David Rolfe of Wedgewood Partners Comments on Qualcomm
However, their lucrative competitive position is under attack on quite a few fronts. At the high end, concerns over global smartphone saturation has dampened growth expectations. At the ultra competitive low end of the smartphone market (more akin to richer features in more traditional cell phones) where integrated semiconductor chips can sell for as little as $10, the Company has a more difficult time differentiating their chips from other suppliers – most notably Asian supplies.
While the Company maintains a healthy +30% market share in the low end, Mr. Market, in our view, is convinced that a collapse in the Company's average selling price of their chips and chipsets is imminent. The Company has long raged such battles. Over the past ten years, the range of smartphone average selling prices (ASP) has remained relatively steady between $190 and $220. Over the past few ye ars, the Company's royalty rates have been based on smartphone ASP of approximately +$210. We expect a sentiment change on ASP pricing as Apple (a key Qualcomm base band chip client) rolls out a refreshed iPhone lineup later this year. Indeed, while the iPhone 4 and iPhone 4S still sell briskly in the millions of units, these two smartphones are positively geriatric at 21 and 36 months old, respectively. That said, a prospective drop of 10% in ASPs to $195 over the next few years a foregone conclusion as the Company has said as much the question is whether or not volume will pick up, in proportion, to offset the ASP decline.
Qualcomm's licensing revenue is typically a function of device ASPs and volume. We view ASPs as a double edged sword and as a result, over the long er term, should exhibit a flat to slightly declining trajectory. As the value proposition of smartphones become more attractive due to lower prices (compared to smartphone prices just a few years ago), we expect low priced feature phone subscribers will ultimately trade up to low end smartphones with higher ASP's, relative to their feature phone predecessors. In addition, given the highly commoditized nature of low end smartphones, we expect volume will closely offset, if not outpace average selling price declines. On the "high end," we think spectrum innovation from Qualcomm and telecom operators will drive a continued desire by consumers to upgrade devices in order to take advantage of faster, more efficient networks.
In addition, fears of a rejuvenated Intel making inroads in the mobile processor space with their next generation Atom based mobile processors are also weighing on the shares. Lastly, concerns over declining royalty rates at the profitable patent licensing division are quite real down the road. As the smartphone market migrates from 3G/4G, then on to LTE only devices, royalty rates will no doubt decline. Even with declining LTE royalty rates, the Company still possesses best in class IP in apps processing, WiFi integration, power efficiency and smartphone carrier roadmaps to propel robust unit growth. The Company has over 300 devices approved, based on their LTE chips, and over 400 design wins on future LTE devices. Further, the industry research firms of Gartner and Strategy Analytics expect cumulative smartphone unit sales of approximately 5 billion from 2012 to 2016.
In summary, Qualcomm's competitive edge is its unrivaled patent portfolio of 3G and 4G air interface technologies. Around two thirds of the Company's consolidated operating profits are generated by licensing this technology to electronics manufacturers, most notably feature phones and smartphone OEMs, which seek to include cellular equipment in their devices. At $60 per share, the market implied growth rate of the company (revenues) is less than 10%, as well as assuming a 300 400 basis point decline in operating margins. Given that Qualcomm is our 5th largest holding, we certainly believe that the market is over discounting the concerns chronicled above.
From Wedgewood Partners second quarter 2013 investor letter.