the U.S., South Korea and China, which have made claims similar to Apple's about how customers pay Qualcomm.
Or it could be that Apple's iPhone franchise is financially vulnerable like never before, and litigation is the way a cornered corporation strikes back to protect a fragile business.
The lawsuit against Qualcomm comes at a point when sales of new smartphones have slowed to a crawl. Research firm IDC expects global smartphone sales will increase 4.2 percent this year, a bit better than last year's 2.5 percent, which was the slowest rate ever. Apple's revenue from its iPhone line fell last year for the first time in the device's history.
That is a particularly painful set of market conditions for Apple, which generates about two-thirds of its annual revenue from iPhone sales. And perhaps more worrisome for Apple, it's also becoming tougher for the company to maintain its remarkably consistent profit margins.
Apple is known for being allergic to anything that dents its high and resilient gross margins -- the percentage of total revenue left over after Apple pays to make its products. They have hovered around 38 to 40 percent quarter after quarter. It's a figure on which Apple and its investors fixate. I'm not sure the company needs to focus anymore on continuing to hit those gross margin targets, but that's a discussion for another day.
The trouble is that costs for essential parts of smartphones, including memory chips and screens, have been rising, and phone makers are having trouble passing the full freight of the cost increases on to their customers. Bernstein Research analyst Toni Sacconaghi estimated iPhone gross margins have dropped 15 percentage points since 2012 and will most likely decline further.
To be fair to Apple, it has developed new lines of business, including sales of apps and streaming music subscriptions, that generate significantly higher margins than the iPhone does. But the iPhone remains the business on which Apple depends.
Investors' fears about Apple's gross margin pressure have abated a bit in recent months. But the future trend is unmistakable. Apple keeps adding more high-cost parts and materials to the iPhone, including reportedly an ultra high-resolution screen in one of the next iPhone models and perhaps technology to enable future 3D or virtual reality-style features. Apple has been clever about finding ways to subtly increase the prices it charges for iPhones, but competition from Samsung and other makers of high-end smartphones means Apple can't charge iPhone buyers enough to fully offset rising costs.
Another lever Apple can pull, of course, is to lower its bills for the technologies and parts that go into the iPhone. If costs go down, gross margins go up. Apple's payments to Qualcomm for each phone is a secret, but Apple would clearly benefit if it can cut those payments in a court victory or a litigation settlement with Qualcomm.
Keep that essential goal in mind during what is sure to be many months of headlines about the Apple-Qualcomm dispute. This may be a fight between technology powers, but base human instincts are at work here. Apple's courtroom battle is motivated by fear.
Apple doesn't actually pay Qualcomm directly for its patented technology. Instead, Apple suppliers such as Foxconn pay the fees.
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