Quick Thoughts: FB and QCOM – Beat, Guide and Drop

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–       FB and QCOM both beat consensus expectations for Dec Q sales and EPS handily, however rising costs at FB and skittish guidance from QCOM sent both stocks down after hours, QCOM sharply so

–       QCOM lost some SoC business w Samsung, suffers from AAPLs share gains, and awaits resolution in China. These factors will weigh on 2HF15, but are not catastrophic. We see upside to guidance.

–       FB is rapidly growing its expenses, as it previously advised, aiming to offer users new services that can be monetized – e.g. video. Investors fear initiatives will eat profit, a la AMZN and GOOG

–       Both companies are with positioned for the long run with potential 2015 catalysts – Chinese resolution for QCOM and expenses kept with in guidance for FB

Both FB and QCOM delivered outstanding numbers after the close today, yet both were down after hours on investor skittishness over guidance. Despite delivering another healthy beat on nearly 49% YoY revenue growth and hitting a $12B annual revenue milestone, shares of FB were off -2% as investors were concerned new initiatives would sap profitability. For QCOM, which handily beat consensus and announced resolution of a dispute with a large Chinese licensee, a trifecta of issues including the loss of some Samsung business, Apple’s surge in market share, and an investigation by Chinese regulators weighed heavily on the stock sending it down over -8% in the after hours session.  Like their tech peers who already announced earnings, both companies also indicated FX challenges with FB forecasting a 5 point hit, while QCOM’s exposure is a bit more muted given the company’s exposure to Asian markets which haven’t been impacted as much as Europe. Still, both companies have the potential to deliver upside against expectations, with potential 2015 catalysts setting up both companies for the long run.

QCOM beat, with topline coming in at $7.1B versus the $6.9B consensus and EPS surprising at $1.34, well above both the $1.25 consensus and top end of guidance at $1.30. For the company, which has been mired in difficulties surrounding its business in China, news of a resolution with a Chinese vendor that had been holding off royalty payments was welcome, especially given QCOM’s ongoing negotiations with Chinese antitrust authorities over its IPR licensing policies. The resolution will add some revenue next quarter to the QTL business as the vendor pays some catch up royalties. On the licensing side of the business, the company is also increasing its forecast of 3G/4G device shipments to 11-19% YoY growth driven by low-end demand and upgrade cycles in developed markets. Still, the positive news was overshadowed by QCOM missing a design win in a key flagship smartphone, the negative effects of Apple’s iPhone share gains on QCOM customers, lower ASPs, and of course the pending outcome to the Chinese antitrust investigation.

News broke last week that Samsung was dropping QCOM’s Snapdragon 810 processor from its latest line of flagship Galaxy S devices and QCOM today confirmed it had lost a design without disclosing the OEM, though it’s safe to assume the flagship device is likely Samsung’s latest Galaxy S. We don’t think this is a big of a deal for QCOM as some journos have suggested as Samsung has historically only equipped its US bound Galaxy S and Note devices with QCOM’s Snapdragon processors given the market’s LTE needs. Nearly identical Galaxy S models shipped to other markets rely on Samsung’s own Exynos processors. From April 2014 through December 2014, it’s likely the Galaxy S5 sold no more than 40M units globally, of which no more than half were destined for the US. 20M Snapdragon processors at a $40/chip wholesale price could account for the $800M downward revenue revision. We think this is conservative given Samsung’s recent struggles against not only Apple’s latest iPhone, but a host of new Chinese competitors like Xiaomi that sport Qualcomm processors. Samsung’s latest Galaxy S5 sold 25% fewer units in its first three months than the previous model, and its unlikely the handset maintained similar momentum later in the year. QCOM won’t win back the Samsung design, but with devices from LG, Huawei, Lenovo, and Xiaomi likely to gain share, this mitigates some of the pain for the QCT business.

Management also warned of lower chip demand in light of Apple’s share gains. The iPhone has some Qualcomm silicon, notably the baseband, but the SoC/processor is Apple’s own design produced by third party fabs. As such, Qualcomm’s revenues from an iPhone sold are well below the revenues gained from another customer’s flagship smartphone. While the iPhone 6 and 6 Plus are undoubtedly taking some market share from QCT’s Android and Windows based customers, the large majority of the demand is from existing iPhone users spurred to upgrade to the new large screen models, muting the real impact on Qualcomm’s SoC business. That business, with over 60 design wins across nearly every key Android and Windows device, still looks very good.

Finally, QCOM continues to suffer under a cloud of uncertainty related to the Chinese antitrust matter as it risks a fine or settlement with regulators. The NDRC (National Development and Regulatory Commission) investigation and negotiations have likely led to underreporting of sales by Chinese licensees hoping to skirt agreements in the interim. For QCOM, this means royalties for some 200M devices, or 1/7th of the devices subject to its license agreements are not being reported. Management continues to assure investors progress is being made in negotiations, but the outcome is not yet certain. QCOM is likely negotiating to keep its agreements in force and looking to settle with a fine and move on with business, while regulators would like to change licensing terms bringing royalties lower. Resolution of the matter is a likely catalyst for growth.

Moving onto FB, which saw revenue up 49% YoY to $3.85B versus consensus expectations of $3.77B and EPS of $0.54 against $0.49 expected, the quarter featured plenty of good news highlighted by continued growth in mobile and a successful video strategy. Mobile now makes up 69% of ad revenue at nearly $2.5B and will easily top $10B this year, not bad for a business that didn’t exist three years ago. FB also disclosed a staggering threefold increase in daily videos served to 3B, up from 1B in September. Time spent by average person on Facebook also grew 10% over last year and Facebook Messenger now has over 500M monthly active users behind Whatsapp’s 700M. All impressive numbers, so what happened?

Facebook continues to be in high growth mode, and the opportunities pursued by the company dwarf its current revenue generating abilities. As a result, Zuck and Company are plowing money back into the business growing headcount and spending more on R&D and Marketing. The result is a guidance that sees non-GAAP expenses growing as high as 65% for the upcoming year. This seems reasonable if FB can continue to deliver topline growth at the same rate it has been over the past couple of years, but acquisitions like last year’s Whatsapp acquisition for $22B continue to haunt the company with large SBC expenses in 4Q14 and more expected in 2015 without any inclination of monetizing the user base until it hits 1B. Zuck’s generous 2014 takeout is poised to make up half of FY 2015 SBC, which is projected to be in the range of $3B-$3.3B, and nearly twice the SBC of AMZN over the past year. Attracting talent in the valley is costly and SBC is a key perk that brought the company a 45% increase in headcount. The comp is all the more eyepopping in that its greater than FB’s outlook on CAPEX, which comes in between $2.7B-$3B for the period and also nearly a 65% increase over FY14 levels. With an already high level of SBC spend, it’s unclear how much more room Zuck has to make more key acquisitions without seriously diluting investors. And acquisitions will come in 2015, though its uncertain what the scope or scale will be given Zuck’s 2014 track record.

For the most part the company is firing on all cylinders and still has properties like Instagram, Oculus, and Whatsapp that aren’t being monetized well. The question for investors though is whether its level of spend is wise. Betting against FB’s participation in the growth of digital would be foolish, particularly given the service has over a billion users and has managed to successfully grow its mobile business from zero to nearly $7.5B in a matter of 2.5 years. We are comfortable with the company’s long-term prospects, though sudden increases in spending may weigh on the stock.

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

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