Shares of Qualcomm (NASDAQ:QCOM) slid 8% to a multi-year low on Jan. 28 after the company issued soft guidance for its second quarter and disclosed that South Korean mobile giant LG (NASDAQOTH:LGEAF) was disputing its wireless licensing fees. That's bad news for Qualcomm's QTL business, which owns 3G and 4G patents which allow it to take a 3% to 5% cut of the wholesale price of every smartphone shipped worldwide.
Last quarter, the QTL business generated 28% of GAAP revenue and 78% of pre-tax earnings. However, revenue fell 12% annually, while pre-tax earnings declined 15%. Let's take a closer look at the reasons for those declines, and whether or not Qualcomm can stop the bleeding at its most profitable business.
The fundamental problems with QTL
When the smartphone market exploded after Apple launched the iPhone in 2007, few OEMs thought twice before paying Qualcomm its licensing fees. But as competition increased and the market became commoditized, margins plummeted among Android handset makers. Last year, Canaccord Genuity estimated that Apple's high-margin iPhones had swallowed up 94% of the entire smartphone industry's profits despite only controlling 14% of the market.
This means that Android leaders like Samsung (NASDAQOTH:SSNLF), Xiaomi, Huawei, and LG are desperately fighting off around a thousand other OEMs for a shrinking share of the remaining profits. The situation is dire -- last year, LG reported that it only made 1.2 cents in profit for each smartphone shipped. To beef up those margins, smartphone makers fought back against Qualcomm's license fees.
Government regulators started to back their domestic smartphone makers. Last year, China fined Qualcomm $975 million for anticompetitive practices, and the company agreed to collect royalties based on only 65% of the net selling price of a handset, which was slightly lower than the wholesale price. But even after that ruling, many Chinese OEMs underreported shipments to pay Qualcomm lower licensing fees.
To make matters worse, regulators in South Korea and Taiwan launched similar probes into Qualcomm's licensing practices. If Qualcomm is forced to lower fees in those two markets, QTL revenue will take a big hit -- China, South Korea, and Taiwan generated 82% of its total sales in fiscal 2015.
Best and worst case scenarios
Qualcomm expects QTL revenue between $7.3 billion and $8.0 billion for fiscal 2016, which would represent an 8.1% decline to a 0.7% gain for the year. Qualcomm stated that the high end of the range assumes that it makes "meaningful progress" in signing new agreements with OEMs in China to resolve underreporting issues. The low end of the guidance assumes that the number of unreported devices in China will rise and that Qualcomm makes "little to no progress on signing new license agreements or amendments".
That guidance notably doesn't take into account the new dispute with LG. Qualcomm states that while the "claims are without merit", a resolution might not occur until after fiscal 2016 ends. If that happens, Qualcomm expects its full-year QTL revenue to "be affected by several hundred million dollars", which could dramatically reduce the unit's year-over-year growth.
However, it's unlikely that Qualcomm will make "little to no progress" with Chinese OEMs. Qualcomm recently signed new agreements with Xiaomi, Haier, QiKu, and Tianyu, indicating that progress was being made. During last quarter's conference call, Qualcomm president Derek Aberle stated that the company still needed to "conclude agreements with a handful of key Chinese OEMs" but didn't mention any companies by name. These holdouts reportedly include leading Chinese OEMs Lenovo and Huawei.
What needs to be done
In addition to regulatory challenges, several of Qualcomm's oldest CDMA patents already started expiring in 2010. Qualcomm has updated its portfolio by developing new wireless technologies, acquiring smaller companies, and buying patents directly from companies, but it could have a tough time justifying those expenses if the QTL business keeps fading. For now, all Qualcomm can really do is secure more agreements in China, resolve the issue with LG, challenge the probes in South Korea and Taiwan, and hope that other similar probes don't pop up.
Looking ahead, Qualcomm needs to reduce the weight of the QTL business on its top and bottom lines. To do this, Qualcomm is expanding the chipmaking (QCT) business into new markets like drones, connected cameras, connected cars, and data centers. The recent launch of the Snapdragon 820 and its renewed partnership with Samsung should also strengthen the QCT's core mobile business.
Qualcomm expects the QCT business to only post "low to mid-single digit" operating margins in the second quarter, but it expects its pre-tax earnings to improve in the second half of 2016. That growth definitely won't offset QTL's weight on the bottom line, but it might soften the blow of more bad news throughout the year.
Leo Sun owns shares of Qualcomm. The Motley Fool owns shares of and recommends 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.