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After I published my first article on Spreadtrum Communications (NASDAQ:SPRD) in response to Muddy Waters’ concerns, I received some questions as to what really happened in 2009: Why did Wu Ping leave? What did the current CEO Leo Li do to actually turn around the company?

Based on pure public information and cross reference from different media, I have come up with the following story:

Mr. Wu Ping resigned in February 2009. Based on the public information collected, I suspect that Wu Ping resigned for two major reasons. First, Wu Ping and another co-founder made a strategic decision that they deployed much of the company’s resources on the R&D of TD-SCDMA-based chips in around 2004 and gave up on WCDMA completely. It turned out to be a huge mistake. Due to technological reasons, Minister of Industry and information Technology of the People’s Republic of China delayed the issuance of 3G license from previously scheduled 2005 to early 2009. Thus, Spreadtrum was unable to capitalize on the recently developed TD chips. Also, the huge investments crowded out resources for GSM chips, which were essentially the cash cows for the company. Wu Ping faced much pressure from the board and investors during the time, as he himself admitted in an interview a couple of years later.

Secondly, Wu Ping was not a good operation manager. As I mentioned in my previous article, the other founder, Chen Dadong, openly talked about the poor quality control and messy management within the company during Wu Ping’s time that “even the CEO didn’t know the actual cost per chip while negotiating prices with clients."

The board didn`t lose confidence in Wu Ping overnight, but rather through a series of poor strategic decisions and operation management.

Spreadtrum Key Financials

2008 Q1

2008 Q2

2008 Q3

2008 Q4

2009 Q1

2009 Q2

2009 3

2009 Q4

USD

USD

USD

USD

USD

USD

USD

USD

Revenue

39.5

40.2

20.0

10.2

8.2

16.2

38.4

42.3

COGS

21.7

22.1

11.2

13.0

6.6

12.4

23.4

24.4

Gross Profit

17.8

18.2

8.7

(2.7)

1.6

3.8

15.0

17.8

Net Income

2.8

2.6

(31.3)

(52.8)

(8.3)

(13.1)

0.6

1.4

Source: Capital IQ

But what happened in 2009 when Wu Ping left?

The first opportunity came as a 90 million RBM TD-SCDMA research contract offered by China Mobile in May 2009. It was recalled by Chen Datong (see the interview) that “Leo Li and five other VPs of the company made an agreement, that if the product cannot meet the technical requirements by May, they would resign together.” (Note that Spreadtrum developed the first TD-SCDMA chip in China under Wu Ping’s management.) The 90 million contract helped Spreadtrum’s top line reflected in 2009 Q2 financial statements. (Chinese media reported this contract in 2009.)

In addition, Leo Li emphasized client relationship management and quality control ever since he took over the company. In June 2009, Spreadtrum ramped up a 6600L baseband chip developed under Wu Ping and launched the product aiming to compete against Mediatek’s MT6225. With comparable performance, the 6600L chip was cheaper by $1 USD on its own and by $2 USD in terms of integrated solution. The price advantage is huge given that the average profit on a low-end cell phone is about $1.4 USD. As a result, Mediatek, the market leader that enjoyed over 90% of market share back then, was forced to participate in this price war in the second half of 2009. Note that Mdiatek’s gross margin has been sliding since 2009 Q3, indicating an increasingly competitive marketplace.

MediaTek Key Financials

2008 Q1

2008 Q2

2008 Q3

2008 Q4

2009 Q1

2009 Q2

2009 3

2009 Q4

Gross Margin

50.8%

52.8%

53.0%

52.6%

56.1%

59.1%

60.2%

58.7%

Revenue

637.6

735.2

871.9

629.7

704.9

858.3

1,071.1

909.5

COGS

313.7

347.3

410.1

298.7

309.2

351.0

426.4

375.6

Gross Profit

323.9

387.9

461.8

331.1

395.7

507.3

644.7

533.8

Net Income

132.7

167.9

223.2

87.8

206.5

279.3

367.7

273.3

Source: Capital IQ

So where exactly did Spreadtrum get its sales?

Spreadtrum has been partnered with several Independent Design Houses (IDHs) and original design manufacturers (ODMs), including Wingtech Group, Spreadstone, Benephon, and Amoi. Note that Spreadtrum and Wingtech established a strategic partnership in April 2008. China’s gray market handsets industry exploded in 2009 and further increased in 2010. (See iSuppli’s data here - pdf.)

Wingtech Group is a Chinese provider for integrated cell phones program design, production, and wireless terminal-based value-added service. According to iSuppli, Wingtech’s handset shipment was around 23 million units in 2009, ranked number 1 among all the IDHs (see here).

Stringent product quality control and a successful pricing strategy had enabled Spreadtrum to ride the wave of an exploding gray market handsets industry in 2009, which was, in my opinion, the truth of this seemingly impossible turn-around story.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Source: Behind Spreadtrum's Improbable Turnaround