Royalties Trouble Ahead for Qualcomm?

As smartphones become more ubiquitous around the world, their average selling prices, or ASPs, are likely to fall.This will mean lower royalties for Qualcomm for every smartphone sold, since it collects a certain percentage of royalty for every smartphone that uses its chips.But the higher volume of smartphones sold, and the transition of China to LTE, will help offset the lower prices.

Mar 8, 2014 at 4:00PM

Lower prices, higher volumes
Smartphone chip royalties are a huge gravy train for Qualcomm, and one that it would like to keep intact. Although the smartphone market has been growing at a blistering pace, it's still at its infancy and there are still many more years of growth ahead. As the value proposition of higher-end smartphones improves with falling smartphone prices, many lower-income demographics, especially in the emerging economies, will eventually trade up their low-priced feature phones for low-end smartphones. This phenomenon is already taking place.

Gartner estimates that smartphone shipments will grow at 17.6% per year through 2018. At that rate, roughly 45% of the world's population will own a smartphone by 2018, up from just 22% currently. Low-end smartphones have a higher ASP than the average feature phone. This, together with the higher smartphone penetration rate, will very likely offset the falling ASPs of smartphones for Qualcomm.

Can Qualcomm maintain baseband chipset lead?
Qualcomm has a 95% global revenue share of the LTE market. The firm's huge lead in the this market has enabled it to command premium pricing.  Qualcomm's chipset ASP's shot up from $17 to $24 last year.

Firms such as Nvidia and Intel have achieved significant LTE compatibility with their app processors. MediaTek also recently announced their first 64-bit LTE chipset to compete with Qualcomm's 64-bit Snapdragon 410 chips in the mid-range market. It will, therefore, be difficult for the firm to maintain the extremely high LTE market share going forward. It's latest results have proved, beyond a shadow of doubt, that its revenue growth is slowing down—10% last quarter vs. 30%+ in the previous three years or so.

Therefore, going forward, Qualcomm will see slower top and bottom-line growth, primarily because it's up against so much competition from top chip manufacturers. Its chipset ASPs are also likely to come down since it will no longer enjoy the near-monopoly status it has commanded in this market for the last few years.

Huge Chinese market
The transition of China's largest wireless carrier China Mobile (NYSE:CHL), from the non-industry TD-SCDMA to LTE is likely to have both positive and negative impacts on Qualcomm. For one, more handset manufacturers are highly likely to start building 4G chipsets that support lower-end smartphones targeted at the Chinese market.This might mean lower market share for Qualcomm.

Qualcomm is currently facing regulatory troubles in China over allegations that it charges higher royalties there than in other countries. This can potentially be problematic for the company since it earns close to half of its revenues there -- 12 billion in fiscal year 2013, mostly from licensing and selling chipsets to players such as Apple. If the Chinese Government rules that Qualcomm is guilty of the malpractice, then it could be looking at a fine of 1% to 10% of its revenue in China.

Despite these headwinds, the transition to LTE by the Chinese is also one of Qualcomm's largest opportunities. The Chinese market is simply massive-- China Mobile has about seven times more customers than Verizon. The LTE market will significantly increase Qualcomm's addressable royalty base, which will mean higher revenue.

Returns to shareholders
It's worth mentioning that Qualcomm sports one of the best returns to shareholders among the tech sector. In fiscal 2013, the company paid out 86% of its free cash flow as dividends, equal to $2.1 billion, and a further $4.6 billion in share buy backs.

Qualcomm's former CEO Paul Jacobs vowed last September to return 75% of the company's free cash flow in fiscal 2014 to shareholders via dividend payouts and share buybacks. The current CEO Steve Mollenkopf has not offered any changes to those guidelines since his inauguration.

Bottom line
Although the ASPs of smartphones is expected to gradually fall from around $220 to $150 in the next five years, the higher smartphone penetration in China and the emerging economies is more than likely to offset the lower prices, hence Qualcomm overall royalties should not be negatively affected to any large degree.

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Joseph Gacinga has no position in any stocks mentioned. The Motley Fool recommends Apple and Nvidia. The Motley Fool owns shares of Apple, China Mobile, and Qualcomm. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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