Quick Thoughts: QCOM – Little Trouble in Big China

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–       QCOM delivered 4QFY14 results EPS of $1.26 on sales of $6.69B, falling short of the consensus expectations of $1.32 and $7.03B in revenue

–       QCOM is struggling to collect royalties from unprofitable secondary Chinese brands in the midst of its antitrust dispute with the Chinese government

–       Long term, we expect the problem to become moot as Chinese share consolidates toward large licensees prepared to pay QCOM because of their export ambitions

–       This may take more than a quarter or two to play out, putting near term expectations at risk, but we are bullish on QCOM’s long term position for both patents and chips

At least when Qualcomm misses a quarter, they actually give you some detail about why it happened. (Hint, hint, Jeff Bezos) Sales came in $340M lighter than expected at $6.69B and EPS missed by 4.5%, coming in at $1.26. Along with the admirably granular report and sober guidance by business unit, Qualcomm spoke frankly about its current difficulty in collecting 4G royalties from vendors in China and of new antitrust investigations by regulators in the US and the EU. Those issues have the stock down more than 5% afterhours. While that’s probably appropriate given the short term headwinds and uncertainty created by these challenges, I remain very bullish on Qualcomm’s position for the future of TMT.

China is a double edged sword for QCOM. Some 50% of QCOM’s FY 2014 came from China, up from 29% in FY10. Most of that figure are smartphones from international brands like Apple and Samsung which use Chinese contract manufacturing partners, but a growing portion is coming from local Chinese OEMs. QCOM has signed some 75 single-mode agreements to collect royalties on devices that use its LTE patents. While these royalties are lower than those for multi-mode 3G/4G devices, the market for LTE devices is poised for stunning growth in China itself, where QCOM didn’t previously collect royalties. The Chinese mobile market has some 1.2B subs of which only some 50-60M have LTE connections, at best 5% 4G penetration. China Mobile currently has the only operational 4G network with some 500K base stations. China Telecom and China Unicom are expected to launch their 4G networks in the coming year. The 4G opportunity in China alone for QCOM for the next several years is staggering assuming a sizeable portion of current mobile connections upgrade to 4G devices.

QCOM bears however, have emphasized the propensity of Chinese companies to dodge licensing requirements and under report device shipments. Most major manufacturers with significant device exports to developed markets have played ball with QCOM. While the current licensee in dispute with QCOM wasn’t identified, QCOM’s Derek Aberle noted that licensing issues have been occurring with companies selling into the Chinese market and some emerging markets. License violators are home grown Chinese handset makers with no aspirations to sell into the US or Europe. Hampering the ability of QCOM to collect revenue is the ongoing investigation of the licensing business by the China National Development and Reform Commission (NDRC). Indigenous handset makers have used the investigation as a smokescreen to “push the envelope” and not fully report their activities subject to licensing agreements. While no decision has been reached by the NDRC, QCOM notes penalties could be fines in the range of 1-10% of prior year revenues topping out at $1.3B based on FY 2014 sales to China. Given the NDRC’s track record of pursuing Western companies, a fine is likely but magnitude remains in question. Still, we expect the major Chinese players to play fair with QCOM and the company will reap meaningful revenues from Chinese OEMs.

As QCOM dominates mobile much in the way Intel dominated the PC, it wasn’t much of surprise when management noted a couple new investigations in the US and Europe commenced over the past couple of months. The US Federal Trade Commission launched an investigation into the licensing business including the application of FRAND principles. That investigation is still in early stages and no official complaint or allegation of wrongdoing has been filed. In Europe, the European Commission is investigating the company’s activities in the chip business and use of rebates and financial incentives to push baseband sales. That investigation is also still in its early stages. The outcomes of both are difficult to predict at this point, but likely won’t be resolved for at least a year.

With these storm clouds hovering over QCOM, it will likely take several quarters for the legal and regulatory issues to play out, but the company’s modest valuation suggests that much of that uncertainty is already embedded in the stock. Meanwhile, the company will continue to sell a lot of chips and collect royalties. With the number of connected devices expected to reach 10B in 2018, no other company in the TMT universe is as well exposed to mobile growth. It may well be a bumpy ride, but I think Qualcomm is travelling in the right direction.

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

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