Qualcomm (NASDAQ:QCOM) is well known as a leading provider of smartphone-oriented chips, including applications processors, cellular modems, and connectivity. Its technology is used in many of the latest smartphones, including the wildly popular Apple (NASDAQ:AAPL) iPhone family of phones, as well as in many major flagship devices that run Google's (NASDAQ:GOOG) (NASDAQ:GOOGL) Android.
Interestingly, though, the huge success that Apple has seen in capturing market-segment share in high-end smartphones has had a negative impact on the chip giant. Let's take a closer look at why that is.
Let's talk about chip content
A modern smartphone is filled to the brim with chips, which is why the smartphone revolution has been a major boost for many chip companies. Two of the most important chips inside a modern smartphone are the applications processor and the cellular baseband.
Qualcomm has, arguably, the best cellular modem technology today and, at least as far as merchant silicon goes, has leadership in applications processors. This means that for flagship devices from vendors that don't design their own chips (such as Apple), Qualcomm generally gets both the applications processor and baseband spots, usually in the form of a single integrated solution.
In addition to these big-ticket items, a baseband win for Qualcomm often means that additional content comes along for the ride, such as an RF transceiver and even an audio codec chip.
Taking a closer look
To get a sense of what I've described, let's look at the teardowns of Apple's latest iPhone 6 and the LG G4, a top-tier Android flagship phone.
In iFixit's iPhone 6 teardown, the site reported finding the following Qualcomm chips:
- Envelope tracking chip
- Power management chip
- RF transceiver and companion chip for carrier aggregation
iFixit's teardown of the G4 reveals the following Qualcomm-developed chips:
- Snapdragon 808 processor (combines applications processor and modem)
- Two power management chips
- RF Transceiver
- Audio codec
It's pretty clear that Qualcomm is providing more chip value into the LG G4 than it is into the iPhone 6, especially since Apple designs its own applications processor, and I suspect that this holds true for many of the Qualcomm-powered Android flagships relative to the iPhone 6.
Further, given that Apple tends to buy chips in extremely high volumes (and is known for its hardball supplier negotiation tactics), sales to Apple of a particular component might represent lower-margin business than sales to a non-Apple vendor.
What has been the impact to Qualcomm's business as a result?
On Qualcomm's most recent earnings call, management indicated that "share concentration in the premium tier affected demand for certain OEM devices that use [Qualcomm] chipsets more than our previous expectations."
In other words, share shift toward Apple's iPhone -- and, potentially, toward the Samsung (NASDAQOTH:SSNLF) Galaxy S6, which uses a Samsung-developed processor and, in some regions, a Samsung modem -- meant fewer sales of devices such as the LG G4.
This share shift, according to Qualcomm, has led to a situation in which Qualcomm's customers need to adjust their own inventory levels downward to be more in line with demand, driving down demand for Qualcomm processors.
Qualcomm's cost cuts make sense
The high end of the mobile-processor market is typically more lucrative than the lower end, where average selling prices are lower and there's more competition.
With the high end of Qualcomm's business now seeing pressure from the success of Apple's iPhone (and there's no sign that Apple is going to drop the ball anytime soon), as well as the loss of the applications processor spot in the Galaxy S6, it shouldn't come as a surprise that the company is trying to bring down its cost structure to align with a future in which the high end of the market remains difficult for merchant chip vendors.
The good news, though, is that Qualcomm executives have signaled that it plans to bring operating margins of its chip business up to at least 16% by the fourth quarter of its fiscal 2016, up from the 2-4% it expects in the fourth quarter of fiscal 2015.
These expectations, per Qualcomm CFO George Davis, do not "assume the potential upsides from market improvement or recovery of premium tier share at a leading vertical OEM."
I'll be keeping a close eye on the progress that Qualcomm makes in expanding the operating margins of its chip business.
Ashraf Eassa owns shares of Qualcomm. The Motley Fool recommends Apple, Google (A shares), Google (C shares), and Qualcomm. The Motley Fool owns shares of Apple, Google (A shares), Google (C shares), 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.