Quick Thoughts: Qualcomm Analyst Day – Hang On for a Bumpy Ride
– China is a double-edged sword for QCOM – regulators and scofflaws plague QTL, while QCT is successfully competing for Snapdragon and baseband business.
– Projected device ASP erosion of 9-10% will hit royalties, but will be offset by chipset unit volume growth driven by emerging market smartphone demand
– QCOM is driving global wireless technology innovation, combining aggressive R&D spend with historical leadership and positioning itself to attack new opportunities.
– The regulatory and licensing issues will take several quarters to resolve – meanwhile QCOM’s potentially dominant position may be temporarily immaterial to investors.
QCOM’s annual analyst day saw rookie CEO Steve Mollenkopf and his leadership team take the stage to persuade investors of the company’s dominant position in nearly all wireless markets despite headwinds from regulators in China. The company earlier in the day unveiled a new baseband chip pushing the boundaries of LTE-Advanced technology with 450 Mbps speeds in a more power efficient 20-nm package. It also revealed that it is planning on entering the server chip market, with Facebook a likely launch customer deploying QCOM’s ARM based server chips across its webscale data centers. Despite the company’s leading positions across mobile and plans to enter adjacent markets, growth over the next five years is expected to proceed at an 8-10% clip, fairly conservative guidance given the continued growth of smartphones and the likely size of emerging mobile opportunities. The prospect of Chinese regulators levying stiff penalties continues to haunt management and investors with Mollenkopf’s team giving only vague indications progress is being made for a resolution. Still, the company tried to allay China concerns with videos during the interludes between speakers featuring companies like Xiaomi, China Mobile, and foundry SMIC extolling the virtues of their QCOM partnership.
China is QCOM’s largest and most important market making up about 50% of the company’s revenue, with both major QCOM business units participating in the market. QTL, the intellectual property licensing business, has been challenged by a China National Development and Reform Commission (NDRC) investigation into the company’s royalty agreements, affecting the company’s business in the country since it was disclosed in January. The NDRC investigation, which could levy a fine as high as 10% of the company’s annual China revenue, has led some Chinese OEMs to skirt licensing agreements by underreporting device sales. The ongoing investigation, the regulators longest since the passage of China’s 2008 anti-monopoly law, has also affected the company’s ability to sign agreements with OEMs that hadn’t previously licensed QCOM IPR. The NDRC has recently been aggressive with foreign companies, fining Volkswagen and Chrysler as well as several Japanese auto parts makers.
QCOM President Derek Aberle, who has been leading negotiations with the NDRC indicated the company is making progress with regulators, but no terms have yet been disclosed. While Chinese protectionism remains a major hurdle, the ambitions of the leading domestic device makers in global markets is an important negotiating chip for QCOM, and we expect the Chinese market to consolidate toward these more compliant international licensees going forward. Of course, QTL delivers the large majority of QCOM profits, and any substantial changes in licensing terms for Chinese manufacturers – and subsequent demands by other licensees to match those terms – would weigh heavily on future expectations for royalty income. Despite the uncertainty, QCOM is forging ahead spending more on SG&A to beef up its compliance and enforcement activities. For QCT though, China is strong as ever with over 20% YoY growth in MSM shipments. QCOM’s low end chips have been successful displacing indigenous competitors like MediaTek, while brand recognition of Snapdragon has been a strong selling point for Chinese OEMs with some 45% of Chinese consumers indicating it was their most preferred brand. QCOM has also been able to provide value for OEMs seeking to export their products with the company’s Global Pass solutions. China is clearly a double edged sword.
Beyond the China troubles, business looks healthy for QCOM in its core handset market. With decelerating growth in developed markets, emerging market (EM) smartphone adoption is still at its early stages and expected to be on a tear through the end of the decade as smartphones become more affordable and accessible for EM consumers. While this will weigh on device ASPs to the tune of 9-10% declines according to QCOM, unit volume growth will offset the impact. The installed base of smartphones is expected to more than double in four years to 3.4B units driven by EM demand. With developed market smartphone sales stable and predictable given regular replacement cycles, EM consumer behavior may give QCOM some longer term tailwind as low end buyers are likely to upgrade to more expensive handsets. A BCG report commissioned by QCOM suggests EM consumers are willing to spend 20-40% of their income on a smartphone and 50% are likely to give up vacation and days off from work rather than part with their devices. Given the utility of smartphones especially in areas with few affordable alternatives to access the web, these figures are believable.
QCOM also continues to invest heavily in R&D and maintaining its wireless leadership with increasingly complex products. This morning just before kicking off the event, it unveiled its latest baseband chip, the Gobi 9×45 with LTE Advanced CAT10, which can deliver speeds of up to 450 Mbps in a smaller and more efficient 20nm package. The secret sauce is carrier aggregation supporting both forms of LTE spectrum. Supporting the latest Gobi is its second generation RF360 envelope tracker that uses 20% less power and takes up 30% less space on the board giving OEMs more real estate. While release dates and launch OEMs are still unavailable, the two products are among the most complex MSM chips released by the company. With a road map that already has teams working on 5G as well as continuing to advance 4G, QCOM is indeed uniquely positioned. Its nearest baseband competitor Broadcom exited the cellular business in June, leaving Intel, MediaTek, Spreadtrum, and Marvell as the remaining players. While QCOM has 64% of the baseband market, it overwhelmingly dominates LTE with 95% share according to Strategy Analytics. QCOM is also banking on display technologies, focusing on enabling 4K, which is already supported by the company’s Snapdragon 810 apps processor. It recently licensed its MEMS based Pixtronix display to Sharp. QCOM claims the display offers better color gamut than LCD and OLED with lower power and faster change modes. Aberle indicated the display could be scaled up. The company’s commitment to R&D is likely to work in its favor as it invests in adjacent markets borrow smartphone innovations and incrementally adding to R&D when necessary. The semiconductor technologies that will drive the emerging markets in the Internet of Things, automotive infotainment, and networking devices, have plenty of overlap with the core handset business. Assuming it maintains its product leadership, QCOM is poised to grab significant share of the 5B+ non handset connected devices expected to ship in 2018.
QCOM’s product leadership and dominance in wireless has had the unintended consequence of attracting regulatory scrutiny around the globe. Beyond China’s NDRC, both the US Federal Trade Commission and the European Commission have launched inquiries into the business with the FTC questioning the company’s licensing practices at QTL and the EC looking into pricing and rebate practices at QCT. In terms of wireless IPR, QCOM has undeniable market power, but doesn’t behave as much given its pricing agreements. We do not believe that the ~3% average royalty rate extracts unreasonable economic rents given the depth and breadth of technology included under a license agreement, but regulatory authorities may disagree. With regulatory risk weighing on and priced into the stock, we don’t expect much movement upward in QCOM stock until the regulatory uncertainty and royalty collections difficulties in China are resolved.
For our full research notes, please visit our published research site.