Qualcomm (NASDAQ:QCOM) is scheduled to announce its Q2 FY2014 results on April 23. The semiconductor giant is facing top-line growth concerns amid saturation at the high end of the smartphone market and a growing mix of emerging market sales. Last quarter, Qualcomm’s revenues rose just 10% year-over year – in line with guidance but a sharp decline from the growth rates of around 30% posted in the previous four quarters. While growing smartphone penetration in emerging markets is helping keep unit sales high, it is also having an adverse impact on the ASP (average selling price) levels of both mobile chipsets as well as devices. The company is therefore looking to defend margins through ongoing cost management initiatives. Last quarter, Qualcomm’s net earnings came in ahead of guidance as its chipset margins improved by 400 basis points sequentially on healthy expense optimization across verticals.
The strong margin performance last quarter caused Qualcomm to increase its full-year EPS guidance by 1% at the midpoint. The company expects the second half of the year to be substantially better than the first half, as handset makers launch their flagship high-end products and its cost-cutting efforts show their full impact. Going forward, higher shipments of LTE smartphones as China transitions to the new 4G standard are likely to provide some near-term support to ASP levels, but we expect that to be more than offset by a broader decline in smartphone prices due to intensifying competition at the low end (see Assessing Competitive Risks To Qualcomm As A Nascent LTE Market Matures). We also expect Qualcomm to suffer market share declines, especially at the low end, to local players such as MediaTek in emerging markets. Our $73 price estimate for Qualcomm is about 10% below the current market price.
Impact Of High-End Saturation On ASPs
The decline in Qualcomm’s ASP levels for chipsets and mobile devices is reflective of the high-end smartphone market reaching saturation levels in developed markets amid efforts by carriers such as Verizon (NYSE:VZ) and AT&T (NYSE: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 last year. The impact could be gleaned easily from Apple’s (NASDAQ:AAPL) holiday-quarter results as well, which showed its North American sales contracting by 1% year-on-year. Even Samsung’s (OTC:SSNGY) mobile division posted its first sequential revenue decline in nearly three years last quarter, as the average price of its handsets declined by almost 7% sequentially and more than 1% year-over-year due to a higher mix of low-end smartphones.
With most of the smartphone demand in developed markets 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 (OTCPK:LNVGY), Coolpad (OTC:CHWTY), Huawei and Xiaomi.
With a billion-strong mobile subscriber base and carriers increasingly trying to transition their 2G bases to 3G/4G, China presents a huge opportunity for Qualcomm, to not only gain from its chipset sales but also earn a steady stream of licensing revenues. Growing penetration of 3G/4G data services, especially in emerging markets, could drive Qualcomm’s valuation up by as much as $20 billion, provided its chipset market share doesn’t fall drastically due to growing competition from local rivals such as MediaTek.
LTE Adoption In China
The biggest opportunity for Qualcomm in China comes from China Mobile (NYSE:CHL), which is transitioning from the 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 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 among its subscribers 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 its 3G disadvantage and make up for lost time. This provides Qualcomm with a big opportunity to further its LTE dominance and gain baseband market share in China, especially now that the carrier will sell only five-mode handsets going forward.
However, any advantage that Qualcomm will have over rivals is only in the near term, with five-mode chips from local players expected to enter mass production in Q2 and the first handsets with these chips likely to appear in Q3 this year. So far, Qualcomm has managed to leverage its first-movers’ advantage to claim a lion’s share (95% in Q3 2013) of the LTE baseband market. Going forward, we expect Qualcomm to increasingly feel the impact of LTE commoditization as the eventual entry of local Chinese players such as MediaTek and Spreadtrum (NASDAQ:SPRD), as well as overseas rivals such as Nvidia (NASDAQ:NVDA), Broadcom (BRCM) and Intel (NASDAQ:INTC), increases competition, especially at the low-end.
However, Qualcomm’s upside potential in China could be offset by an anti-monopoly probe it is facing in the country. The National Development and Reform Commission (NDRC) has said that it is looking into complaints that the company is charging a higher royalty rate in China than in other countries. If this is found to be the case, it could 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 biggest drivers of its licensing revenues in the coming years.
Disclosure: No positions