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By Brian Colello, CPA | 12-29-2015 03:00 PM

Behind Qualcomm's Recent Downgrade

Regulatory concerns led us to downgrade the innovative tech firm's moat rating, says Morningstar's Brian Colello.

Brian Colello: We recently downgraded our moat rating for Qualcomm (QCOM) to narrow from wide. The reason why we did this is, as we think about wide-moat stocks, we think about them generating excess returns on capital with near certainty over the next decade.

We encountered a problem with Qualcomm as we think about them facing regulatory battles by various regulators across the world--but most notably in South Korea. The South Korea preliminary report suggests that Qualcomm's royalties, which have been somewhere between 3% to 5% of the price of the phone, could be based on a lower amount.

Now, we're not exactly sure what the amount might be. It might be the $10 price of the baseband chip that connects the phone to the network; it might be the price of all of the cellular components, so maybe that's $50 worth. It's hard to say. There is not a lot of clarity around what the royalty base might be for Qualcomm going forward. But again, we define wide-moat companies as generating excess returns with near certainty, and we don't have near certainty on how a regulator might rule against or in favor of Qualcomm.

We still think Qualcomm's IP is very solid. They have exceptional IP that has allowed them to get 3% to 5% of the price of the phone everywhere else for the past few years, and we think that will continue for the next decade or even 20 years. But because we view wide-moat stocks as being companies that will generate excess returns with near certainty, we can't rate Qualcomm's moat as wide because the regulatory outcome is naturally hard to predict.

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