Update Qualcomm (QCOM)

On November 4 Qualcomm (QCOM) reported mildly disquieting news.

 Oh, earnings for the company’s fiscal fourth quarter that ended in September were okay. At 48 cents a share they met Wall Street projections. Revenue came in about $4 million light but on total revenue of $2.68 billion I don’t find that especially significant.

 I’m not even deeply concerned by the downward guidance for earnings and revenue for the next quart, the first fiscal quarter for 2010. The company’s estimate of earnings per share of $2.10 to 2.30, versus the Wall Street consensus of $2.32 falls in the usual ballpark for management trying to low ball a projection so they can beat it. (Although I think that Qualcomm is actually feeling the pressure from cell phone manufacturers especially in Korea that ordered too many chips and I am disappointed by the lower guidance for the December quarter since I was expecting acceleration in sales during that period.)

What concerns me most is the continued erosion of Qualcomm’s revenue stream from royalties.

 Qualcomm gets a huge 32% of its revenue from licensing and royalties on its patents for the CDMA technology that is key to so many wireless networks and phones. Almost all 3G (third generation) systems use CDMA technology. That royalty stream is even more important to the company than that percentage figure suggests: Because the company doesn’t spend much of anything to generate that royalty revenue, its operating profit market on that revenue is a stunning 82%.

For its business as a whole, Qualcomm’s operating margin was just 21.4% over the last twelve months, according to Morningstar.

Does that give you an idea of how important that royalty revenue is to Qualcomm?

Unfortunately, that royalty stream has been under attack.

First in the courts. The company has lost a major intellectual property case to Broadcom (BRCM) in the last year and will pay that competitor almost $900 million over four years. It has been fined for anti-competitive behavior in Korea and faces complaints in Japan and the European Union.

Second, in the market place. When phone makers sell their phones for less, Qualcomm’s percentage royalty falls as well. And when phone makers face intense competitive pressures and rapidly falling margins, as they do now, they negotiate lower royalty rates. In the just completed quarter royalty rates we down 0.4 percentage points from the previous quarter and 0.8 percentage points from the fourth quarter of fiscal 2008.

The big question facing investors who own this stock is How much of that news is already in the stock price? Some unquestionably since every analyst on Wall Street knows that, out of the box, royalty rates for 3G phones were going to be lower than for earlier systems. But some isn’t. The degree of ferocity of the attack on Qualcomm’s royalty stream isn’t in the price. Nor is the success of competitors such as Broadcom in winning suits and increasing their share of the market.

I think it’s worth holding Qualcomm a little longer since the short-term trends—upward momentum in technology shares and the traditional positive seasonality in the December quarter for stocks in general and technology stocks in particular—are in its favor. But I am cutting my target price here from $55 by March 2010 to $48 by March 2010.

Full disclosure: I own shares of Qualcomm in my personal portfolio.

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