Qualcomm Inc (NASDAQ:QCOM) indicated that it was unclear whether Apple Inc.’s (NASDAQ:AAPL) contract manufacturers (CMs) will underpay royalties, which is contractually obligated, going forward. Unfortunately, Qualcomm did not indicate whether it would pursue retribution against the CMs, which acknowledge they owe Qualcomm, to collect these royalties. As Apple noted in its January legal complaint, it withheld payments to its CMs in the amount that it felt Qualcomm owed it under a separate cooperation agreement. Qualcomm alleges Apple actively induced its CMs to underpay royalties to Qualcomm in the same amount because Qualcomm did not make the payment to Apple under the separate cooperation agreement. More importantly, as Wells Fargo Securities noted previously, the cooperation agreement between Apple and Qualcomm ended at the end of Dec 2016, so come the June quarter (because payments are recognized one quarter in arrears), Qualcomm is not contractually obligated to pay Apple anything. The key question the firm was hoping to glean from the Qualcomm conference call was whether Apple will continue to withhold payments from its CMs. Qualcomm seems to believe that the CMs will eventually pay what’s contractually owed but the unknown is whether the CMs will take the hit or if they will ask Apple to pay them. The firm’s and, it believes, Street forecasts currently assume the status quo from an Apple gross margin perspective (i.e., that Apple will not pay its CMs and, hence, not take a gross margin from higher cost of goods sold). However, with the cooperation agreement having ended, the firm would think Apple would have to pay its CMs (the cited $1 billion over three quarters), which would negatively impact Apple's quarterly gross margins by 50bps starting in the June quarter, all else equal. It sees no easy resolution to this issue between the parties and, while it presumes Apple will continue to withhold payments to its CMs, the possibility of an increase in COGS does pose some modest risk.
Based on roughly 15x the firm’s FY18E EPS estimate. Key risks include potential demand pressures due to global economic uncertainties, China exposure, mis-step in product cycle, legal disputes and greater than expected margin pressures.
The firm sees uncertainties around off-cycle demand, June quarter guide, and litigation offsetting positives such as potential for tax reform and iPhone 8 "super cycle".