Differentiated Hedging

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By BRational
May 29, 2002

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I have not posted on this board in over a month. It's difficult to believe I have not felt compelled to say something in a whole month about Qualcomm! But, perhaps like many others, I have not been particularly interested in the recent market gyrations, which seem to have their own dynamic that seems to be increasingly dissociated from what goes on in the real world of the business in which the company is engaged. Then again, market turmoil is reflective of a global political and financial situation that can be a legitimate cause for concern, and in the absence of convinced investors all that is left is the money churning created by professional traders, and the rules of that game, to the extent that they remain the same over any meaningful period of time, are different from those of the real economy of production and consumption of goods and services.

But those rules are beginning to change again, as more individual "investors" seem to be trusting their hard-earned monies to hedge fund operators�a sure sign that that particular bearish bubble may be about to burst (Those interested in the rising popularity of hedge funds and the peril it poses can read the article by James Grant called Clipped Hedges in the latest issue of Forbes; noted there:

Carrefour last month disclosed plans to sell hedge funds in French supermarkets. "We want to democratize the hedge fund business," Thierry Gosset, administrative director for financial services of the world's second-largest retailer, told Bloomberg News. ...

In all times and all markets, excess is a leading indicator of peril. In the breakneck proliferation of hedge funds, excess is turning into absurdity. According to the New York Times, the worldwide population of hedge funds is approaching 6,000. With the help of $144 billion in new money, assets climbed 38% last year to $563 billion.
If one had gone to sleep about a month ago, and stopped following the ups and downs of Qualcomm's share price, and then just now woke up, one would be forgiven for thinking that not much has changed. The share price is about where we left it, every day brings another warning about 3G in Europe and the high prices paid for spectrum, along with accounting concerns about how revenues are booked and losses not booked. But one would have missed several important pieces of evidence that the Qualcomm story and investment premise is just as valid as ever, and that the company has been doing rather well in both relative and absolute terms.

Undoubtedly the most significant story has been the KDDI numbers after the introduction of 1X against DoCoMo's FOMA service. We have heard about the 330,000 new subscriber adds in April, more than three times what FOMA had managed to attract in over seven months of service. Of course one month does not a trend make, and the company may have stacked up the deck to deliver strong first month take-up (in which case one wishes Unicom could learn some of their tricks...), so we will be watching carefully for May's numbers, due out in a few days. If the trend holds, as it is expected to, (otherwise we would have probably heard by now that the new service is not catching on), this would provide the strongest case yet for the "differentiation" hypothesis that Talksfree and others on this board and elsewhere have raised.

But differentiation not so much at the level of consumer awareness (that somehow Qualcomm CDMA technology is better...), but at the level of the operator's ability to deliver new data services at reasonable prices. In fact, one could argue that success in this case means that the consumer is not aware of the technology, and that this is CDMA 2000 instead of W-CDMA. When consumers adopt because they like the handsets, services and the price, without having to learn about the alphabet soup of radio interface protocols�then we can look forward to the kind of revenue growth that only mass adoption will bring about.

I see four things that stand out in the KDDI experience (if it holds), which argue convincingly for the 1X case, and more generally for the 3G business model:

(1) New handsets, with color screens and fancy sound, that are creating a "must have" wave not seen in the handset arena since the early days of cool Nokias against drab Ericssons� is this the exclusive purview of 1X? Of course not, but 1X has already ramped up chipset production, and is therefore delivering these capabilities with chipsets that sell at about the same price as the previous generation. From Qualcomm's standpoint, this avoids the unavoidable erosion of margins in the previous generation of chipsets�in fact the company has timed the ramping up of 1X rather remarkably to allow it to not only maintain but improve its margin in the chipset business. For the consumer then, the new handsets are fun again, and they offer new functionality, hence stimulating the replacement market. GregBlack's post earlier captures this excitement quite well from South Korea's vantage point (If you need a refresher, check out KDDI's new 1X handsets and more of the new wave of handsets at the 3G Today web site.

(2) New services�in KDDI's case it's the picture-mail (sha-mai?), location-based services like navigation enabled by gpsOne-capable chipsets, and BREW, about which we need to hear more in the coming months. Japan is the most likely locale to deliver and prove a transferable killer app for the consumer market. (Check out this new KDDI service, which allows users to transmit a picture along with a map of the place where the picture was taken...).

(3) No disruption in existing capabilities and services, with full backward compatibility of existing handsets, all on the same upgraded 1X network. Again, the user is spared the pain of having to understand what device works where. You want new services, get new cool devices, otherwise you keep what you have, and you may be able to get some of the new services�though it won't be long before you decide to upgrade.

(4) The economics from both user and operator perspectives. This is where 1X is really delivering�in handset prices, which are comparable to the previous generation models, with some room for high-end devices, and in the cost to the operator, given the economics of the upgrade and the fact that 1X provides twice the voice capacity as a bonus of sorts--- costs that allow the operator to provide reasonably priced offerings that speak to a mass market.

Every day has been bringing one or the other positive development in the fundamental drivers of Qualcomm's business, and continuing evidence of successful introduction and deployment of 1X 3G and now EV-DO in new markets. The company's guidance is by all expectations quite conservative, and is being reaffirmed at every opportunity. The big unknown in the remainder of the year is the North American market in light of the planned rollout of 1X by Sprint and Verizon (though their initial experience in the markets where their "Express Network" has been introduced looks quite promising (check out slide 11 in a recent Verizon presentation to Lehman.) Meanwhile, Sprint has been moving handsets with 1X chipsets (equipped for voice only, not fast data) since the beginning of the year. Sprint still has the snazziest handsets of any carrier in the US, and seems to have more planned introductions at the 1X network is launched�so one would expect at least handset replacement to continue and accelerate. Delays in the US would likely be very detrimental to Qualcomm.

While the market has tended to overreact any time a negative story about mobile phones appears�and there have been many such stories� the record shows that Qualcomm has in fact been holding up better than most tech powerhouses. This was recently illustrated in the comparative performance of chipmakers over the past year, linked by Putka some time back, showing that Qualcomm Inc. was the only one of the top 20 companies to see an increase in its sales of communications chips and components, rising 14.6 percent in 2001. At several opportunities over the past year, I had tried to show comparative numbers highlighting that Qualcomm's business performance was in a league all its own amidst its peer group. I had not realized just how distinctly differentiated the company's performance was from that of the other chipmakers. It helps to keep some perspective on where we've been to try and better understand where we might be heading.

BRational (hiding away from daily gyrations)

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