Qualcomm (NASDAQ:QCOM) develops and patents various mobile phone communication technologies such as CDMA/WCDMA and OFDMA, which it licenses to mobile phone and tablet manufacturers. Qualcomm charges royalties on each handset sold based on the technology used, plus a one-time licensing fee for handset vendors such as Apple (NASDAQ:AAPL), Nokia, Samsung, and LG.
Qualcomm is the leading patent holder in advanced 3G mobile technologies, with more than 250 licensees in its CDMA portfolio, of which more than 175 are WCDMA/TD-SCDMA-related. The company also licenses more than 90 single-mode OFDM/OFDMA licensees.
Qualcomm's royalty is an extremely important segment for the company. Although royalties make up just 30% of its overall revenue, the segment's very high operating margin -- 85% vs. 17% for the chip business -- means that it contributes two-thirds of the company's overall operating profit.
Qualcomm collects a certain percentage of the wholesale selling price of mobile phones that utilize its technologies as royalties. The company is, however, facing a conundrum due to two major headwinds: the falling ASP of smartphones, and the gradually declining royalty rate of mobile devices. For instance, Qualcomm collected royalties of roughly 4.3% of mobile phone sales that used its technologies in 2008. In 2013, however, that rate had fallen to just 3.2%. Additionally, smartphone ASPs have been in a freefall across the board.
At first glance, this trend looks quite alarming, as it threatens Qualcomm's gravy train. But, taking a peek into what's really happening behind the scenes, it's clear that Qualcomm is not in any immediate danger of seeing its overall royalties diminish.
Growth in 3G/4G smartphone shipments to remain fairly strong
The high-end mobile market has become largely saturated. For instance, Verizon and AT&T, America's largest mobile carriers, reported a combined decline in smartphone activations of almost 17% in the final quarter of fiscal 2013, compared to a similar period in the previous year. Additionally, the ASP of mobile devices that use Qualcomm technology has been declining since 2013.
The good news, however, is that the slack in smartphone sales in developed economies is being taken up by higher sales in developing economies such as China. According to IDC, smartphone sales in China grew 67% in 2013 to 350 million. China accounts for 35% of the world's smartphone shipments, and IDC predicts that China smartphone shipments will grow another 30% in the current year.
3G/4G smartphones typically command higher ASPs than 2G smartphones. As the value proposition of higher-end smartphones continues to improve alongside falling prices, more people in developing economies are trading up feature phones for smartphones. Mobile phones around the world are also rapidly transitioning from 2G to 3G/4G. Cisco estimates that by 2018, only 26% of the world's mobile devices will run on 2G networks, down from 68% in 2013.
Global Mobile Devices Connections -- 2G, 3G, and 4G
The transition to 4G networks, however, could be troublesome for Qualcomm, since the company does not enjoy the same dominant IP portfolio for 4G technologies that it does with CDMA. Additionally, Qualcomm's LTE royalty rate is lower than 3G, although it's not clear by what margin.
But, Cisco estimates that only 15% of smartphones will run on 4G networks by 2018, compared to almost 60% on 3G.
Although Qualcomm estimates the growth in global 3G/4G shipments will slow down in 2014 compared to previous years, it will still clock in around 11%-18%, which is a respectable clip.
Higher smartphone shipments trump falling smartphone ASPs
Smartphone shipment volumes will likely outstrip the rate at which smartphone prices fall over the next several years. Smartphone ASPs for all major mobile OSs, apart from BlackBerry, fell sharply in 2010-2013. The IDC, however, predicts that the ASP decline will slow down going forward.
That's quite encouraging for Qualcomm and smartphone vendors. But, better still, smartphone shipments are expected to grow at a faster clip than the rate of smartphone ASP decline through 2018, again according to IDC.
All major OSs will see falling smartphone ASPs in 2014-2018. The ASP of iPhones will fall the least, while Windows smartphones will fall by the largest margin. The smartphone ASP for all mobile OSs will fall at a CAGR of 5% in 2014-2018. However, this will be offset by an 11.5% CAGR in smartphone shipments over a similar period, leading to an overall 6.5% CAGR in smartphone sales.
Qualcomm remains the leader in smartphone application processor manufacturing, with 54% of the market compared to 16% for second-placed Apple.
In the first quarter of fiscal 2014, Qualcomm reported better-than-expected results. Revenue from its CDMA business grew 12% year over year to $4.62 billion, while licensing revenue grew 8% to $1.9 billion.
In the second quarter, however, investors were disappointed when the company missed the mean analysts' revenue forecast of $6.47 billion, posting revenue of only $6.37 billion. The company, however, posted good MSM chip shipments, which grew 9%, while licensing revenue remained relatively flat at $2.138 billion due to slow rollout of LTE smartphones in China.
Although Qualcomm's mobile device royalties showed minimal growth in the last quarter, the long-term outlook remains good. Growth in smartphone shipment volumes is likely to outstrip the rate at which smartphone prices fall over the next several years.
Joseph Gacinga has no position in any stocks mentioned. The Motley Fool recommends Apple. The Motley Fool owns shares of Apple 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.