Qualcomm: China Is No Concern

Nov.26.13 | About: Qualcomm Inc. (QCOM)

After initially dropping 3%, shares of Qualcomm (NASDAQ:QCOM) recouped most of their losses after disclosing a Chinese antitrust probe (press release here). The company has not been charged by Chinese authorities, and in all likelihood, I don't expect any charges to be filed because Qualcomm has not engaged in monopolistic activities.

Qualcomm's chip technology is far ahead of any competitors with an unparalleled patent portfolio that provides tremendous royalty revenue. However on lower-end chips where there is increasing competition from the likes of Intel (NASDAQ:INTC), which is moving slowly into mobile, and domestic Chinese manufacturers, Qualcomm typically has margins of less than 20%, which is not indicative of a monopoly. The Chinese probes are about two separate issues that don't have to do with Qualcomm being a monopoly.

First, it is no secret that China's economy is not growing as quickly as it was a few years ago, and the regime always has a pulse on the sentiment of the public. To avoid any internal issues, China has launched probes into Qualcomm for monopolistic practices, attacked Starbucks (NASDAQ:SBUX) for charging too much, said Samsung (OTC:SSNLF) phones don't work, and shifted business away from IBM. The Chinese government is in the midst of a PR war against Western companies. These efforts happen periodically to boost the government's standing among the populace and tend to recede as quickly as they start. China remains dependent on Western companies to continue to modernize and develop its economy; it is not about to recede from the world. This issue is purely transitory.

Moreover, China is in the midst of updating its wireless network to LTE. This will force China Mobile (NYSE:CHL), the world's largest carrier, to pay licensing fees to Qualcomm, which it had previously avoided. Supplying chips to China Mobile phones could boost sales by 5-10% for QCOM. However, China isn't all that interested in adding this layer of cost to China Mobile customers, especially with an ever-present concern over inflation. With negotiations over the price, China will pay Qualcomm for its chips and to license its patents about to intensify ahead of the LTE rollout, it is no coincidence that China announced this antitrust probe.

China is essentially exerting political pressure to force Qualcomm into giving discounts. Ironically, the U.S. makes it illegal for our companies to bribe overseas officials but is powerless from stopping foreign officials strong arming our companies. In the end, I imagine Qualcomm will give China a below-market price for its products, and the antitrust issues will happen to disappear as well. The market clearly does not see any significant antitrust issues for Qualcomm given the mild reaction in trading. With access to another 700 million subscribers, even a discounted deal will provide significant upside to EPS over the next five years.

I now expect a resolution of the China issue to lead to lower margins, given the 10-20% discount Qualcomm will have to agree to. However, this deal will dramatically increase shipments, making it EPS positive. With a deal with China Mobile more likely, I feel more comfortable in management's guidance to a strong second half of 2014 after a more tepid first half. I think Qualcomm should earn $5.20-$5.35 in 2014, so it is still trading at a very reasonable multiple of 13.4x. QCOM also has $17 per share in cash, leaving it with a 10x ex-cash multiple, exceptionally cheap for a company levered to the smartphone revolution and about to fully engage the China market, albeit at a lower margin point.

Investors who sold on the headline without considering its motivations made a mistake. China is doing this in advance of LTE negotiations, and investors should look for a 10-15% increase in shipments in 2014. I continue to believe Qualcomm should trade 15x earnings ex-cash, meaning fair value is about $95. Investors should use any weakness on the China headline to load up on shares.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.