Qualcomm (NASDAQ:QCOM) is the world's largest mobile chipmaker. Sales of its flagship Snapdragon SoCs (system on chips) generate most of its revenue, but the chipmaking (QCT) business faces tough headwinds over the next few years. Let's examine those challenges, and see how Qualcomm plans to counter them.

Understanding the key challenges

Over the past few years, Qualcomm lost market share to Taiwanese chipmaker MediaTek, which initially aimed for the low-end market with its cheaper ARM-based SoCs with integrated 4G modems and GPUs. MediaTek subsequently targeted the high-end market with its Helio chips, which were promoted as cheaper alternatives to Qualcomm's top-tier Snapdragon chips.

A Snapdragon 835 compared to a penny.

A Snapdragon 835 compared to a penny. Source: Qualcomm.

Qualcomm recently reclaimed some market share from MediaTek with the Snapdragon 835, the world's first 10nm mobile SoC, but many growing Chinese smartphone makers -- including Oppo, Vivo, and Xiaomi -- still use MediaTek's SoCs. As price expectations in the smartphone market continue dropping, other OEMs could favor MediaTek's cheaper chips over pricier Snapdragons.

Meanwhile, big OEMs like Apple (NASDAQ:AAPL), Samsung (NASDAQOTH:SSNLF), Huawei, and Xiaomi are producing their own first-party SoCs to cut both Qualcomm and MediaTek out of the loop. If other OEMs join that list, Qualcomm's chipmaking revenue could tumble.

Several companies and regulators also claim that Qualcomm uses its patent licensing (QTL) business to support its chipmaking one with anti-competitive strategies. A recent FTC lawsuit alleges that Qualcomm's ability to charge rival chipmakers licensing fees for wireless technologies made it impossible for them to match Qualcomm's chip prices.

How badly are these headwinds hurting Qualcomm?

These headwinds seem daunting, but Qualcomm's chipmaking business has been recovering on the strength of its flagship Snapdragon 835 SoCs, which power top-tier devices like Samsung's S8.

It's also gaining ground against MediaTek in low-end and mid-range devices with its 400 and 600 series chipsets. That's why its QCT revenue growth has held up fairly well over the past year.

 

Q3 2016

Q4 2016

Q1 2017

Q2 2017

Q3 2017

QCT Revenue

$3.9B

$4.1B

$4.1B

$3.7B

$4.1B

YOY growth

0%

14%

0%

10%

5%

Source: Qualcomm quarterly reports.

Moreover, the QCT unit's bottom line growth remains surprisingly resilient, even as the smartphone market is commoditized with cheaper devices:

 

Q3 2016

Q4 2016

Q1 2017

Q2 2017

Q3 2017

QCT EBT

$365M

$687M

$724M

$475M

$575M

YOY growth

26%

145%

23%

179%

58%

EBT = earnings before taxes. Source: Qualcomm quarterly reports.

Granted, that growth remains wobbly due to the aforementioned challenges, but it also indicates that Qualcomm won't lose its throne as the world's top mobile chipmaker anytime soon.

Investing in the future

Nonetheless, Qualcomm is already diversifying the QCT business away from mobile devices. First it launched special Snapdragon chipsets for connected cameras, drones, cars, wearables, and other gadgets to capitalize on the growing Internet of Things (IoT) market.

Qualcomm's chips power infotainment systems in Volkswagen vehicles.

Qualcomm's chips power infotainment systems in Volkswagen vehicles. Source: Qualcomm.

It also acquired IoT and automotive chipmaker CSR in 2015, and it's close to closing its acquisition of NXP Semiconductors (NASDAQ:NXPI), the biggest automotive chipmaker in the world.

Once that deal closes, Qualcomm's addressable markets will expand by about 40% to $138 billion by 2020. Qualcomm also recently launched high-end server chips to challenge Intel's near-monopoly in data centers. All these moves should widen its moat against its rival chipmakers.

The key takeaways

Qualcomm's chipmaking business has much lower margins than its licensing business, but it drives its top line growth. The QCT business also faces more manageable headwinds than the QTL business, which is currently besieged by lawsuits and demands to reduce its cut (up to 5% of the wholesale price) of smartphone sales.

However, the QCT business' decent growth can't fully offset the ongoing problems at the QTL business -- which posted a whopping 42% annual drop in revenues last quarter. That's why analysts still expect Qualcomm's revenue and earnings to respectively fall 2% and 6% this year.

Therefore, Qualcomm investors should keep following both business, but realize that the biggest threats to its long-term growth involve the licensing business instead of the chipmaking one.

Leo Sun owns shares of Qualcomm. The Motley Fool owns shares of and recommends Apple. The Motley Fool owns shares of Qualcomm. The Motley Fool recommends Intel and NXP Semiconductors. The Motley Fool has a disclosure policy.