Qualcomm (NASDAQ:QCOM) is facing an anti-monopoly probe in China amid allegations that it has been abusing its dominant market position to charge discriminatory fees. The National Development and Reform Commission (NDRC) made its first public comments about the Qualcomm investigation on February 19, saying that it is looking into complaints that the company is charging a higher royalty rate in China than in other countries.  Earlier this month, the China Mobile Communications Industry Association said that it had filed a similar complaint against Qualcomm. The allegations come as China prepares for a big push into 4G in the coming months, after the government handed out TD-LTE licenses in December. The country is seeing strong adoption of 3G data services and the LTE rollout is expected to provide the local smartphone industry with a significant boost. As 4G LTE adoption ramps, the Chinese government seems intent on obtaining lower royalty rates to keep costs low and protect the interests of local players.
If found guilty, Qualcomm could face fines of anywhere between 1 and 10% of its annual revenues in the country. While the company earns almost half its revenues from China (over $12 billion in FY 2013), a bulk of those come from licensing patents and selling chipsets to foreign players such as Apple that have their supply chain in the country. It is therefore unlikely that such a large portion of Qualcomm’s revenues are at risk of incurring a fine. However, the regulatory moves do put a lot of Qualcomm’s future revenue growth in harm’s way, given that China and its local players are likely to be the company’s biggest revenue driver in the coming years. Our $73 price estimate for Qualcomm is about in line with the current market price.
Qualcomm’s China Potential Driven By 4G Transition
The high-end smartphone market in developed markets has become largely saturated amid efforts by carriers such as Verizon and AT&T to control subsidies and boost margins. Last quarter, Verizon and AT&T reported a combined decline of almost 17% in their smartphone activations over the same period in 2012. The impact could be gleaned easily from Apple’s holiday-quarter results, which showed its North American sales contracting by 1% year-on-year. A few developed regions such as Europe and Japan saw some strength going into 2014, as the former recovered from the eurozone debt crisis and the latter benefited from Apple’s recent iPhone deal with NTT Docomo (NYSE:DCM).
However, with some of these remaining bastions of growth in developed markets finally captured, Qualcomm’s future revenue growth will be increasingly driven by emerging markets such as China and India. These countries have very low 3G/4G penetration, and carriers there are intent on driving data usage through smartphones. According to IDC, smartphone sales in China increased by 67% over the previous year to reach 350 million in 2013, giving the country a share of about 35% of the world market. That figure is expected to increase by another 30% to 450 million this year.  Most of the growth is likely to be driven by local players such as Lenovo, Coolpad, Huawei and Xiaomi.
The biggest opportunity for Qualcomm in the country is China Mobile (NYSE:CHL), which is planning to transition from its TD-SCDMA standard to TD-LTE. China Mobile is not only China’s largest wireless carrier, but also the world’s, with a subscriber base of over 760 million that overshadows Verizon’s (NYSE:VZ) by almost seven times. Its market share of Chinese wireless subscribers stands at about 65% currently. However, the carrier hasn’t been able to leverage its dominance in the overall market to drive 3G adoption in the country due to shortcomings with the TD-SCDMA standard, which wasn’t widely supported by handset makers. With the TD-LTE transition, China Mobile is looking to offset the 3G disadvantage and make up for lost time. This provides Qualcomm with a big opportunity to grow its license base since it can now collect royalties from the sale of handsets on China Mobile’s LTE network. Earlier, handset manufacturers supporting TD-SCDMA did not have to pay Qualcomm any royalties since the technology wasn’t covered by its patents.
Upside Limited By Risks To Royalty Rate
However, NDRC’s aggressive posturing as an anti-monopoly watchdog could curtail Qualcomm’s ability to impose licensing fees and therefore limit its upside from China Mobile’s 4G transition. China Mobile has also changed its 4G requirements from five-mode basebands to three-mode, in a bid to bring down smartphone prices. The three-mode 4G smartphones do not have support for WCDMA and FDD-LTE, thereby decreasing the amount of royalties that handset makers will have to pay Qualcomm. Qualcomm’s royalty rate for LTE-only is about 125 basis points lower than for 3G. (Tech Rumor of the Day: Qualcomm, The Street, June 2009) Since Qualcomm doesn’t have a strong presence in TD-SCDMA and its royalty rates for LTE are lower than 3G, handset makers manufacturing 3-mode LTE smartphones are liable to pay lower licensing fees to Qualcomm, at closer to LTE-only rates.
In the near term, we expect most of the high-end smartphones to continue to use the more mature five-mode chipsets, while the local players experiment with three-mode chipsets for mass-market smartphones. This is because we expect most international OEMs to be reluctant to undertake the additional costs of manufacturing custom-made smartphones for China Mobile alone, limiting the near-term valuation impact to Qualcomm. Going forward, however, as China Mobile expands its LTE coverage and 4G achieves scale, we expect more manufacturers to build 3-mode handsets and Qualcomm’s royalty rates could take a bigger hit in the long run.
We currently estimate that the penetration of 3G/4G within total device sales will increase from about 55% in 2013 to 70% by the end of our forecast period. Together with the assumption that users upgrade their 3G/4G devices once every four years in the long run, we estimate that 3G/4G will grow to account for a little over 50% of global wireless connections by the end of the decade – up from 23% in 2012. However, China Mobile’s 4G transition and rising data demand in emerging markets means that the penetration of 3G/4G devices on which Qualcomm collects royalties could increase much more rapidly. According to GSMA, 50% penetration for 3G/4G connections could be reached as early as 2017.  If penetration levels increase to 60% by the end of the decade, 3G/4G device sales could account for almost 85% of the total device sales – about 15% ahead of our current estimate (see Qualcomm’s $20 Billion Opportunity From Growing 3G/4G Penetration).
This could bring an additional upside of $8 billion to Qualcomm’s top line by the end of our forecast period, as greater 3G/4G device sales lead to not only higher royalty fees but also additional chipset sales for the company. This could add another $20 billion, or about 15% to our valuation for Qualcomm. However, the potential impact on royalty rates due to regulatory issues and growing LTE-only adoption could limit the upside if Qualcomm’s average royalty rate falls below our long-term estimate of 2.6% going forward.
- China accuses Qualcomm of overcharging, abusing dominance, Reuters, February 19th, 2013
- China’s Smartphone Shipments to Exceed 450 Million by 2014, IDC, September, 2013
- Half of all mobile connections running on 3G/4G networks by 2017, GSMA, November 2012
Disclosure: No positions