Licensing Digs Moat for Qualcomm

We expect

Qualcomm is first and foremost the steward of the digital communication technology known as CDMA, which is commonly referred to as a third-generation, or 3G, wireless communications standard. 3G allows devices to send and receive voice signals and wireless data and has played a major role in the proliferation of mobile devices. Qualcomm’s treasure trove of patents (with a monopoly in 3G and a significant portion of 4G) allows the firm to charge device makers a royalty fee as a percentage of the price of each 3G and 4G device sold, as most 4G phones are backward compatible with 3G.

In addition to licensing its intellectual property portfolio, the firm designs chips used in smartphones. This part of the business does not have nearly as strong of a competitive advantage as licensing, nor is it as profitable. Qualcomm’s high-end Snapdragon application processors were once commonplace in high-end smartphones, but the shift toward in-house chips has threatened this position. The major blow occurred when Samsung used internally developed chips in its Galaxy S6 device. While Qualcomm has reclaimed some business at Samsung, there will be fewer lucrative opportunities going forward, owing to competition and original-equipment manufacturers that build their own chips. The firm also historically had a competitive edge in baseband chips, which are critical to devices’ inherent ubiquitous connectivity. Qualcomm had been the sole baseband supplier at Apple for multiple iterations of the iPhone, but Intel INTC has since won a portion of this business. Qualcomm is acquiring NXP Semiconductors, which we expect to significantly diversify its revenue sources.

Royalties Are High Margin but Under Fire Our narrow economic moat rating stems from intangible assets and is based on our outlook for Qualcomm's ability to collect royalties over the next decade. With a near monopoly on CDMA technology patents, Qualcomm is able to charge a royalty fee as a predetermined percentage (3%-5%) of the price of each 3G device sold. With all 3G wireless networks based on CDMA technology, as well as most 4G phones having backward compatibility with 3G, we expect the firm to earn significant royalty fees over the next decade and probably beyond. As a whole, this revenue stream has 85%-plus operating margins. Accounting for almost three fourths of operating income, the licensing business is the primary driver of Qualcomm's economic moat.

With respect to 4G, the firm holds many essential patents for the relevant OFDMA technologies but not to the same extent as in 3G. However, we expect Qualcomm to earn comparable royalty rates on pure 4G devices, factoring in additional nonessential patents (faster speeds, network improvements, and so on). By company estimates, more than 95% of 4G handsets in the market will still be backward-compatible with 3G in 2018. It remains to be seen how 5G will be defined (new technology or improved 4G), but we anticipate persisting compatibility with 4G and potentially 3G networks whenever 5G may come to fruition. We project Qualcomm will be able to collect some form of royalty on a substantial majority of smartphones for at least 10 years, if not 20.

Our concerns regarding the firm’s moat are based on the recent run of regulatory investigations into Qualcomm’s royalties. Inquiries have revolved around whether Qualcomm’s royalties should be based on the price of the entire phone or a lesser base, such as the total price of all cellular components (baseband, radio frequency, and antennas in the device). In 2015, the Chinese government concluded that Qualcomm’s IP is valuable enough to justify ongoing royalty payments, albeit based on only 65% of the price of the phone.

More recently, the Korea Fair Trade Commission concluded that certain business practices related to Qualcomm’s licensing agreements violate South Korean competition law. In addition to a fine of KRW 1.03 trillion (approximately $868 million), the KFTC intends to issue a corrective order relating to the practices in question; this order has yet to be disclosed, and Qualcomm is expected to appeal it. Repercussions of this ruling have propagated, as in January 2017 the U.S. Federal Trade Commission filed a complaint charging Qualcomm with using anticompetitive tactics to maintain its monopoly in the supply of its baseband chips used in smartphones. The complaint stated that by threatening to disrupt smartphone manufacturers’ supply of baseband processors, Qualcomm receives excess royalties for its standard essential patents that enable cellular connectivity. These royalties allegedly deter competition and elevate costs. Given that two decades of industrywide precedents of royalties are based on the full price of the phone, we think Qualcomm will ultimately be able to successfully defend itself (likely with a similar ruling as in China), facing fines as the predominant consequence.

Following the U.S. FTC complaint, Apple sued Qualcomm after the latter allegedly demanded unreasonable terms for its technology and withheld $1 billion in rebate payments in retaliation for Apple cooperating with the KFTC investigation of Qualcomm’s licensing business. On the chip side of Qualcomm’s business, Apple alleges it had been receiving quarterly rebates for exclusively using Qualcomm modem chips in iPhones. However, this dynamic shifted as Apple began using Intel modems for a portion of its iPhone 7 device, while also meeting with Korean and U.S. regulators in 2016 to discuss Qualcomm’s licensing practices. Qualcomm now faces a high risk of being completely designed out of future Apple iPhones for the baseband chip, though its modems have been historically superior to Intel’s offerings in certain geographies where 3G CDMA networks are prevalent, such as with Verizon in the United States.

We expect lengthy legal battles on multiple fronts as regulatory agencies and major customers alike seek to diminish Qualcomm’s lucrative royalties. While these could ultimately lead to certain revisions in royalty calculation methods, we still expect Qualcomm to withstand the attacks on its business model and continue collecting licensing revenue.

Although Qualcomm also boasts patents in noncellular areas of the device that it believes would be strong enough to extract royalties from device makers in isolation, it remains to be seen if this is plausible. This additional IP is claimed to encompass the application processor, graphics processor unit, near-field communication, sensors, camera, audio processing, and other areas. Should royalties shift from the price of the phone (currently $200 on average) to the price of cellular components with the phone (roughly $50), we are skeptical that Qualcomm would be able to leverage its noncellular patents to capture a higher royalty base (say, between $50 and $200).

NXP Deal Strengthens Moat The recently announced NXP Semiconductors acquisition, expected to close by the end of calendar 2017, will allow Qualcomm to leverage its chip design and connectivity expertise in the automotive and Internet of Things areas. As a leading semiconductor supplier to the automotive space, NXP already boasts a leadership position in infotainment, in-vehicle networking, and radar and safety systems. For example, NXP's solutions are designed into 14 of the top 15 infotainment customers in 2016. With multiyear design cycles and deep customer relationships acting as barriers to entry, Qualcomm will be able to leverage NXP's business with carmakers to expand its processor business into the car, in our opinion. This strategy is in line with the rise in connectivity and computing prowess that is propagating from luxury vehicles more broadly across the market. Consequently, the combined firm would be well positioned to benefit from the proliferation of advanced driver assistance systems and the incremental steps toward fully autonomous vehicles.

A broad-based portfolio of microcontrollers positions NXP well for the burgeoning Internet of Things phenomenon. However, in our view, it is its global network of distribution channel partners that will help Qualcomm unlock substantial synergies in expanding the addressable market beyond the mobile domain. Additionally, NXP is a leader in near-field communication used in security cards and more notably the Apple iPhone for uses such as mobile payments. This technology could allow Qualcomm to expand its content in devices, subsequently increasing the switching costs for customers, should it successfully further integrate the processors it already sells into smartphones.

With firms tethered to the maturing smartphone market looking for growth elsewhere, we think the diversification benefits of the deal signify the biggest positive of Qualcomm-NXP as a combined company. Furthermore, we believe the deal will strengthen Qualcomm’s narrow moat rating.

Reduced Royalty Rates Could Hurt, but Cash Flow Allows for R&D We assign Qualcomm a high fair value uncertainty rating, as its chip business faces the risk of continued share loss and its licensing business faces the threats of reduced royalty rates and collection issues. The vertical integration trend implemented by leaders Apple and Samsung is beginning to propagate to the second tier of smartphones, which is an area Qualcomm has heavily relied on in recent years. Should all major high-end OEMs use only in-house application processors, Qualcomm's chips would be relegated to lower-priced handsets that would curb chip margins. Additionally, Intel improved its baseband chips to the point that they were featured in some iPhone 7 units and could garner greater share in future iterations. Regardless of how technically superior its designs are, Qualcomm is running out of lucrative opportunities on the chip side. In licensing, we're most concerned about the South Korea and U.S. FTC lawsuits, as they may conclude that royalties should be based not on the entire price of the phone, but on some lesser amount. If this were to be upheld and implemented worldwide, Qualcomm's licensing revenue would face a steep decline.

Qualcomm has a healthy balance sheet. In addition to a solid dividend of $0.53 per quarter, the firm returned just over 100% of free cash flow during fiscal 2016. This amounted to share repurchases of $3.9 billion and dividends of $3 billion. Qualcomm’s 4% dividend yield is above average in the semiconductor industry.

As the licensing business is the strongest cash-generating segment of the firm and becomes a larger source of total revenue, we believe Qualcomm will be able to maintain a large cash cushion. This will allow it to fund research for new products or additional acquisitions, all while enabling the firm to navigate the peaks and troughs commonplace in the semiconductor industry.