Qualcomm (QCOM) is off to a solid start in fiscal year 2014, with the company posting earnings growth of (Non-GAAP) 20% year-over-year in the first quarter of fiscal year 2014. Although its revenue of $6.62 billion missed the analysts' estimate of $6.665 billion, the result has at least removed investors' fears about the slowdown in smartphone sales affecting Qualcomm. With the strong first quarter result, the company looks perfectly positioned to replicate this performance in the remaining quarters, with most of the growth coming from emerging countries, especially China.
LTE adoption in China, a new growth opportunity
Qualcomm sold 213 million Mobile Station Modem (MSM) chips in the first quarter of 2014, which is more than its previous guidance of 195 million-210 million. Strong sales of Qualcomm's chips in the first quarter of 2014 were due to the demand from emerging regions like China, which helped the company offset a potential decline in sales from developed regions. China is a major geographic region for Qualcomm in terms of revenue generation, with 49% of the company's total revenue in fiscal year 2013 coming from customers and licensees based in China.
Recent years have been trying for Qualcomm, as the company has experienced difficulty earning royalties on China's 3G network format, TD-SCDMA, which is backed by China Mobile (CHL). This network was considered different from the one covered by Qualcomm's patents, so handset manufacturers supporting TD-SCDMA weren't required to pay royalties to Qualcomm. This adversely affected Qualcomm's royalty revenue from China, and the company missed the market opportunity arising out of the transition from 2G to 3G. Royalty and licensing revenue play an important part in Qualcomm's profits, contributing two-thirds of its pre-tax profit in fiscal year 2013. Thus, Qualcomm's license business is a highly profitable one to follow, despite its revenue contribution amounting to 30% in fiscal year 2013.
Qualcomm will look to revive its lost fortunes in China from the adoption of 4G LTE technology. In December last year, the Chinese government allocated the 4G spectrum licenses. Qualcomm has already built a strong patent portfolio in 4G LTE, and the company looks perfectly positioned to capitalize on the LTE market opportunity. The world's biggest telecom service provider in terms of subscribers, China Mobile, has already rolled out its LTE services on the TD-LTE network, followed by China Telecom (NYSE:CHA), which launched its LTE services recently. China Unicom (NYSE:CHU) is expected to launch its 4G services later this year. More than 55 LTE licensing deals have been signed with handset manufacturers covering Qualcomm's technology, and growth in LTE penetration in China will boost the company's royalty revenue.
However, Qualcomm risks receiving lower royalty revenue, as China Mobile has changed its 4G requirements from five-mode basebands to three-mode. The three-mode 4G smartphones don't support FDD-LTE and WCDMA, so it becomes cheaper for smartphone manufacturers to deliver products, since the royalty rates are lower in three-mode.
The negative impact won't affect Qualcomm in the long term, as high-end smartphones will continue to use five-mode chipsets. In addition, issue of 4G spectrum to China Telecom and China Unicom in the widely used TDD-FDD network in this year will also add significant value to Qualcomm's licensing business.
China's transition to LTE will not only positively affect royalty revenue, but will also add value to Qualcomm's chipset business. The company released its Snapdragon 410 chipset last year, which features a 64-bit architecture processor and an integrated multi-mode 4G LTE modem. The chip targets entry-level smartphones priced at sub-$150, and providing 64-bit architecture along with LTE support to low-end of mobile devices will enable the company to capitalize on the growing smartphone penetration in China and other emerging markets. Qualcomm has over 70 3G LTE multimode designs, with the leading Chinese OEMs based on its Snapdragon 400 chipsets, and with the introduction of 64-bit architecture, the company is set for more design wins in the region.
Why Lenovo is important for Qualcomm in the China market?
Last month, Lenovo (OTCPK:LNVGY) announced that it would be buying the Motorola handset business from Google (GOOG) for $2.91bn. This purchase will make Lenovo the third-largest smartphone maker in the world. The combination of Motorola's product line and Lenovo's strong presence in emerging countries, especially China, will come handy for the top PC maker. Lenovo is the second-biggest smartphone vendor in China, and with its strong distribution reach coupled with Motorola's products, the company will look to drive the volume of Motorola products.
With respect to Qualcomm, Lenovo's rise in China and other emerging countries will provide a new tailwind opportunity for the company, as Lenovo is an important customer for Qualcomm. Last year, Lenovo revealed its intentions to expand its presence in the smartphone market of 20 more countries using Qualcomm advanced LTE products. Qualcomm is already into its fourth-generation LTE products, and will play an important role in Lenovo's growth strategy that targets the LTE smartphone market.
Last month, Lenovo announced its first LTE phone, Vibe Z, powered by Qualcomm's Snapdragon 800 processor. Having its chip in Lenovo smartphone products will help Qualcomm gain traction in China's smartphone market. In addition, design wins from Lenovo will help Qualcomm offset a potential loss of upcoming designs from Samsung (OTC:OTC:SSNLF), as China's number one smartphone vendor looks to reduce dependence on Qualcomm by powering its devices from chips made in-house.
China and other emerging countries are vital to Qualcomm's growth, as developed markets are saturating quickly. The following is Qualcomm's estimate of device shipments:
Source: First Quarter, 2014 presentation
Thus, growth in the device shipments has slowed in developed regions, and emerging regions will be the major drivers of Qualcomm's revenue growth going forward. The rise in penetration of smartphones in emerging regions may put pressure on the average selling price (ASP) of devices, thereby affecting royalty revenue, but growth in the sales volume will offset this negative impact. After looking at the strong growth prospects, I recommend buying this stock.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Business relationship disclosure: Fusion Research is a team of equity analysts. This article was written by Rohit Gupta, one of our research analysts. We did not receive compensation for this article (other than from Seeking Alpha), and we have no business relationship with any company whose stock is mentioned in this article