Qualcomm Earnings Preview: Facing ASP And Margin Concerns Despite Holiday Season Boost

Qualcomm (NASDAQ:QCOM) is scheduled to release its Q1 FY2014 results on January 29th. The semiconductor giant has had a record run over the last six quarters, riding the rising global demand for mobile devices to grow revenues year-over-year by an average of 28% each quarter. As a result of this sustained strong top-line growth, Qualcomm increased its September-ending FY2013 revenue guidance twice last year and ended up with revenues pretty close to the high end of guidance. While mobile devices and chipsets have been growing strongly in terms of unit sales, the ongoing transition to 4G LTE in developed markets and the rising penetration of smartphones in the emerging markets have also had a positive impact on their average selling prices (ASPs). At the same time, increasing 3G penetration in emerging markets such as China and India has given Qualcomm a wider base to collect high-margin royalties from in recent years. However, Qualcomm’s gross margins have taken a hit in recent years, declining from around 65% in Q1 2011 to 59% last quarter due to growing chipset competition from rivals such as MediaTek, Nvidia (NASDAQ:NVDA) and Broadcom (NASDAQ:BRCM).

While Qualcomm’s Q1 should be boosted by a spurt in demand for high-end smartphones during the holiday season, this market is increasingly showing signs of saturation amid efforts by carriers such as Verizon and AT&T to control subsidies and boost margins. Going forward, we also expect Qualcomm’s revenue growth to face headwinds from a growing mix of emerging market sales depressing ASP levels, both for chipsets and mobile devices. The company has guided for a 5-11% growth in revenues for FY2014 – a sharp decline from the average revenue growth rate of 31% it delivered in the last three years. Qualcomm expects to get more cost-efficient over time in order to offset that impact by growing operating profits at a faster rate than revenues, but doesn’t expect results to reflect that before the second half of this year. Higher shipments of LTE smartphones as China transitions to the new 4G standard are likely to provide some near-term support to the ASP levels, but we expect that to be offset by a broader decline in smartphone prices due to intensifying competition at the low end. Our $71.50 price estimate for Qualcomm is about in line with the current market price.

See our complete analysis for Qualcomm stock here

Emerging Markets Will Drive Qualcomm’s Future Growth

The smartphone market has shown significant growth in recent years. Gartner estimates that almost 700 million smartphones were shipped worldwide in 2012, a growth rate of more than 43% over 2011. The consumer shift to smartphones continues to be strong despite some lingering macroeconomic uncertainty, and it is likely that the momentum will have pushed the smartphone market closer to the 1 billion mark by the end of 2013. At the same time, the growth of other mobile devices such as tablets is picking up serious momentum. IDC estimates that tablet sales grew by over 78% in 2012 to 128 million units, and will continue to grow rapidly for the next few years to reach more than 400 million unit sales by the end of 2017. ^[1]

Most of the future smartphone volume growth is likely to come from emerging markets such as China and India, where 3G/4G penetration is still very low and carriers are intent on driving data usage through smartphones. According to IDC, more than 210 million smartphones were sold in China last year, giving the country a share of almost 30% of the world market. With a billion-strong mobile subscriber base and carriers increasingly trying to transition their 2G bases to 3G, China presents a huge opportunity for Qualcomm, to not only gain from its chipset sales but also earn a steady stream of licensing revenues (see Qualcomm Introduces Three New Entry-Level Chipsets To Target Emerging Markets). Growing penetration of 3G/4G data services, especially in the emerging markets, could drive Qualcomm’s valuation up by as much as $20 billion provided its market share doesn’t fall drastically due to growing competition from local rivals such as MediaTek (see Qualcomm’s $20 Billion Opportunity From Growing 3G/4G Penetration).

The biggest opportunity for Qualcomm there is China Mobile, which is planning to transition from its TD-SCDMA standard to 4G LTE. China Mobile is not only China’s largest wireless carrier, but also the world’s, with a subscriber base of over 760 million that overshadows Verizon’s by almost seven times. Given Qualcomm’s early lead in LTE and its relatively low presence in the earlier standard TD-SCDMA, China’s transition to LTE should not only give it a wider base from which it can collect royalties, but also to further its chipset market share.

ASP Decline Likely To Offset Growth In Unit Sales

However, an increasing mix of mobile phones sold in emerging markets will likely cause mobile ASPs to fall, limiting the upside to both chipset revenues as well as licensing fees. The company saw its chipset ASPs last quarter decline by 4% sequentially due to a higher mix of lower-priced chipsets, and expects this to continue in Q1 as well. It also expects its mobile device ASPs to decline by 1% in FY2014. Most of the expected decline is probably due to China’s emergence as a potential 4G powerhouse in the coming years, with the government having handed out TD-LTE licenses in December and likely to give FDD-LTE licenses by the end of this year. In preparation, China Mobile and China Telecom have already awarded contracts to infrastructure vendors such as Huawei, ZTE, NSN and Alcatel Lucent to build out their respective LTE networks. Up until now, LTE compatibility was an essential requirement for handsets only in the U.S. market. But China’s LTE foray will see handset manufacturers start to increasingly support 4G in their low-end smartphones as well.

The impact from this trend on Qualcomm is twofold. Rising low-end penetration of LTE will not only cause Qualcomm to lose market share to emerging market rivals such as MediaTek, which is to be somewhat expected considering that Qualcomm accounts for over 95% of the LTE market currently, but also hurt its pricing power as 4G becomes more mainstream. Qualcomm’s near-monopolistic hold on the LTE market has so far helped it command a premium pricing in the market, which we expect to continue in the near term as well. From less than $17 in 2010, Qualcomm’s chipset ASP rose to over $23 in FY2013. However, the increasing mix of emerging market sales and the gradual proliferation of LTE handsets should cause chipset prices to fall as the LTE market matures in the long run.

In addition to a loss of LTE market share, a decline in chipset prices will cause LTE handsets to become cheaper as well, directly impacting Qualcomm’s licensing revenues. Since Qualcomm’s 3G/4G technology is widely used in handsets, it collects a certain percentage of the price of almost every smartphone sold as royalty. This makes handset ASP a very important driver of its high-margin licensing business, which accounts for almost half of Qualcomm’s value by our estimates. Growing LTE penetration at the high end has been one of the reasons behind average handset prices rising by more than 15% since 2010. But as the technology gets widely adopted in emerging markets such as China, handset ASPs are likely to face increasing pressure in the coming years, limiting the upside to Qualcomm’s valuation from increasing 3G penetration.

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1. Tablet Shipments Forecast to Top Total PC Shipments in the Fourth Quarter of 2013 and Annually by 2015, According to IDC, IDC Press Release, September 19th, 2012 [↩]