Qualcomm Posts Mixed Q1 As Operational Efficiencies Counter Decline In ASPs; China Potential Ahead

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Qualcomm (NASDAQ:QCOM) announced a mixed set of Q1 FY2014 results on January 29th, as revenues rose only 10% year-over year, but net earnings came in ahead of guidance on healthy expense optimization across verticals. Although in line with guidance, revenue growth declined sharply from historical growth rates of around 30% due to an increasing mix of emerging market sales which depressed ASPs (average selling prices) of both mobile chipsets as well as devices.The emerging-market boost helped Qualcomm’s chipset sales come in ahead of guidance, but caused its ASP (average selling price) levels to decline to their lowest in six quarters. On the licensing side as well, 3G/4G device ASPs declined by almost 4% sequentially and over 2.3% from the year-ago levels. However, Qualcomm’s cost management initiatives helped the company post strong chipset margins, which increased by 400 bps sequentially and came in ahead of expectations.

The company expects the second half of the year to be substantially better than the first half, as handset makers launch their flagship high-end products and its cost-cutting efforts show their full impact. The strong margin performance in Q1 front helped Qualcomm increase its full-year EPS guidance by 1% at the mid-point. Going forward, higher shipments of LTE smartphones as China transitions to the new 4G standard are likely to provide some near-term support to ASP levels, but we expect that to be more than offset by a broader decline in smartphone prices due to intensifying competition at the low end (see Assessing Competitive Risks To Qualcomm As A Nascent LTE Market Matures). We also expect Qualcomm to suffer market share declines, especially at the low-end, to local players such as MediaTek in emerging markets. We have slightly revised our price estimate for Qualcomm to $72.50, almost in line with the current market price.

See our complete analysis for Qualcomm stock here

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Emerging Markets To Drive Qualcomm’s Growth

The decline in Qualcomm’s ASP levels of chipsets and mobile devices is reflective of the high-end smartphone market reaching saturation levels in developed markets amid efforts by carriers such as Verizon and AT&T to control subsidies and boost margins. Last quarter, Verizon and AT&T reported a combined decline of almost 17% in their smartphone activations over the same period last year. The impact could be gleaned easily from Apple’s holiday-quarter results, which showed its North American sales contracting by 1% year-on-year. A few developed regions such as Europe and Japan are seeing some strength going into 2014, as the former recovers from the Eurozone debt crisis and the latter benefits from Apple’s recent iPhone deal with NTT Docomo. Qualcomm, being a key Apple supplier, is likely to see some growth opportunities in these markets in the coming quarters.

However, with some of these last remaining bastions of growth in developed markets finally captured, Qualcomm’s future revenue growth will be increasingly driven by 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 in 2012, giving the country a share of almost 30% of the world market. That figure is expected to have exceeded 350 million in 2013, with the country’s share increasing to around 35%. [1]

With a billion-strong mobile subscriber base and carriers increasingly trying to transition their 2G bases to 3G/4G, 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 emerging markets, could drive Qualcomm’s valuation up by as much as $20 billion provided its chipset 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).

LTE Adoption In China

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. The carrier recently received TD-LTE licenses from the government to offer 4G services in China, and is looking to market it aggressively to offset its 3G TD-SCDMA disadvantage. It has even signed a subsidy deal with Apple to sell the iPhone thorough its stores. The other Chinese carriers are expected to follow China Mobile’s footsteps in increasing 4G penetration in the country, with the government expected to roll out FDD-LTE licenses as well before the year-end. Given Qualcomm’s early lead in multi-mode 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 sales.

However, China Mobile has changed its 4G requirements from the usual five-mode basebands to include three-mode as well, in a bid to bring down smartphone prices. The three-mode 4G smartphones do not have to support WCDMA and FDD-LTE, thereby decreasing the amount of royalties that handset makers will have to pay Qualcomm. Qualcomm’s royalty rate for LTE-only is about 3.25%, as compared to 4-5% for 3G. [2] Since Qualcomm doesn’t have a strong presence in TD-SCDMA and its royalty rates for LTE are lower than 3G, handset makers manufacturing 3-mode LTE smartphones for China Mobile are liable to pay lower licensing fees to Qualcomm, at closer to LTE-only rates. In the near-term, we expect most of the high-end smartphones to continue to use the more mature five-mode chipsets, while the local players experiment with three-mode chipsets for mass-market smartphones. The reason for this is that most international OEMs will be reluctant to undertake the additional costs of manufacturing custom-made smartphones for China Mobile alone, limiting the near-term valuation impact to Qualcomm. Going forward, as China Mobile expands its LTE coverage and 4G achieves scale, Qualcomm’s royalty rates could take a bigger hit.

We also anticipate developed markets increasingly moving towards LTE-only networks in the coming years, as VoLTE (voice-over-LTE) matures and carriers look to exploit the margin advantage of running LTE networks over 3G. Verizon, for example, is looking to deploy VoLTE on its network and expects to launch handsets compatible with this technology later this year. Increasing adoption of LTE-capable smartphones in recent years has caused Qualcomm’s royalty rate to decline by over 300 basis points in the last couple of years. VoLTE’s maturing could lead to greater sales of LTE-only smartphones, accelerating the decline in the long run.


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Notes:
  1. China’s Smartphone Shipments to Exceed 450 Million by 2014, IDC, September, 2013 []
  2. Tech Rumor of the Day: Qualcomm, The Street, June 2009 []