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Qualcomm (NSDQ:QCOM) has done it again. The chipmaker has managed to strike a licensing deal with another major unlicensed China-based smartphone manufacturer, Oppo, as announced last week. This patent deal would allow the latter to design, develop and sell handsets and other electronic devices equipped with Qualcomm’s 3G WCDMA and 4G (LTE-TDD, TD-SCDMA and GSM) technologies in exchange for a royalty fee, at a royalty rate that’s consistent internationally. This comes as another positive news for Qualcomm shareholders.

Healthy income addition

The announcement comes as a second big win for Qualcomm in China, after Xiaomi. Both Oppo and Xiaomi were selling 3G/4G handsets but they weren’t paying royalties to Qualcomm for using its wireless technology. So it was an opportunity loss for Qualcomm. It has already developed the wireless technology, which would be relevant only for a finite number of years going forward, so not being able to strike licensing deals with these Chinese majors was like not reaping full returns on its investments.

However, the patent deal comes across as a positive announcement for Qualcomm and its shareholders. The company unlocked value and future revenue streams by going through some legal channels and forcing Oppo’s hand into paying royalties. From the standpoint of financials, the good part about this deal is that unlocking a licensing revenue stream from Oppo required next-to-nothing capital expenditures.

Granted that it would have taken some lobbying and sitting with some expensive lawyers on Qualcomm’s part, but nothing really on the technology side. More to the point, the royalty fee will be a straight out addition into the EBITDA section; it won’t have any operating expenses or “cost of goods” items to eat into its financial contribution. This is how Qualcomm manages to make most of its profits.

(Source: Market Realist)

Also, its worth noting that these will be risk-free returns. As long as Oppo continues to sell its 3G/4G devices, it will have to pay Qualcomm a royalty fee, period. Sure the royalty payments can fluctuate with Oppo’s sales volume, but that’ll be a risk-free revenue stream for Qualcomm as the latter won’t have to further invest in technology to keep the royalties coming in. This is one of the healthiest forms of income in my opinion.

But what exactly would be the size of these royalty payments? 

Size of the deal

Well Qualcomm’s Technology Licensing division (QTL) has a royalty rate that’s separate for both 3G and 4G devices. It’s 5% of the average selling price of 3G devices, and 3.5% of the ASP of 4G devices. The company has discussed about these rates in its FY15 annual report, as follows:

“The rectification plan provides, among other things, that for licenses of only our 3G and 4G essential Chinese patents for branded devices sold for use in China starting on January 1, 2015 (and reported to us in the third quarter of fiscal 2015), we will charge running royalties at royalty rates of 5% for 3G CDMA or WCDMA devices (including multimode 3G/4G devices) and 3.5% for 4G devices that do not implement CDMA or WCDMA (including 3-mode LTE-TDD devices), in each case using a royalty base of 65% of the net selling price.”

Due to leakages, seasonality and discounting, the company’s average royalty rate is expected be somewhere around 2.9% for FY16. But how does that translate into USD numbers?

Well, we’ll have to take Oppo’s sales volume and ASPs to start the calculation. The Chinese smartphone maker managed to sell about 50 million devices in 2015 and aims to sell about 120 million devices by 2017. The company competes on low margin, high volume basis, and its ASPs are quite low compared to the likes of Samsung, Apple and even Motorola.

So attaching a 2.8% royalty fee to all those 120 million devices, with an estimated ASP of let’s say $120, with a royalty base of 65% of the devices' ASP, yields a royalty payment of $262 million for 2017 alone. This is what Qualcomm’s risk-free royalty income would be, just from Oppo, if the smartphone vendor manages to sell that many devices at the estimated average selling prices. The best part, it would be a straight out addition to Qualcomm’s EBITDA, and it would be recurring in the forthcoming years until 3G/4G continues to be used.

Estimated revenue: ($120 * 120 million * 0.65 *0.028) = $262 million for FY17 alone.

 Tempering excitement

Granted that things look great on paper, but the projected scenario may not necessarily turn out as expected. For starters, Qualcomm’s royalty rate could dip and that could cause a drag on its projected revenue stream.

Also, the licensing deal could be limited to just licensing Qualcomm's 3G/4G tech, which means that Oppo may not necessarily use Qualcomm’s SoCs in its devices. The returns could be limited just to Qualcomm's licensing division.

There’s also a risk of Oppo not being able to reach its projected sales target. The smartphone vendor is basically projecting its sales volume to shoot from 50 million in FY15 to 120 million in FY17 which is an ambitious projected jump of 140%.

And lastly, the depreciation in Chinese Yuan is a major concern. The currency has lost 6% of its value against a basket of 13 currencies this year alone, and any further depreciation in its value could shrink Qualcomm’s gains from the newly struck deal with Oppo.

Investor takeaway

Qualcomm managed to unlock a royalty revenue stream without spending anything extra on developing its technology. More importantly, it’s a risk-free royalty income that’s a straight out EBITDA addition for the wireless giant. I see this deal as big news for Qualcomm investors despite the caveats mentioned above.