A month old but good and applicable to Korea:
QCOM: The Economics of Royalties and Direct Sales Explained
Salomon Smith Barney
Wednesday, August 04, 1999
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--SUMMARY:--QUALCOMM, Inc.--Telecommunications Equipment
* We continue to recommend Qualcomm with a 1-H rating. * Stock weakened when Motorola reiterated that it plans to enter the CDMA chipset market
* Regardless of source component supplier, Qualcomm still gets a royalty fee on "every" CDMA phone and infrastructure sold.
* If Motorola sells the chipset without software no royalty is paid to Qualcomm by Motorola, BUT the fee would be paid by the company writing the software and/or using the chipset.
* Manufacturers that use QCOM's ASICs receive a discounted royalty fee so their rates would rise if they purchase chipsets from others.
* Ericsson's recent decision to use QCOM's chipset despite reviewing "ALL" other potential suppliers highlights the QCOM advantage. ------ At yesterday's Annual Analyst Meeting, Motorola announced, as it had last year, that it plans to enter the market for CDMA chipsets. We believe there is no negative financial impact to Qualcomm. Thus, we continue to recommend Qualcomm with a 1-H rating. In our opinion, the weakness is an excellent opportunity to purchase shares in a company that is fast becoming synonymous with the wireless internet.
1) Qualcomm is paid a royalty fee by manufacturers of wireless equipment, including mobile phones, base stations and chipsets that utilizes one or all of its several hundred patents. This is true regardless of the source of the components used in the equipment. Moreover, the rate is the same whether the manufacture uses one or all of Qualcomm's patents.
2) Qualcomm has licensed others the ability to manufacture chipsets for CDMA in order to broaden the market and to meet the multiple source requirements of other manufacturers. In addition to Motorola and Lucent, LSI, DSP Communications, Prairie Communications and VLSI have the right to manufacture CDMA chipsets under license from Qualcomm. Motorola can sell CDMA ASICs but would have to pay Qualcomm a royalty fee unless the chipset is sold without the software. The buyer of the ASIC, who would then write the software, would be responsible for paying the royalty to Qualcomm. In either case a royalty fee is paid, it is just a question of who will pay Qualcomm.
3) Qualcomm's licensees receive a discount on their royalty fee if they purchase their chipset requirements from Qualcomm. Thus, manufacturers that elect to purchase their requirements elsewhere would have to pay a higher royalty fee. This would be the case if for example a handset manufacturer were to purchase their ASICs from any of Qualcomm's licensees. Despite having to pay a higher rate, companies such as Nokia have elected to use their own ASIC because of their view of the competitive advantage of having written their own software. Others such as Ericsson, most of the Koreans and Japanese manufacturers as well as for some of Motorola's products, the choice was to use Qualcomm's ASICs due to price, features, reliability and time to market issues. After all, Qualcomm only designs the ASICs and writes the software. The production capacity is actually provided by Intel and IBM.
The following is an excerpt from our recent Qualcomm report on the economics of Qualcomm's business. We believe it would be useful to reprint it here. The profitability of various outcomes differ, but regardless of the components used and the manufacturer, Qualcomm will get its share of every CDMA phone sold and CDMA infrastructure sold.
The economics of Qualcomm's business model vary considerably depending on whether the phone is sold by: 1) QUALCOMM; 2) a licensee that purchases ASICs from QUALCOMM; 3) a licensee such as Nokia and Motorola that use their own ASICs; or 4) Motorola. Thus, we have put together a table that illustrates the different operating margin contributions.
Our assumptions are that the average royalty rate paid to QUALCOMM on a mobile phone is 4% of the "factory price" of the phone except for Motorola, which only pays about 2.5% of the factory price of the phone. On ASICs, we assume Qualcomm's gross margin is close to 55% and 50% for operating margin. Thus, a single ASIC can contribute as much as $12 to the pretax line. We have excluded the royalties from wireless infrastructure from this exercise since it is much more concentrated and the infrastructure vendors are likely to continue to purchase all their ASIC needs from QUALCOMM since it is a low-volume proposition. In fact, 10 times as many mobile phone ASICs are sold than infrastructure. Thus, if a phone is sold for a factory price of $200, the following operating income contribution would occur:
Figure 1: Economics of Royalties vs. Direct Sales Source of Phone Sale Assumptions Margin Contribution QUALCOMM $200 * 6% operating margin $12 QCOM licensee that is $200 * 4% + $12 $20 also an ASIC customer Licensee w/own ASIC $200 * 4% $8 Motorola w/own ASIC $200 * 2.5% $5 From the chart above, it is clear that: 1) Qualcomm's handset division must generate at least 10% operating margin in order for the company to be able to justify remaining in the business once the industry has sufficient handset capacity; 2) the most profitable outcome for QUALCOMM is for the Koreans and the Japanese manufacturers to be successful not only in their home markets but on a more global basis; 3) and the least profitable would be a world dominated by Motorola. Neither extreme is likely to occur. Our assumptions are for QUALCOMM to continue to grow its mobile phone sales at a rate slightly less than the market, while mobile phone sales whether its CDMA, GSM or D-AMPS continue to be dominated by Motorola and Nokia. ---------------------------------------------------------------------------- Salomon Smith Barney is a U.S. registered broker-dealer. It is a member of Citigroup Inc. and is affiliated with Citibank, N.A. and its subsidiaries and branches worldwide (collectively "Citibank"). Despite those affiliations, securities recommended, offered, sold by, or held at, Salomon Smith Barney: (i) are not insured by the Federal Deposit Insurance Corporation; (ii) are not deposits or other obligations of any insured depository institution (including Citibank); and (iii) are subject to investment risks, including the possible loss of the principal amount invested. Salomon Smith Barney including its parent, subsidiaries and/or affiliates ("the Firm"), may from time to time perform investment banking or other services for, or solicit investment banking or other business from, any company mentioned in this report. For the securities discussed in this report, the Firm may make a market and may sell to or buy from customers on a principal basis. The Firm, or any individuals preparing this report, may at any time have a position in any securities or options of any of the issuers in this report. An employee of the Firm may be a director of a company mentioned in this report. Although the statements of facts in this report have been obtained from and are based upon sources the Firm believes to be reliable, we do not guarantee their accuracy, and any such information may be incomplete or condensed. All opinions and estimates included in this report constitute the Firm's judgment as of the date of this report and are subject to change without notice. This report is for informational purposes only and is not intended as an offer or solicitation with respect to the purchase or sale of a security. This report was prepared by Salomon Smith Barney Inc. and is being distributed by Nikko Salomon Smith Barney Limited under license. This publication has been approved for distribution in the United Kingdom by Salomon Brothers International Limited, which is regulated by the Securities and Futures Authority. The investments and services contained herein are not available to private customers in the UK. This report does not take into account the investment objectives, financial situation or particular needs of any particular person. Investors should obtain individual financial advice based on their own particular circumstances before making an investment decision on the basis of the recommendations in this report. The research opinions of the Firm may differ from those of The Robinson-Humphrey Company, LLC, a wholly owned brokerage subsidiary of Salomon Smith Barney Inc. Salomon Smith Barney is a service mark of Salomon Smith Barney Inc. (c) Salomon Smith Barney Inc., 1999. All rights reserved. Any unauthorized use, duplication or disclosure is prohibited by law and will result in prosecution.
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