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Here's How Qualcomm Makes Its Money

One company with a fairly unique business model is Qualcomm (NASDAQ: QCOM). It's very much a chip-making powerhouse as it is the leading merchant vendor of mobile applications processors with its Snapdragon family of chips. It also repurposes its core mobile chip technology to serve other markets, such as automotive, Internet of Things, and even personal computers. Qualcomm also has significant chip efforts beyond applications processors, such as RF front-end chips, 3D-sensing technology, and fingerprint scanners.

Qualcomm's chip business is known as Qualcomm CDMA Technologies, or QCT for short.

Image source: Qualcomm.

But Qualcomm is more than a chipmaker; it also licenses out its large and growing portfolio of wireless patents. Indeed, you might not realize that the company not only profits from selling chips into smartphones (and if you're reading this on an Android-based smartphone, the odds are good that it has a Qualcomm processor inside), but it also gets a cut of the selling price of each smartphone as a royalty payment.

That licensing business is called Qualcomm Technology Licensing, or QTL.

Let's take a closer look at just how each of these business units contributes to the whole of Qualcomm.

Chips drive revenue, but licensing drives profits

Historically, Qualcomm's chip business generated significantly more revenue than its wireless technology licensing business. After all, if the company receives a 3% cut on a smartphone that sells for $200, that's $6 in revenue, but selling an applications processor and related components into that same smartphone might yield something more on the order of $20 in revenue for the company.

Metric FY 2018 FY 2017 FY 2016
QCT revenue (in millions) $17,282 $16,479 $15,409
QCT operating income (in millions) $2,966 $2,747 $1,812
QCT operating margin 17% 17% 12%

Data source: Qualcomm 10-K filing.

On the flip side, Qualcomm's licensing business is generally more profitable than its chip business. That's true from both an operating margin perspective -- in other words, the percentage of each revenue dollar that gets converted into operating income is much higher for QTL than it is for QCT -- as well as from a raw operating profit dollar perspective.

Metric FY 2018 FY 2017 FY 2016
QTL revenue (in millions) $5,163 $6,445 $7,664
QTL operating income (in millions) $3,525 $5,175 $6,528
QTL operating margin 68% 80% 85%

Data source: Qualcomm 10-K filing.

Why is that the case? Quite simply, a royalty check is nearly pure profit. Sure, there are some expenses associated with that business, such as the costs involved with filing patents, hammering out licensing deals with licensees, paying (expensive) legal personnel to work to ensure licensee compliance, and other things, but historically QTL's operating margin has been extremely high.

Now consider the costs involved with the company's chip business. First, there's a huge amount of money that goes into simply developing the wide array of chips that the company sells. On top of those significant development costs, chips aren't free to produce -- there are significant manufacturing costs involved (wafer manufacturing, packaging and testing, shipping, and so on), which means that the gross margin percentage of a chip sale is dramatically lower than that of a royalty check.

Why is QTL cratering?

You might have noticed in the QTL table above that the business has been on the decline over the last two fiscal years -- revenue, operating income, and operating margin are all down. So, what gives?

The big problem that QTL is facing is that Apple, as well as an unnamed licensee, both refused to pay up. That problem impacted QTL in both its fiscal 2017 as well as its fiscal 2018. The company also said in its 10-K that its QTL operating expenses rose in 2018 relative to 2017 "primarily from higher litigation costs."

It's also worth noting that QTL is the segment that's likely perceived by investors as being the most at risk, with the company's fundamental business model of collecting royalties as a percentage of the final device price potentially being in jeopardy.

Investor takeaway

Qualcomm is ultimately a company that's all-in on wireless. Its chip business depends primarily on the smartphone market and its ability to grow its dollar content within the smartphone market, although there are adjacent markets in which the company has been successfully deploying its chip technology, too. And, of course, Qualcomm's wireless technology business depends on the market for cellular-connected devices.

It's also important to understand that while Qualcomm has a large and profitable chip business, the company's profitability ultimately hinges on the performance (and long-term viability) of its wireless technology licensing business. That licensing segment -- in more ideal conditions -- can be a massive source of profitability and strength, but with that business coming under legal fire right now, it's hard not to view it as something of a liability.

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Ashraf Eassa owns shares of Qualcomm. The Motley Fool owns shares of and recommends Apple. The Motley Fool owns shares of Qualcomm and has the following options: long January 2020 $150 calls on Apple and short January 2020 $155 calls on Apple. The Motley Fool has a disclosure policy.

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