Spreadtrum Communications: What To Believe

Last Friday, Jan. 5 2012, Spreadtrum Communications, Inc (NASDAQ:SPRD) was down more than 22%. We anticipate that SPRD is going much lower, probably to the single digits. The reason is very simple – investors have found out the truth. Spreadtrum Communications’s RF component supplier RF Micro Devices (RFMD) preannounced Q3 revenue of approximately $225M, versus the company's previous guidance of $250M and analysts' consensus estimate of $250M. Lower than expected sales of 2G components to China based customers for entry-level handsets contributed to the shortfall, as did weak sales by RF's multi-market products group. Furthermore, 2G demand in general was significantly below customers' expectations at the end of the quarter. Against this US company’s bleak revenue announcement that caused its stock to drop 19%, can anybody believe that Spreadtrum Communications’s Q3 revenue was up 92%? (See Spreadtrum Communications ’s Q3 earning report here.)

Spreadtrum Communications is a China based handset chip vendor mainly for the low-end 2G feature phones, using GSM and GPRS networks predominately in the Chinese market. Spreadtrum Communications’s business focuses on the low-end 2G Chinese feature phone market. The feature phone market is a dying business as 3G/4G smart phones using CDMA-2000/WCDMA networks are gaining market shares significantly in recent years. Based on iSuppli and iimedia research, 2010 is the last year for such feature phones to have positive growth in China (see here). Its major competitor in this market space is the leading Taiwan-based chip company MediaTek that has about 70% of Chinese market share (iSuppli.com), while Spreadtrum Communications has about 20%.

To gain market share, the two competitors have been engaging in fierce price wars over the past years (see here and here). As a result, their profits have dropped dramatically. Due to the shrinking overall Chinese 2G market and rapidly dropping profit level, in its own first quarter 2011 report, MediaTek reported that its net income plunged 70.3% to NT$3.31 billion (US$115 million), from NT$11.13 billion, a year earlier (see here). To the contrary, surprising all investors, Spreadtrum Communications reported that its GAAP net income was US$27.5 million, compared with US$6.6 million in 1Q11, a stunning 317% increase; its Non-GAAP net income was US$30.4 million, compared with US$8.7 million in 1Q10, a stunning 249% increase. The technology and market leader MediTek’s profit has dropped 70%, while its small rival Spreadtrum Communications’s profit has increased 249% (Non-GAPP) in the same market space. And this diverging trend has continued since the first quarter of 2011. MediaTek’s profit continues to fall, while Spreadtrum Communications’s profit continues to increase at too-good-to-be-true levels.

Some Spreadtrum Communications bulls have argued that maybe Spreadtrum Communications is gaining a larger market share from MediaTek and this is why Spreadtrum Communications’s profit is increasing while MediaTek’s profit is decreasing. However, how can it be explained that Spreadtrum Communications’s component supplier RF Micro Devices’s Q3 revenue has dropped dramatically, especially due to lower than expected sales of 2G components to China based customers, while Spreadtrum Communications’s revenue has increased 92.0% over the previous year? Can Spreadtrum Communications now produce 100 chips with one RF component while others can only produce just one chip?

In November 2011, we actually encountered the same mathematically impossible mastery from Spreadtrum Communications. Spreadtrum Communications announced to the world that it enjoys a secured 50% market share in TD-SCDMA chips in the Chinese market. But then the US based Marvell Technology (NASDAQ: MRVL) announced that Marvell has "TD smartphone market share of over 70%," according to CEO Sehat Sutadja. MRVL went on to comment, "While we expect increased competition from followers in TD smartphones, we expect to maintain our leadership position and grow revenues next year." This sounds like two companies owning 120% of the TD market. One thing is sure, one of them was not telling the truth since one plus one does not equal three. The question is do you believe a US company that is under scrutiny by all sorts of regulators or a Chinese company under communist rule that is thousands of miles away?

We remind all investors; ask yourself this question and invest cautiously!

PS: Morrison Security Research is not the only organization that does not believe Spreadtrum Communications's report. Jefferies just reduced Spreadtrum Communications price target by 68%. That surely shows that Jefferies does not totally embrace Spreadtrum Communications's story.

Jefferies downgraded Spreadtrum Communications to Underperform with a price target of $11.70. The firm comments,

We downgrade Spreadtrum Communications to Underperform, and reduce our PT by 68% to $11.70, implying 22% downside from current level. We lower our non-GAAP net income est. by 22%/27% for 2012/13 to reflect increasing TD competition and weakening 2G demand. Our industry checks indicate a more realistic TD TAM is 60mn in 2012 vs. our prior/consensus expectation of 80mn/90mn. Increasing competition leads us to turn cautious on its TD market share and ASPs.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. This is not paid research. I am one researcher covering Chinese chip companies in Morrison Security Research. I don't have any involvement with SPRD.

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