Qualcomm (NASDAQ:QCOM) stock has fallen roughly 8% since it reported third-quarter fiscal 2017 results in mid-July showing how Apple (NASDAQ:AAPL) is hurting the company's business. Shares of the chip specialist are down roughly 20% this year, but investors should brace for more downside as its core licensing business is stumbling.
The licensing business is losing its sheen
Qualcomm's third-quarter revenue was down 11% year over year to $5.4 billion thanks to a 42% drop in sales from the Qualcomm Technology Licensing (QTL) business. This segment supplied almost a third of the chipmaker's business last year, but its contribution has now dropped to just 22%.
This is a big red flag for Qualcomm investors as the QTL business is its biggest money spinner, generating almost 83% of its earnings before taxes (EBT) in the prior-year period. But QTL's earnings before taxes dropped a massive 51% year over year to just $854 million during the third quarter, supplying around 59% of the EBT.
Furthermore, the company's EBT as a percentage of revenue dropped from 87% in the third quarter of fiscal 2016 to 73% this time around, indicating that Qualcomm might be settling for lower royalties as the QTL business comes under pressure.
More problems ahead
Apple has taken issue with the fact that Qualcomm gets a larger licensing royalty from premium smartphones due to its percentage-based system. A cheaper phone with the same wireless capabilities will be charged a lower royalty, but Qualcomm gets to enjoy bigger royalty streams from more expensive smartphone features such as a bigger storage or a larger display, though it has nothing to do with them.
Apple is expected to equip its upcoming iPhones with OLED displays, which would have contributed significantly to Qualcomm's coffers given their expensive nature, except that Apple stopped paying Qualcomm royalties in a dispute that remains ongoing.
It's also possible Apple will favor using more of Intel's cellular modems for its upcoming iPhone generation. The current iPhone 7 models use both Qualcomm's and Intel's cellular modems, but the dispute is likely to switch the momentum in the latter's favor.
What's even more alarming is that Apple could be building its own cellular modem.
Apple also has opened a can of worms for Qualcomm as other companies have started questioning the chipmaker's royalty agreements. Samsung, for instance, has leveled allegations that Qualcomm is blocking the South Korean giant from selling its Exynos smartphone processors to smartphone OEMs (original equipment manufacturers).
Additionally, Intel has decided to join the fight against Qualcomm, alleging it has forced smartphone OEMs into "purchasing the chipsets they need from Qualcomm and Qualcomm alone."
It seems likely Qualcomm will end up coming out with a new royalty structure and this could eventually throttle the company's licensing revenue and dent its biggest source of profit.