Quick Thoughts: FB and QCOM 2Q14 – Image is Everything!

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–          FB blew past 2Q expectations on every metric. Sales up 60% YoY. Ad sales up 67%. Mobile ad sales up 151%. Operating margins were 59% up from 44% a year ago. EPS beat by 31%.

–          Ad spending is clearly shifting to digital, and FB is executing perfectly. ARPU jumped 41% YoY to $2.24. Upward revisions are inevitable, giving the stock more room to appreciate.

–          QCOM delivered 9% YoY sales growth and 40% EPS growth, topping consensus sales and EPS by 4.4% and 18% respectively, driven by its bellwether chip business.

–          However, investors were spooked by cautious guidance for 4QFY14 earnings and concerns for collecting royalties in China. Total 2014 3G/4G units may be underreported by 15-17%.

Another day, another set of big TMT earnings report. Tonight – Facebook and Qualcomm. Both companies reported big beats. Facebook delivered a serious smack down to both consensus and its year ago compares. Sales grew at a 60%+ annual growth rate with advertising revenues up an astounding 67%. Analysts were expecting $2.81B in revenues and Facebook gave them $2.91B. Consensus EPS was $0.32 and Facebook beat it to the tune of $0.42. Mobile advertising revenues, the basis of the bear case after the 2012 IPO, were up an astounding 151%. No wonder the stock set new highs in after hours trading – bravo.

Qualcomm also delivered a big beat. Sales were 4.4% higher than consensus and up more than 9% YoY at $6.81B. Adjusted EPS was up more than 40% to $1.44, beating consensus projections by more than 18%. However, unlike Facebook, Qualcomm offered its results with a spoonful of harsh medicine. Chinese smartphone manufacturers are not complying with Qualcomm’s licensing terms – it believes calendar year 2014 3G/4G smartphone unit shipments will be under reported by nearly 200 million units, leading to a 6-8% shortfall in royalty payments. While the company will pursue its claims with full aggression, resolution will take time and near term results will suffer for it. 4QFY14 guidance pointed to EPS below the current consensus expectations, and while QCOM has often beaten its own guidance, the Chinese royalty impasse has investors worried. As such, QCOM is trading down big despite the exceptional June quarter results. Ah well.

Back to Facebook and its unequivocally GREAT quarter. After the handwringing over the mobile transition in the wake of its IPO, Facebook is now a full on mobile company deriving 62% of its ad revenue from mobile advertising. Facebook didn’t even sell mobile ads until 3Q12, and after less than two years, the business is nearing $2B in quarterly revenue with growth that shows no signs of slowing. The mobile story shows Zuckerberg and company clicking on all cylinders. Mobile users are up big – more than 400M access Facebook only from their mobile devices. Average effective price per ad is up 123% YoY, despite the 25% drop in impressions caused by the practical restrictions of serving ads on smaller mobile screens. Advertisers and marketers now understand the advantages of delivering ads to users on mobile devices, and are willing to pay more for them. While desktop ad sales only grew 8% in the quarter, and may be an even greater challenge going forward, the burgeoning mobile opportunity more than makes up for it.

Advertising is Facebook’s core business, and the execution has been phenomenal. The company managed to attract 91 of Ad Age’s 100 Leading National Advertisers to use its Custom Audiences product to improve targeting and was able to successfully rollout autoplay video ads without alienating its users. All in all, the company saw 46% global ARPU growth, well ahead of even aggressive analyst expectations. Ad ARPU growth was geographically balanced, with the US/Canada market up 58%, Europe up 56%, Asia up 50% and the rest of the world up a respectable 38%. Monetization is a priority and well on schedule, even if recent acquisitions, like the $19B WhatsApp deal and the $2B Oculus purchase are FAR from generating meaningful sales.

While the growth has been balanced, general ARPU levels remain seriously skewed. US and Canadian users are responsible for $5.79 in quarterly revenue apiece, while European users deliver less than half of that at $2.61. Meanwhile, lower ARPU users outside the US and Canada make up 85% of MAUs but make up only 56% of revenue, largely because the company’s advertising efforts in these markets are not quite there. The quarter could have been even bigger if monetization were more evenly spread – the 2014 World Cup was Facebook’s largest event to date with over 350M users making 3B interactions during the month long tournament, but most the large majority of those interactions were between lower ARPU users outside of the US. It will be interesting to see the impact of the World Cup on Twitter, which saw serious boosts activity based on the global tournament but has also struggled to monetize its non-US user base.

Facebook has a lot of runway left to replicate its successful US monetization strategy globally. It’s also riding a paradigmatic secular shift of advertising toward online. While Google remains the dominant digital ad venue, Facebook really upped the ante in mobile. Of course, Facebook also toys with other business models such as payments and devices, but Zuckerberg gets that his company isn’t quite a platform, but rather a “cross platform platform” dependent on the software and devices provided by much larger players like Apple and Google. Given his laser focus on monetization and user growth, we expect subsequent quarters will offer similar beats.

Also reporting today was another tech juggernaut 500 miles south of Silicon Valley. Qualcomm delivered strong and better than expected results, yet is trading down afterhours given a lower than expected guidance for the company’s FQ4. The company’s results were no less than spectacular with EPS coming in at $1.44 beating by $0.23 or a 19% upside surprise and revenue beating by almost $300M coming in at $6.8B. Fundamentally the business looks strong with the licensing business seeing higher ASPs on which the company collects royalties and strong growth in MSM chip shipments. Looking deeper into the details, Qualcomm which always gets granular with guidance, indicated lower estimates around the QTL business largely driven by underreporting of royalties in China.

Qualcomm is a polarizing name on the street with its share of bulls and bears. On the one hand, the company dominates mobile wireless technology with a host of 4G LTE patents and has a commanding share of silicon going into most phones and tablets with its broadband modems and apps processors. It gets a royalty from nearly every smartphone and 3G/LTE enabled tablet sold. We continue to believe Qualcomm is the best positioned company in mobile technology with a commanding lead in IPR and semiconductor innovation. Intel has been burning piles of cash for years trying to crack mobile and only realized $51M in mobile revenue while spending $1.12B in the latest quarter. Others like Texas Instruments and Broadcom, have given up on competing with Qualcomm. There are few worthy rivals.

Still, Qualcomm’s mobile dominance has risks. CEO Steve Mollenkopf joined the earnings conference call from Beijing, China – appropriate, given the focus that investors have placed on the company’s struggles in the world’s biggest mobile market. A generation ago, Qualcomm reached agreements with Chinese officials to have its WCDMA technology become the countries mobile standard, only for the country to turn its back and develop a home grown TD-SCDMA standard that might skirt Qualcomm’s IPR claims.  Today, the company is under investigation by China’s National Development and Reform Commission (NDRC) for matters related to the country’s anti-monopoly law. The NDRC has the power to issue cease and desist orders related to certain conduct, confiscate gains deemed illegally obtained, impose fines ranging from 1-10% of prior year’s revenue, and require modifications to business practices. While Qualcomm’s IPR position and historical patent licensing agreements give it comprehensive protections in most of the world’s jurisdictions, there is little precedent of the NDRC acting against western companies. While Qualcomm, and western diplomats, are hopeful that international precedents will hold sway and that agreements that preserve its intellectual property rights will be negotiated, the outcome in China remains murky.

With the NDRC investigation over Qualcomm’s head, some Chinese OEMs have chosen to stonewall on their royalty obligations, underreporting their 3G/4G sales and failing to comply with the terms of their licensing agreements. Qualcomm believes that of calendar year 2014 3G/4G device unit sales of roughly 1.3B, just 1.04-1.13 will yield royalty payments. While the average price point on these rogue device sales is almost certainly at the very low end, the 170-260M shortfall could be hitting Qualcomm’s royalty collections by as much as 10%. This frank revelation, and the cautious 4QFY14 guidance that it inspired, spooked investors and sent shares down some 5% in after-hours trading.

While the circumstances are undoubtedly vexing for Mollenkopf and the rest of management, the potential damage seems far more contained than the post-close panic suggests. Most of the Chinese problem is with small, marginal players who are severely disadvantaged vs. the larger domestic players, like Xiaomi, Lenovo and Huawei, who have significant aspirations for global expansion, and as such, are more compliant with western business practices. As domestic market share consolidates into the hands of these megaplayers, and I believe that economies of scale dictate that it will, much of Qualcomm’s problem will evaporate. Ultimately, the opportunity set for Qualcomm, given its IPR and semiconductor design leadership in mobile technologies, is massive and not reflected in the tepid expectations and the valuation placed on it.

For our full research notes, please visit our published research site.

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