Qualcomm: Higher Smartphone Penetration Will Trump Royalties Decline

The growing rate of smartphone penetration around the world has left many Qualcomm (NASDAQ: QCOM  ) investors worried that the trend will eventually lead to lower smartphone ASPs, or Average Selling Prices, and, consequently, lower royalties for the giant chipmaker. Investors are also worried that growing competition in the 4G LTE space will eventually lead to lower revenue for market-leading Qualcomm.

Lower prices, higher volume
These concerns are understandable given that BI Intelligence estimates that one in five people around the world owns a smartphone, up from just one in 20 a few years ago. Royalties collected from smartphones that use Qualcomm's patented 3G technology are no doubt a big gravy train for the tech firm. The royalties are usually based on the prices of the handsets, meaning that if prices drift lower, the firm's royalties collected per phone will inevitably fall. This is the biggest concern holding the stock price down in the current bull market.

But, what these investors are failing to see is that, despite the impressive growth in smartphone ownership, there is still plenty of room to run. As the value proposition of 3G smartphones improves due to falling prices, many people who own low-priced feature phones will eventually trade up to low-end smartphones. The Gartner Group estimates that 1 billion smartphones will be shipped in 2013, for the first time overtaking feature phone shipments.

Growth in smartphone shipments is expected to be around 17.6% per annum from 2013-2018. At that kind of growth rate, about 45% of the world's population will own a smartphone by 2018, up from the current 20%. The relatively higher ASPs of these commoditized lower-end smartphones (in relation to their lower-priced feature phone counterparts) will eventually offset, or even outpace, the decline in smartphone average selling prices. Higher smartphone volumes will eventually trump falling prices. Qualcomm bears could be dead wrong on this one.

4G LTE market challenges
But, that's just part of the story. Another common worry is that Qualcomm cannot maintain its first-mover advantage in 4G LTE technology in the face of growing competition from the likes of Intel (NASDAQ: INTL  ) , NVIDIA (NASDAQ: NVDA  ) and Broadcom (NASDAQ: BRCM  ) . NVIDIA and Intel have already achieved significant LTE compatibility with their respective app processors, while Broadcom is expected to follow suit after its recent deal with Renesas. MediaTek is an emerging market player that will launch its LTE solutions in a few months, and is expected to give Qualcomm a run for its money.

Qualcomm currently owns more than 95% of the nascent LTE market, and its near-monopoly has helped the company command premium pricing. This trend is likely to continue in the near-term. Qualcomm's chipset ASPs shot up from just $17 in 2010 to $24 by mid-2013. In the longer-term, however, it will be hard for the company not to cede some market share. Emerging market rivals, such as MediaTek, are likely to introduce lower-end LTE penetration and will serve a specific niche not reached by Qualcomm. As 4G becomes more mainstream, the gradual proliferation of 4G LTE handsets in a maturing market may lead to falling chipset prices, and will put pressure on Qualcomm's high margins.

The entry of China into the fray is likely to accelerate the process. The Chinese government is expected to hand out 4G LTE licenses by the end of 2013. Both China Telecom and China Mobile  (NYSE: CHL  ) have awarded infrastructure contracts to several vendors such as ZTE, Huawei, and Alcatel Lucent to build their LTE networks. China's foray into LTE will force handset manufacturers to develop phones that support 4G in lower-end smartphones as well. This will not only wrench some market share from Qualcomm, but also lower average LTE chipset prices. China Mobile is, however, likely to be the main game-changer that will more than offset the lower market share and lower LTE chipset prices for Qualcomm.

Addressable royalty market likely to increase
The negative impact of China's entry into the LTE business is likely to be offset by China Mobile's transition from its current non-industry TD-SCDMA standard to LTE. China Mobile is not only China's largest wireless carrier, but the world's too, with a 750 million-strong subscriber base, close to seven times the size of Verizon's subscriber base. Considering Qualcomm's overpowering lead in LTE patents, and its low presence in the TD-SCDMA standard, China's entry into 4G LTE will most likely work in its favor, giving the company a wider LTE royalty base.

Trefis financial analysts estimate that the gradual shift from 2G to 3G/4G will increase the global penetration of mobile devices that support 4G LTE from the current 50% to 65% in 2016. The current trend of higher adoption rates of low-end smartphones in emerging markets could further increase 3G/4G penetration to as high as 80% by 2018. Even if the ASPs of smartphones fall from the current $220 to about $150 in the next four or five years, the higher penetration rate of 3G/4G will eventually offset lower LTE chipset royalties for Qualcomm.

Bottom line
Higher smartphone ownership rates, especially in emerging economies, are more than likely to offset falling smartphone ASPs. The transition of China Mobile from the non-industry TD-SCDMA to 4G LTE is also likely to offset the lower LTE chipset prices for Qualcomm, accompanied by growing competition in the space. Overall, Qualcomm is more likely to benefit from these industry trends that, at first, appear to be potentially challenging.

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