Qualcomm's (NASDAQ:QCOM) share price outperformed the S&P 500. Year to date, Qualcomm's share has increased 9.6% whereas the S&P 500 index increased 7.2% over the same period. Historically Qualcomm has enjoyed impressive growth on the back of the booming smartphone industry and this has resulted in higher royalty income. However, in the last few months of the current year its growth has slowed down to some extent due to a number of factors, including the increasing saturation rate of smartphones in the developed markets and comparatively weak demand of high-end smartphones in the emerging markets.
According to its business model, Qualcomm earns higher royalty income from high-end smartphones than from low-end devices. Due to purchasing power differences, the average selling prices of smartphones in the emerging markets are lower than developed markets; this resulted into lower royalty income per device for Qualcomm.
In the first quarter of 2014, the 3G/4G devices' average selling prices declined by 4% sequentially and by more than 2.3% annually. This trend is likely to continue because the competition amongst smartphone sellers will increase for the sake of market share and this will result in more and more low-end devices in the emerging markets. However, with the advancement of technology more high-end devices will be available in the developed markets and it is in that market where Qualcomm must maintain its dominance through new products. According to the research firm International Data Corporation (IDC), the average selling price of an Android smartphone will decline to $202 per device by the end of 2018 which will ultimately affect Qualcomm's revenue stream.
Latest Quarter's Financial Results
In the second quarter of fiscal year 2014, Qualcomm reported a mixed bag of results. Qualcomm reported a net income of $2.26 billion, an improvement of 9% from the second quarter of 2013 and a single-digit increase of 4% from the first quarter of 2014. Qualcomm beat analysts' estimates in terms of EPS. Diluted earnings per share, excluding income from the Qualcomm strategic initiatives (QSI) segment, some share-based compensations, acquisition-related items and tax items were $1.31. That reflects an increase of 12% from the second quarter of 2013 and was 4% higher than the preceding quarter. The earnings per share growth was driven by a 9% increase in the reported devices sales during the second quarter and an increase of 8% from the preceding quarter.
However, Qualcomm missed the revenues estimates of $6.49 billion and instead generated $6.37 billion. The sales increased 4% from the second quarter of the previous year but declined 4% compared to the preceding quarter. Revenues were mainly driven by demand for multimode 3G/LTE chipsets and licensing revenues. The market shift towards low-end smartphones in the emerging markets can be blamed for Qualcomm's single-digit revenue growth in the latest quarter. Shipments of MSM chips totaled 188 million units for the quarter reflecting an increase of 9% from the second quarter of 2013 but were 12% lower on a sequential basis. This sequential decline also contributed towards the revenue estimate miss for the quarter. Due to these factors share price slipped from $81.32 to $77.61 in the last week of April. However, this drop was a temporary trend and the share price has recovered to some extent and is currently trading at $80.43.
Qualcomm Targets China
The wireless network infrastructure market is in a phase of transition as mobile network operators seek to address increasing mobile traffic demands amidst global economic uncertainties. This paradigm shift is bringing new challenges and opportunities to infrastructure vendors. China, which is a big telecom market, is going through a shift from 3G towards 4G networks yet only 1 percent of customers are 4G subscribers.
China Mobile announced its policy to procure 4G terminals with support for both TDD- and FDD-LTE and now plans to sell only five-mode 4G handsets. The move benefits Qualcomm as its five-mode handsets carry higher royalties than three-mode handsets. Qualcomm has widely used its portfolio of five-mode chipsets and it will provide Qualcomm an advantage over its competitors. Qualcomm should benefit from a near-term spurt in baseband demand from China Mobile as local players ramp up their five-mode production. More importantly, it removes the risk of three-mode chipsets replacing five-mode chipsets as the more widely sourced standard at China Mobile, making it easier for Qualcomm to collect royalties on handsets that support global standards. Considering Qualcomm's overpowering lead in LTE patents and its small presence in the TD-SCDMA standard, China's entry into the 4G LTE network will most likely work in its favor giving the company a wider LTE royalty base.
So far, China Mobile has sold more than 12 million TD-LTE smartphones and the company aims to sell 100 million 4G devices by the end of this year. The 4G LTE enabled smartphones are expensive compared to the 3G enabled smartphones and this gap is likely to continue for the next few years. Due to this pricing gap and increasing adaptation of 4G LTE in China, Qualcomm's revenue stream will improve in the next two quarters of fiscal year 2014. Qualcomm estimates a 23% increase in the shipment of 3G/4G devices to the emerging markets and a 6% increase in shipments to the developed markets. Despite the fact that average royalty income will slip, the emerging markets should be big sources of future earnings growth for Qualcomm.
Acquisition of Wilocity
Recently Qualcomm announced that it has purchased startup chipmaker Wilocity, to be ahead in the high-speed wireless technology called WiGig which will become a standard feature on smartphones and other products. Typically Wi-Fi operates in two main frequency bands whereas WiGig operates at 60 gigahertz and is estimated to send data three to four times faster the rate of the fastest version of Wi-Fi. Qualcomm's vision is to increase bandwidth 1000x by a combination of increasing spectrum, putting small cells everywhere outside and getting access to ad-hoc small cells inside homes and businesses. This acquisition fits in with the company's vision and is a smart strategic move which will provide Qualcomm a lead in the WiGig sector. Competitively, this also puts Qualcomm in the 60 GHz driver's seat by an estimated 6 to 12 months. Wilocity is already shipping to Dell with high volume, end users products and the competition is not. The inclusion of WiGig into Qualcomm's Snapdragon 810 processor will set an industry standard. This addition to Qualcomm's portfolio will help the company to boost its revenue stream in the coming years.
Qualcomm's outlook is quite strong despite a slowdown in the sale of high-end smartphones during the first six months of 2014. Qualcomm expects revenues of $6.2 billion to $6.8 billion for the third quarter of 2014 and $26 billion to $27.5 billion for full fiscal year 2014. IDC estimates that smartphone shipments are expected to rise by only 19% this year, compared to the 39% jump seen in 2013. With the favorable industry prospects, it is believed that Qualcomm's stock will hit its average target price of $85.81 and this will give rise to an upside potential of 6.6% to its current price. This upside potential seems a bit conservative and this stock has the strength to go even higher.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Business relationship disclosure: The article has been written by a Gemstone Equity Research research analyst. Gemstone Equity Research is not receiving compensation for it (other than from Seeking Alpha). Gemstone Equity Research has no business relationship with any company whose stock is mentioned in this article.