Qualcomm Should Tread Carefully Amid Smartphone Saturation, China Troubles

| About: Qualcomm Inc. (QCOM)
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Having ridden the mobile revolution to new highs, Qualcomm (NASDAQ:QCOM) rewarded its shareholders with the announcement of a 20% hike in quarterly dividends and the addition of $5 billion to its share buyback program. Qualcomm shareholders will now be getting a quarterly dividend of 42 cents a share, up from 35 cents previously, while also benefiting from the increased buyback authorization which pushes the total figure to $7.8 billion. This shows investors that management is willing to reinvest in the stock, which is trading close to its all-time highs. The higher cash allocation to shareholders is due to the strong operating cash flows that Qualcomm has been generating over the past year. The company generated about $8.8 billion in operating cash flows in FY 2013, around 46% higher than the previous fiscal year.

Being at the forefront of the technological innovation happening in the 3G and 4G world, the mobile semiconductor giant has benefited from the burgeoning demand for smartphones and other mobile devices. The company's unique business model allows it to profit from not only the sale of its own Snapdragon chipsets, but also the higher margin licensing fees that it derives from the sale of all mobile devices which can connect to 3G/4G networks.

However, a bulk of the smartphone demand in the coming years is likely to come from emerging markets such as China, where an increasing sales mix of low-cost smartphones will cause both device and chipset ASPs (average selling prices) to drop. Moreover, the company is facing an anti-monopoly probe in China that could curtail its ability to impose licensing fees and limit its upside from China's 4G transition. In the face of these challenges, Qualcomm may not add a lot of value repurchasing shares at the current market price, which is about 5% ahead of our $73 price estimate for the company.

Saturated Smartphone Market At The High End

The smartphone market has shown significant growth in recent years. Gartner estimates that almost 970 million smartphones were shipped worldwide last year, a growth rate of more than 42% over 2012. A bulk of this growth came at the expense of feature phones, as the shift toward smartphones remained strong despite some lingering macroeconomic uncertainty. At the same time, growth of other mobile devices such as tablets is picking up serious momentum. IDC estimates that tablet sales grew by over 50% in 2013 to 217 million units, and will continue to grow at a healthy pace for the next few years to reach about 400 million unit sales by 2017. [1]

However, the high-end mobile market in developed markets has become largely saturated 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 in 2012. 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:SSNLF) 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 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. [2] Most of the growth is likely to be driven by local players such as Lenovo, Coolpad, Huawei and Xiaomi.

We currently estimate that the 2G to 3G/4G transition will see 3G/4G penetration of mobile devices worldwide grow from about 50% currently to a little under 70% by the end of the forecast period. However, growing adoption of smartphones in emerging markets, buoyed by the increasing number of low-end affordable smartphone options, could see 3G/4G penetration increase to about 85% by the end of our forecast period. Such a scenario would add a further 10-15% upside to our price estimate.

Limited Value Upside From Share Repurchases At Current Valuation

However, an increasing mix of emerging market sales is likely to hit Qualcomm's chipset as well as device ASPs in the coming years. Last quarter, the emerging-market boost helped Qualcomm's chipset sales come in ahead of guidance, but caused its ASPs to decline to their lowest levels in six quarters. On the licensing side as well, Qualcomm's 3G/4G device ASPs declined by almost 4% sequentially and over 2.3% from the prior-year levels. After three years of unmitigated ASP growth on the back of high-end smartphone demand and LTE adoption in developed markets, Qualcomm's ASPs are likely to increasingly feel the impact of high-end market saturation and increasing competition in 3G/4G chipsets in the coming years. Also, China's aggressive regulatory stance could dent Qualcomm's royalty rates - key driver of a high-margin business that constitutes almost half its value by our estimates.

As a result, Qualcomm expects its revenue growth to slow down to 5-11% in FY2014 - a sharp decline from the average revenue growth rate of 31% it delivered in the last three years. In order to offset that impact and grow operating profits at a faster rate than revenues, Qualcomm expects to get more cost-efficient over time but doesn't expect results to reflect that before the second half of the year. The company is therefore looking to drive EPS growth by repurchasing shares using cash for which it has little use in funding a business whose best years of growth are likely behind it. However, Qualcomm will need to guard against overpaying for the shares it plans to repurchase in the market. With the company's shares having rallied by more than 13% in the last six months, we believe that the stock is slightly overvalued at the current price, given the aforementioned concerns about high-end smartphone saturation and China's anti-monopoly probe against the company.

Disclosure: No positions.