Qualcomm: China Problem A Buying Opportunity?

| About: Qualcomm Inc. (QCOM)

Summary

Qualcomm posts solid results but reveals a nasty surprise.

It has serious regulatory issues in China and customers appear to be under-reporting device sales to the company.

Yet the big sell-off might just provide a bit of an opportunity, as Qualcomm is likely to tackle the issues.

Qualcomm (NASDAQ:QCOM) had a nasty surprise for investors on Wednesday. While the third-quarter results were solid, the company warned about a serious regulatory conflict in China as well as the fact that its customers appear to be understating sales device numbers in order to avoid paying licenses to Qualcomm.

Despite the serous issues, I am a cautious buyer after the an aggressive sell-off.

Third Quarter Highlights

Qualcomm posted third-quarter sales of $6.81 billion, which were up 9.0% compared to last year. Revenues also were comfortably ahead of consensus estimates at $6.55 billion.

The company posted a strong increase in net earnings which came in at $2.24 billion, which was up 41.6% compared to last year.

As a result of modest share repurchases, earnings per share were up by 45.6% to $1.31 per share. Non-GAAP earnings of $1.44 per share came in comfortably ahead of consensus estimates at $1.22 per share.

Looking Into The Company's Segments

CEO Steven Mollenkopf was happy with the record results driven by demand for the 3G/4G solutions while the future is mixed. The near-term licensing business outlook is a bit disappointing resulting from problems in China which I will discuss below. This was offset by a stronger than anticipated performance of the semiconductor business.

The revenue composition was not so impressive. Equipment and services sales rose by 14.8% to $4.92 billion. Yet it was disappointing to see a 3.7% fall in the very lucrative licensing sales which fell to $1.88 billion.

Equipment sales growth was impressive, and earnings before taxes improved by 51% to $1.12 billion, resulting in operating margins of 22.5%. Of course, QTL, the licensing business, is most prominent and profitable, and the fall in sales in this unit was very bad for the bottom line. Margins before tax are still an incredible 86% for QTL which means that every dollar decline in sales hits the bottom line almost on a one-by-one ratio.

Operating earnings were quite healthy and rose by 23.7% to $2.07 billion. This was driven by gross margin expansion, an actual reduction in selling, general and administrative expenses as well as a lack of ¨other¨ expenses.

Net earnings were aided by investment income which nearly doubled to $422 million. Also beneficial was a much lower effective tax rate of 10.4%, down a full seven percent points from last year.

The China Problem

The big surprise in the earnings report are the warnings which Qualcomm made regarding its Chinese operations. While the company continues to see significant opportunities, its business practices have been investigated by the China National Development and Reform Commission.

Worse, the company believes that licensees in China are not fully compliant with contractual licenses on licensed products from Qualcomm. Qualcomm itself anticipates 1.3 billion 3G/4G device shipments across the globe this year while it only sees 1.04-1.13 billion units being reported to itself. This means that roughly one in every six units is not reported and is a huge missed revenue opportunity for Qualcomm's license business.

Looking Ahead

Given the issues ahead and slower license sales in China which are partially halted, Qualcomm's revenue guidance is a bit disappointing.

Fourth-quarter sales are seen between $6.5 and $7.4 billion, which suggests flat to 14% year-on-year growth in sales. GAAP earnings which totaled $0.86 per share last year are expected to increase by 20-37% to $1.03-$1.18 per share.

Non-GAAP earnings are seen between $1.20 and $1.35 per share which falls short to consensus estimates at $1.38 per share, due to the issues in China. Analysts were looking for sales of $7.14 billion.

MSM chip shipments are seen between 230-245 million units, up 21-29% compared to last year. Despite the strong unit growth, reported device sales are seen between $53 and $59 billion. This implies a fall between 2% and 12% on an annual basis and is very important as license revenues are calculated based on these sales numbers.

Given the outlook Qualcomm sees annual sales of $26.3 to $27.2 billion on which it anticipates to earn $4.57 to $4.72 per share.

Strong Balance Sheet, And About The Valuation

Qualcomm ended the quarter with a total of $32.7 billion in cash, equivalent and marketable securities. This combined with no outstanding debt gives the company a strong net cash position of around $19 per share.

With 1.71 billion shares outstanding and shares trading around $77 per share, equity in Qualcomm is valued at $132 billion which values operating assets at some $100 billion. This values equity at 3.7 times annual sales and 12-13 times annual earnings.

This is all very appealing, but for now investors appear to be really shocked about the news in China. Not only is the news shocking, also the large gap between licensees reported 3G/4G device sales numbers and Qualcomm's own expectations is rather alarming. This is as Qualcomm is expecting roughly 20% more shipments of these devices compared to the reports it receives from its clients.

As the issues with regulators appear to have the potential to have a meaningful impact, resolving the matter is of utmost urgency. The issues also are the main reason why the outlook was softer than anticipated by the investment community.

The news is out and it is not pretty. The company has to move quickly and resolve the issues in China given that the country is the company's largest growth opportunity.

Just two weeks ago I last took a look at Qualcomm's prospects following a cautious note from analysts at Goldman Sachs. At the time I called myself "cautiously" bullish seeing triggers being China, a cash repatriation holiday, or the new iPhone launch. While China has proven to be a negative trigger, the big negative reaction today provides me with a nice opportunity despite the short- to medium-term woes.

I am buying on this dip.

Return of capital to stockholders: $2.06 billion, including $1.35 billion through repurchases of 17.0 million shares of common stock and $706 million, or $0.42 per share, of cash dividends paid.

Disclosure: The author has no positions in any stocks mentioned, but may initiate a long position in QCOM over the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.