Qualcomm (NASDAQ:QCOM) is set to announce its Q3 2014 earnings on July 23. The semiconductor giant's top-line growth is being restricted by possible saturation at the high end of the smartphone market and a growing mix of emerging market sales. 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. Nevertheless, Qualcomm has managed to defend margins on account of its ongoing cost management initiatives.
Qualcomm announced a mixed set of results last quarter (Q2 2014) as revenues rose only 4% year over year, but net earnings came in ahead of guidance on account of healthy expense optimization across verticals. Although in line with guidance, revenue growth declined sharply from historical rates of over 20%. This is a direct impact of the smartphone market in developed markets reaching its peak, causing handset makers to shift their focus to cost-sensitive emerging markets such as China. As a result, Qualcomm is more vulnerable to near-term fluctuations in smartphone demand in the country. Additionally, 3G CDMA device sales in China suffered ahead of an anticipated LTE ramp-up at China Mobile, which caused retailers to aggressively burn through TD-SCDMA inventory in preparation for the transition. Accordingly, Qualcomm's licensing revenues took a hit, growing by less than 1% over the same period last year.
The company expects the second half of the year to be substantially better than the first half, as LTE sales ramp up in China and its cost-cutting efforts show their full impact. Owing to the strong performance on the margins front, Qualcomm increased its fiscal-year EPS guidance by 1% at the midpoint. Our price estimate of $73.86 for Qualcomm is at a less than 10% discount to the current market price. We will update our valuation after the Q3 2014 earnings release.
Emerging Markets Will Drive Smartphone Growth
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. As a result, we expect Qualcomm's future revenue growth to 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.
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. (See also "Qualcomm's $20 Billion Opportunity From Growing 3G/4G Penetration.")
LTE Transition at China Mobile to Benefit Qualcomm
The biggest opportunity for Qualcomm in China is China Mobile, which is transitioning 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 by almost seven times. Its market share of Chinese wireless subscribers stands at about 65% currently.
Qualcomm faced some headwinds in China last quarter, as customers deferred buying decisions in anticipation of China Mobile's LTE foray and retailers aggressively moved TD-SCDMA inventory to make way for TD-LTE handsets. Given Qualcomm's limited licensing presence in TD-SCDMA, this did not translate into royalty income. On the other hand, it ate into CDMA volumes at other carriers, which would have otherwise contributed to Qualcomm's licensing top line. Qualcomm estimated the CDMA volume hit at 17 million units last quarter.
China Mobile 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 further its LTE dominance and gain baseband market share in China, especially now that the carrier will sell only five-mode handsets going forward. Qualcomm will also be looking to leverage its overwhelming LTE lead over rivals to corner a greater portion of chipset sales in China.
Qualcomm has the most mature and widely used portfolio of five-mode chipsets , all developed on its state-of-the-art baseband technology. Thus, we expect it to benefit from China Mobile's plans to offer five-mode LTE-enabled handsets. Additionally, China Mobile has decided to offer discounts on smartphones that will run on Qualcomm's superfast 4G LTE network.