Qualcomm To See Near-Term LTE Market Share Gains in China But Regulatory Uncertainties Remain

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Confirming earlier rumors, China Mobile (NYSE:CHL) announced recently that it will sell only five-mode 4G handsets from June onwards. [1] This puts an end to a brief adjustment period for local players when they were allowed to ship three-mode handsets to carriers as they looked to catch up with the more advanced five-mode technology. While five-mode 4G terminals provide global support for TD-LTE, FDD-LTE, TD-SCDMA, WCDMA and GSM, three mode leaves out WCDMA and FDD-LTE, making them more suited for domestic use on China Mobile’s network. Qualcomm (NASDAQ:QCOM), which is the industry leader in LTE baseband shipments and has the most mature and widely used portfolio of five-mode chipsets, should benefit from a near-term spurt in baseband demand from China Mobile as local players ramp up five-mode production. More importantly, it removes the risk of three-mode usurping five-mode as the more widely sourced standard at China Mobile, making it easier for Qualcomm to collect royalties on handsets that support global standards.

Given the higher margins on offer, mobile royalties are more valuable to Qualcomm than chipset sales. By our estimates, royalty income contributes over 45% to Qualcomm’s value as compared to about 27% that it derives from chipset sales. Although the reinstatement of the five-mode requirement by China Mobile lifts some of the uncertainty around Qualcomm’s future growth in China, there is still a significant concern that Chinese government’s anti-monopoly probe against the company could lead to lower royalty rates. Our $73 price estimate for Qualcomm is about 5% below the current market price.

See our complete analysis for Qualcomm stock here

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Qualcomm’s China Potential Driven By 4G Transition

The high-end smartphone market in developed markets has become largely saturated amid efforts by carriers such as Verizon and AT&T to control subsidies and boost margins. The impact could be gleaned easily from Apple’s holiday-quarter results, which showed its North American sales contracting by 1% year-on-year. As a result, we expect Qualcomm’s future revenue growth to be increasingly driven by emerging markets such as China and India. These countries have very low 3G/4G penetration, and carriers there are intent on driving data usage through smartphones. According to IDC, smartphone sales in China increased by 67% over the previous year to reach 350 million in 2013, giving the country a share of about 35% of the world market. That figure is expected to increase by another 30% to 450 million this year. [2] Most of the growth is likely to be driven by local players such as Lenovo, Coolpad, Huawei and Xiaomi.

The biggest opportunity for Qualcomm in the country is China Mobile, which is transitioning from its TD-SCDMA standard to TD-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. Its market share of Chinese wireless subscribers stands at about 65% currently. However, the carrier hasn’t been able to leverage its dominance in the overall market to drive 3G adoption in the country due to shortcomings with the TD-SCDMA standard, which wasn’t widely supported by handset makers. With the TD-LTE transition, China Mobile is looking to offset the 3G disadvantage and make up for lost time. This provides Qualcomm with a big opportunity to further its LTE dominance and gain baseband market share in China, especially now that the carrier will sell only five-mode handsets going forward.

Five-Mode LTE Advantage Offset By Regulatory Uncertainty

However, any advantage that Qualcomm will have over rivals is only in the near term, with five-mode chips from local players expected to enter mass production in Q2 and the first handsets with these chips likely to appear in Q3 this year. So far, Qualcomm has managed to leverage its first-movers’ advantage to claim a lion’s share (95% in Q3 2013) of the LTE baseband market. [3] Going forward, we expect Qualcomm to increasingly feel the impact of LTE commoditization as the eventual entry of local Chinese players such as MediaTek and Spreadtrum, as well as overseas rivals such as Nvidia, Broadcom and Intel, increases competition, especially at the low end.

A longer-term advantage for Qualcomm from China Mobile’s policy reversal is in its licensing business. Irrespective of who sells the chipsets, Qualcomm should benefit from the higher royalties associated with five-mode as compared to three-mode. This is because five-mode handsets have support for WCDMA and FDD-LTE, which increases the amount of royalties that handset makers will have to pay Qualcomm. Qualcomm’s royalty rate for LTE-only is about 125 basis points lower than for 3G. ((Tech Rumor of the Day: Qualcomm, The Street, June 2009)) Since Qualcomm doesn’t have a strong presence in TD-SCDMA and its royalty rates for LTE are lower than 3G WCDMA, China Mobile’s continued acceptance of three-mode would have meant handset makers paying lower licensing fees to Qualcomm, at closer to LTE-only rates. Moreover, since five-mode has support for more internationally accepted standards, Qualcomm will have an easier time collecting royalties from Chinese OEMs. In the past, Qualcomm has found it harder to impose its licensing fees on sales of handsets supporting China Mobile’s TD-SCDMA network.

However, Qualcomm’s upside potential from this development could be offset by an anti-monopoly probe it is facing in China. The National Development and Reform Commission (NDRC) has said that it is looking into complaints that the company is charging a higher royalty rate in China than in other countries. If this is found to be the case, it could put a lot of Qualcomm’s future revenue growth in harm’s way, given that China and its local players are likely to be the biggest drivers of its licensing revenues in the coming years (see Qualcomm’s Regulatory Troubles In China Cast A Shadow Over 4G Opportunity).

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Notes:
  1. China Mobile requires 5-mode support for TD-LTE smartphones []
  2. China’s Smartphone Shipments to Exceed 450 Million by 2014, IDC, September, 2013 []
  3. LTE Dominance Raises Qualcomm’s Baseband Share to Two Thirds in Q3 2013, Strategy Analytics, December 20, 2013 []