There Are Clouds on Qualcomm Inc's Horizon

Qualcomm is currently in a dominant position in the mobile chip market, but there are warning signs of potential problems down the line.

May 9, 2014 at 11:00AM

At first glance, Qualcomm (NASDAQ:QCOM) appears to be in a great situation. It recently reported record quarterly revenue and earnings for its highly profitable licensing business, while its chip business grew at a healthy 8%, year over year. It has a dominant market share of around 66% of the overall cellular baseband market, and a staggering 95% of the emerging LTE market.

Of course, nothing stands still, and there are some early signs of potential future problems for Qualcomm. What exactly are the clouds on Qualcomm's horizon, and what do they mean for the company down the line?

Legal troubles 
Qualcomm recently announced that it has received a Wells notice from the SEC. This is basically an indication that the SEC is considering filing an action against the company because of corrupt practices in a foreign country -- specifically, China. While it's still not clear if the action will be filed or what its outcome might be, a look over the SEC's previous actions in similar cases shows settlements and fines ranging from tens of millions to hundreds of millions of dollars.

And Qualcomm is facing another investigation in China, this time with possible fines reaching more than $1 billion. According to The New York Times, China's anti-monopoly regulator has begun investigating whether Qualcomm "abuses its dominant position in the market and charges discriminatory fees." A settlement could include a fine in the range of 1%-10% of Qualcomm's yearly revenue for China -- $12.9 billion in 2013 -- as well as lower licensing fees in the future.

It's telling that both of these investigations involve the same large emerging market. As smartphone demand is slowing in the U.S. and Europe, Qualcomm is relying more heavily on growth in China. But besides seeing increased regulatory scrutiny of its practices there, Qualcomm is facing a market that's not developing as quickly as expected.

Slower smartphone growth in China 
On the second-quarter conference call, Qualcomm reported that licensee device sales were at the low end of guidance. CEO Steve Mollenkopf explained that this was due to delayed purchases ahead of the LTE rollout in China, which is moving slower than expected.

Qualcomm believes that it will make up for this in the second half of this year. Indeed, according to Bloomberg, China Mobile claims that it will have more than 100 million LTE customers by the end of 2014. Given the heavy investments in LTE technology on the part of Qualcomm and of the Chinese service providers, it's not surprising that both are hoping for very positive results.

However, it's not clear to which extent these investments will translate into customers buying devices. 2014 is predicted to be an inflection point in the demand for smartphones worldwide, with year-over-year growth dropping from 39% to 19% in 2013 and 2014, respectively. China is still a good opportunity and is likely to be above those numbers, but in the words of analyst Stacy Rasgon, "any time you have semiconductor companies looking for a back-half recovery, it makes people nervous."

Increased competition 
If these problems aren't enough, Qualcomm is starting to see increased competition. While it currently controls 95% of the LTE market, several companies are making big plays to take away some of its market share.

In particular, Intel (NASDAQ:INTC) has been fiercely determined to get into the LTE market. One sign of this is the recently announced $3 billion loss that Intel's mobile and communications group posted in 2013. The good news for Intel -- and possible bad news for Qualcomm -- is that some of this investment is beginning to pay off, with Intel's first multimode LTE modem shipping last October, and a version of Samsung's Galaxy S5 with Intel inside likely on the way later this year.

A second significant challenge is Broadcom (NASDAQ:BRCM), which acquired LTE-related assets from Renesas Electronics in September of last year. Broadcom has since gone on to release an LTE chip that will be included in a mid-range Samsung phone that should be shipping soon. According to Stuart Robinson at Strategy Analytics, "Broadcom has the potential to emerge as a key LTE alternative to Qualcomm in 2014."

In conclusion 
Qualcomm is looking good, with a profitable licensing business and a dominant mobile-chip business. Looking forward, management recently stated that it expects to "grow double-digit top line and bottom line over the next five years."

Nonetheless, Qualcomm is also facing serious challenges: regulatory scrutiny that might lead to tighter license revenues in China; a slower-than-expected rollout of new cellular technologies; and more competition in the new LTE market. Keep watching Qualcomm's performance in China over the rest of this year in order to get a sense of the company's long-term prospects.

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Srdjan Bejakovic has no position in any stocks mentioned. The Motley Fool recommends Intel. The Motley Fool owns shares of Intel and Qualcomm. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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