Qualcomm Inc. (NASDAQ:QCOM) develops and patents mobile phone communication technologies, such as CDMA/WCDMA (3G technology) and OFDMA (LTE/WiMax technologies), which it then licenses to tablet and mobile phone manufacturers. These mobile phone manufacturers make phones that utilize Qualcomm's technologies and operate on networks based on these technologies. Qualcomm charges royalties on each handset sold based on its technology in addition to one-time licensing fees from handset vendors. Apple (NASDAQ:AAPL), Samsung (OTC:SSNGY), Nokia (NYSE:NOK) and LG (OTC:LGEAF) are some of its key customers.
Qualcomm is the leading patent holder in advanced 3G mobile technologies, which has allowed the company to charge high royalty rates in the past. With over 250 licensees, its CDMA patent portfolio is the most widely and extensively licensed portfolio in the industry. In the past, Qualcomm has been in a tiff with Nokia and India's Reliance over high royalty rates charged by it. The average royalty rate that Qualcomm charges mobile handset vendors has declined gradually over the past few years, as the average selling price of CDMA mobile phones continue to decline and carriers transition to higher-speed 4G networks, where Qualcomm does not have a strong position.
The company's average royalty rate of mobile devices based on its technology declined from 4.3% in 2008 to 3.2% in 2013. We estimate the figure to continue declining over our forecast period, albeit at a slower pace.
Our price estimate of $73.86 for Qualcomm is at an approximate 10% discount to the current market price. Mobile device royalties account for over 45% of our valuation.
Emerging Markets Leading Growth; Lower ASPs To Impact Royalty Rate
The high-end mobile market in developed markets has become largely saturated amid efforts by carriers such as Verizon (NYSE:VZ) and AT&T (NYSE:T) to control subsidies and boost margins. Last quarter, Verizon and AT&T reported a combined decline of almost 17% in smartphone activations over the same period in 2012. As smartphone demand in developed markets nears its peak, handset makers are shifting their focus to cost-sensitive emerging markets such as China and India, among others. Emerging economies have very low 3G/4G penetration, and carriers there are intent on driving data usage through smartphones.
According to IDC, smartphone sales in China increased by 67% annually, to reach 350 million in 2013, accounting for 35% of the world market. That figure is expected to increase by another 30% to 450 million this year, mainly driven by rising demand for low-cost devices.
The average selling price (ASP) of mobile phones is lower in emerging markets, which translates to lower royalty revenue per phone (royalties are based on the price of the handset). In Q1 2014, the 3G/4G device ASPs declined by almost 4% sequentially and over 2.3% annually.
Lower Royalty For 4G-LTE Technology
Qualcomm does not have the same dominant IP portfolio in 4G technologies like LTE as it has in the CDMA network technology. The company believes that it might not be able to achieve the same royalty revenues on OFDMA-based LTE technology, as it enjoyed in CDMA-based technologies. Qualcomm's royalty rate for LTE-only is about 125 basis points lower than for 3G. As the industry transitions from the 3G to 4G technology, Qualcomm's average royalty rate will come under pressure.
The gradual shift from 2G to 3G/4G will increase the global penetration of mobile devices that support 4G LTE from the current 50% to 65% in 2016. The rising adoption of low-end smartphones in emerging markets could further increase 3G/4G penetration to as high as 80% by 2018.
In Q2 2014, 3G CDMA device sales in China suffered ahead of an anticipated LTE ramp-up at China Mobile (NYSE:CHL), which caused retailers to aggressively burn through TD-SCDMA inventory in preparation for the transition. As a result, Qualcomm's licensing revenues took a hit, growing by less than 1% over the same period last year.
Wider Royalty Base Can Offset The Declining ASPs
The expanding smartphone user base can counter the negative impact of declining ASPs on royalty rates to some extent, in our view. BI Intelligence estimates that globally one in five cell phone owners has a smartphone, up from less than one in 20 just a few years ago. The current penetration rate is still quite low and thus there is plenty of room for growth. Gartner estimates smartphone production wil rise about 60% between 2013 and 2016.
As the average smartphone price declines, low-priced feature phone subscribers will find it worthwhile to trade up to low-end smartphones. Smartphone (even low cost ones) offer higher ASPs as compared to feature phones. Thus, Qualcomm will eventually benefit from an incresing number of people switching over to smartphones, enhancing its total royalty base. Higher sales volume can offset (to some extent) the negative impact of declining average smartphone ASPs.
China Mobile's Policy Reversal To Benefit Qualcomm
China Mobile recently reverted its initial policy of procuring 4G terminals with support for both TDD- and FDD-LTE, and now plans to only sell five-mode 4G handsets. The move benefits Qualcomm as its five-mode handsets carry higher royalties than three-mode handsets.
Qualcomm, which has the most mature and widely used portfolio of five-mode chipsets, should benefit from a near-term spurt in baseband demand from China Mobile as local players ramp up five-mode production. More importantly, it removes the risk of three-mode replacing five-mode as the more widely sourced standard at China Mobile, making it easier for Qualcomm to collect royalties on handsets that support global standards. Since Qualcomm doesn't have a strong presence in TD-SCDMA and its royalty rates for LTE are lower than 3G WCDMA, China Mobile's continued acceptance of 3-mode would have meant handset makers paying lower licensing fees to Qualcomm, at closer to LTE-only rates.
The negative impact of China's entry into the LTE business is likely to be offset by China Mobile's transition from its current non-industry TD-SCDMA standard to LTE. China Mobile is not only China's largest wireless carrier, but the world's too, with a 750 million-strong subscriber base, close to seven times the size of Verizon's subscriber base. Considering Qualcomm's overpowering lead in LTE patents, and its low presence in the TD-SCDMA standard, China's entry into 4G LTE will most likely work in its favor, giving the company a wider LTE royalty base.
However, Qualcomm's anti-monopoly probe in China could curtail its ability to impose licensing fees and limit its upside from the country's 4G transition. We will monitor this closely.
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Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.