Qualcomm: Thank You, CFIUS

Rethink Technology business briefs for March 6, 2018.

The CFIUS letter makes clear that security concerns are not “theater”

Broadcom CEO Hock Tan, source: Broadcom.

Broadcom (AVGO) has characterized the delay in the Qualcomm (QCOM) shareholder meeting as

…a blatant, desperate act by Qualcomm to entrench its incumbent board of directors and prevent its own stockholders from voting for Broadcom’s independent director nominees.

Broadcom also has criticized the secrecy surrounding Qualcomm’s request for a Committee on Foreign Investment in the U.S. (CFIUS) review:

Broadcom reiterates that Qualcomm failed to disclose to its own stockholders and to Broadcom that it secretly filed a voluntary unilateral request for CFIUS review on January 29, 2018. Broadcom’s only correspondence with CFIUS was in response to CFIUS inquiries about Broadcom’s nomination of directors to the Qualcomm board of directors, and such requests did not reveal that Qualcomm filed to initiate the CFIUS review on January 29, 2018.

Although Broadcom clearly wants to portray Qualcomm’s management as going behind the backs of its shareholders, I doubt that the secrecy can be considered a failing.

The Wall Street Journal has published a letter by the Treasury Department’s Deputy Assistant Secretary Aimen N. Mir explaining the investigation that was sent to both parties on March 5. Mir divulges some information about Qualcomm that, while not classified, is probably not generally known:

U.S. national security also benefits from Qualcomm’s capabilities as a supplier of products. For example, Department of Defense national security programs rely on continued access to Qualcomm products. Qualcomm holds a facility security clearance and performs on a range of contracts for the United States government customers with national security responsibilities. Qualcomm currently holds active sole source classified prime contracts with DOD.

In my past life in the defense industry, I probably worked for many of those same government customers, and I can attest to their sensitivity regarding security matters. They would expect Qualcomm to proceed with the utmost discretion.

It was entirely appropriate for Qualcomm to alert CFIUS to the national security implications of the Broadcom takeover. The only thing that’s mildly surprising is that Qualcomm even needed to do this. But it’s probably symptomatic of the “compartmentalization” of so many of these types of classified programs.

Personnel in these programs often can’t even acknowledge their existence. Probably, Qualcomm did first alert its customers, who then “suggested” that Qualcomm inform CFIUS since the customers themselves would be precluded from doing so.

The letter’s unintended irony

The Mir letter also describes a broad range of concerns about the impact of weakening Qualcomm’s competitiveness, especially in the emergent technology of 5G:

Reduction in Qualcomm’s long-term technological competitiveness and influence in standard setting would significantly impact U.S. national security. This is in large part because a weakening of Qualcomm’s position would leave an opening for China to expand its influence on the 5G standard-setting process.

Also, a concern is what Broadcom will change post acquisition:

CFIUS, during the investigation period, will continue to assess the likelihood that acquisition of Qualcomm by Broadcom could result in a weakening of Qualcomm’s position in maintaining its long-term technological competitiveness. Specifically, Broadcom’s statements indicate that it is looking to take a “private equity” style direction if it acquires Qualcomm, which means reducing long-term investment, such as R&D, and focusing on short-term profitability.

Almost certainly, this would be the case, especially considering the $106 billion in debt financing the Broadcom intends to use. The letter is refreshingly complimentary of Qualcomm, especially in light of the vilification of Qualcomm as an abusive monopolist at the hands of the Federal Trade Commission.

After applauding Qualcomm’s technological leadership and R&D investments, the letter takes a somewhat different view of Qualcomm’s licensing business than the FTC:

Qualcomm’s current business model is based upon licensing of patented Qualcomm technologies; Qualcomm believes that Broadcom will change that licensing methodology. Broadcom’s CEO Hock Tan recently criticized Qualcomm’s licensing structure, saying he would reset the business model, which he called “broken.” However, Mr. Tan did not elaborate on how he would change the existing model, which currently relies on the licensing business to fund the company’s large R&D expenditures. Changes to Qualcomm’s business model would likely negatively impact the core R&D expenditures of national security concern.

The letter rightly characterizes Qualcomm as a national technological resource, yet it is the very actions of the government in the form of the FTC suit that have contributed to the weakening of Qualcomm and its vulnerability to takeover.

Why I voted the White Card

The impending proxy fight involves voting between competing slates of directors. Shareholders have been mailed proxy ballots, a “white card” for Qualcomm incumbents and a “blue card” for the Broadcom candidates. I voted (online, because it’s easier than mailing in the ballot) for the Qualcomm incumbents.

I’ve often been critical of Qualcomm’s management for its cluelessness regarding its regulatory issues. I firmly believe that reform of Qualcomm’s business practices is necessary. However, I’ve never believed that Qualcomm should or would be required to dismantle its fundamental licensing practices.

Apple (AAPL) has complained about being “taxed” on every iPhone its contract manufacturers make as if the $10 or $15 of added cost is an onerous financial burden. Apple claims, as the FTC has claimed, that Qualcomm has no right to charge royalties at the handset level.

Qualcomm has every right to do so. Qualcomm reached an agreement with the contract manufacturers to license not one or two patents but a large portfolio of patents that might or might not be applicable to a given handset (and not just Apple’s). For simplicity and convenience, the fees were to be paid on a handset basis.

It’s a perfectly enforceable and reasonable licensing contract, and Apple and the FTC will be proved wrong in challenging it. Licensing of patent bundles is a common practice that neither Apple nor the FTC is empowered to overturn. In every successful anti-competition action that has been taken so far anywhere in the world against Qualcomm, not once has Qualcomm been required to abandon the practice.

Convinced as I am that Qualcomm will ultimately prevail against Apple and the FTC, I was surprised to learn in the days before the planned (and now delayed) shareholder meeting that the proxy vote was going to be close. And some are now convinced that Qualcomm would have lost the vote.

Qualcomm’s institutional investors, which own 79% of outstanding shares, seem to have lost their nerve to stay the course. It’s hard to blame them. Given that Qualcomm’s growth opportunities are from certain, while anti-competition actions, such as the recent EU fine of $1.2 billion, seem very certain, the $82/share Broadcom offer must seem like a great way cash out with a net gain.

I continue to believe that the best interests of Qualcomm’s shareholders are served by Qualcomm moving forward with the NXP (NXPI) acquisition. On February 20, Qualcomm upped its bid by 16% for NXP to $127.50/share cash, while lowering the minimum tender threshold to 70% from 80%.

More importantly, Qualcomm reached an agreement to buy the shares of major institutional holders of NXP who together own 28% of the company. Among them was Elliott Advisors, who had vocally opposed the deal until now. Having mollified Elliott probably paves the way for broad-based acceptance of the tender offer and conclusion of the deal.

My investment case for Qualcomm has always been predicated on the NXP acquisition. In announcing the amended offer, Qualcomm pointed out that $1.50 of its non-GAAP EPS target for 2019 of $6.75-7.50 would come from NXP. NXP has been the one sure thing in the Qualcomm growth strategy.

With the acquisition of NXP, its 5G leadership, its brilliant ARM processor design, its innovation in mobile communications, Qualcomm deserves to remain an independent, and most importantly, American, enterprise.

Disclosure: I am/we are long QCOM, AAPL.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.