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(Image courtesy of Qualcomm).

As Apple Dispute Ends, Qualcomm Confronts a Smartphone Slump

Qualcomm and Apple declared last month that they would settle their bitter legal battle over billions of dollars of technology licensing fees. The deal has tamped down the tensions between the world's largest supplier of smartphone chips and the world's most profitable phone vendor. But even as the door closes on the conflict, Qualcomm is facing another, more fundamental threat: a slide in global smartphone sales.

The San Diego, California-based company's revenue fell 4.6% from $5.22 billion to $4.98 billion in the second quarter, slightly ahead of the average analyst's estimate. Profits came to $663 million, or $0.55 per share, compared to $330 million, or $0.22 per share, a year ago. Qualcomm's chip sales declined 4% over the last year to $3.72 billion. Chip shipments slipped 1% year-over-year to 155 million units, the company said.

“We delivered a better than expected quarter with earnings per share above the high end of our estimates,” CEO Steve Mollenkopf said. "The rest of the year will be impacted by a slower market for devices, particularly in China, upstream of worldwide 5G rollouts," he added on a Wednesday conference call. Qualcomm says it will sell 150 million to 170 million chips in the third quarter, down from 199 million a year ago.

The settement should ease some of the pain. Qualcomm's legal dispute with Apple threatened its most profitable line of business: licensing patents it says cover all the fundamentals of 3G, 4G and 5G communications and charging fees for them. Qualcomm makes most of its revenue from selling cellular modem chips used in mobile phones, but most of its profits come from collecting fees from companies using its patent portfolio.

The company's licensing unit made $1.1 billion in the second quarter, down 8% over the last year and up 10% over last quarter. Its operating profit fell 17% annually but increased 14% since the first quarter to $674 million. Qualcomm has long argued that its intellectual property is key to making the iPhone and other smartphones work. That's why it demands Apple and others pay royalties based on the end product's selling price.

Apple challenged how Qualcomm wields its vast patent portfolio. Apple argued in court that Qualcomm leveraged its chip supply to squeeze unfair licensing fees from its customers. Apple stopped making royalty payments and purged Qualcomm's modems from its iPhone last year. Qualcomm compained that Apple was exploiting its patents without paying for them. Qualcomm claims Apple withheld more than $7 billion in unpaid fees.

But as part of the agreement announced last month, Apple entered into long-term licensing and chipset supply deals with Qualcomm. The deal repaired their relationship just in time for the smartphone industry's shirt to 5G. The settlement means Apple will use Qualcomm's chips in future iPhones. The company's 5G modems are considered the most advanced in the world, which may have pushed Apple to make peace with Qualcomm.

Qualcomm will make $4.5 billion to $4.7 billion from the legal settlement in the third quarter, which ends in July. That includes a cash payment from Apple for unpaid royalties and the release of money it reserved during the dispute to refund Apple or its contract manufacturers. Qualcomm says its third-quarter sales will total $9.2 billion to $10.2 billion, up significantly from $5.6 billion a year ago, when Apple was still withholding fees.

"We believe the settlement is a win for both companies, and we are pleased with the result and pleased to have it behind us," Mollenkopf said Wednesday. Qualcomm is also quarreling with Huawei over its patent licensing fees, and Mollenkopf said that the Apple agreement may make it easier to resolve the dispute. Huawei will pay Qualcomm $150 million in the third quarter as the two companies continue to negotiate a licensing deal.

Qualcomm’s share price has soared more than 50 percent since April 15, the day before the Apple deal was disclosed. Qualcomm said the settlement will boost its profits $2 per share as shipments of Apple devices ramp up. Royalty payments from Apple will resume in the third quarter. (Despite that, the licensing unit is projected to report third quarter revenue of $1.225 billion to $1.325 billion, down 8% to 15% from a year ago).

Qualcomm declined to detail the terms of its licensing deal with Apple. Qualcomm has long required Apple and other customers tapping its portfolio of roughly 130,000 patents to pay fees based on the selling price of the end product. That was a point of contention with Apple, which asserted that the royalty rate should be based on the selling price of Qualcomm's chips, or a fraction of a premium phone today. Qualcomm disagreed.

The company's earnings underline the recent slowdown in the handset space. Qualcomm said its sales in the third quarter, excluding the payment from Apple, would total $4.7 billion to $5.5 billion. That represents a year-over-year decline of around 10% to 16%. David Wise, Qualcomm's chief financial officer, said the slowdown was due to demand slipping in China and a possible pause of purchases ahead of 5G device shipments.

The smartphone market is not as strong as it used to be, Mollenkopf warned. "We now expect global handset units to decline slightly year-over-year offset by continued growth in non-handsets resulting in overall unit growth of approximately 3%," he said. Qualcomm slashed its estimates for global 3G, 4G, and 5G device shipments in 2019. He said that 1.85 billion units will be shipped before the end of the year, not 1.90 billion units.

As the handset market slumps—in the first quarter, global shipments fell 4% to 330 million units, according to Strategy Analytics—Qualcomm is looking into other lines of business. To take over more of the smartphone, the company has ramped up sales of RF power amplifiers, switches and other parts that surround the modem. Qualcomm is also expanding its efforts around the Internet of Things, including cars and factories.

The company also claims that it can convert its 5G leadership into strong sustained growth. Currently, customers are planning to add its advanced 5G modems to 75 smartphone models, Mollenkopf said. Many of these high-end handsets will also feature its radio-frequency front-end modules. Qualcomm expects its 5G sales to start ramping up in 2020 as more 5G services are introduced globally.

Around 1.395 billion phones are set to be shipped in 2019. And 5G shipments are estimated to be 0.5%, according to IDC. But by 2023, 5G smartphones will represent 26 percent of all shipments, with 3G shipments dropping from around 4 percent to 2.2 percent of the total market. In addition, 4G smartphones are expected to have 95.4 percent market share in 2019, and 71.4 percent of the 1.542-billion-unit market in 2023.

"Our 5G technology and product leadership, as well as our expansion into new industries and product categories, creates a strong foundation for long-term revenue and earnings growth," Mollenkopf said in a statement. "We enter into the 5G era with strength in products, a favorable competitive dynamic and more customer diversity and technology breadth than in earlier generations of cellular," he said on the analyst call.

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