China Puts the Hurt on Qualcomm, Inc.

Qualcomm faces some major headwinds in the largest smartphone market in the world. Fortunately, only one business segment is affected while the other is doing quite well in the Middle Kingdom.

Evan Niu
Evan Niu, CFA
Jul 24, 2014 at 8:00PM
Technology and Telecom

Source: Qualcomm.

Qualcomm (NASDAQ:QCOM) is at the center of the smartphone world in more ways than one. Being the dominant vendor for processors, baseband modems, and intellectual property, the mobile chip giant enjoys a unique place in the value chain. Meanwhile, China is the world's largest smartphone market, a title it earned last year.

That combination has a lot of potential for Qualcomm's business, but right now the company is facing an uphill battle in the Middle Kingdom. Qualcomm reported earnings last night and it's hitting a pretty big speed bump in China.

Revenue for the quarter jumped 9% to $6.8 billion, adjusted operating income was up 19% to $2.4 billion, and net income soared 35% to $2.47 billion. MSM shipments of 225 million units easily crushed Qualcomm's own guidance of 198 million to 213 million units. All of those figures sound fine and dandy, registering a beat on both top and bottom lines relative to consensus estimates. Yet, shares have taken a beating in part because of a storyline playing out in China.

The licensing business
Qualcomm is reducing its near-term outlook for its technology license, or QTL, licensing business due to a dispute it is having with an unnamed Chinese OEM. Qualcomm believes that this vendor is underreporting its unit shipments, resulting in lost royalty revenue until Qualcomm can resolve the dispute. In fact, Qualcomm believes there are multiple licensees underreporting 3G and 4G device sales, so the problem could be more widespread.

Low-end 3G tablets are on the rise in China as well, but for the most part these tablet manufacturers are not the same as smartphone manufacturers. This means that Qualcomm has to ink new licenses with these tablet OEMs, which can take time. Overall, it's still a positive long-term trend for cellular tablet adoption, but there are some near-term hurdles to clear first.

Device sales for the second half of fiscal 2014 in the QTL business are being cut by 8% as a result.

It doesn't help that China's National Development and Reform Commission, or NDRC, reportedly just determined that Qualcomm has a monopoly, according to China's state-run Securities Times. The NDRC started its investigation into Qualcomm's licensing business late last year. Qualcomm does expect that it will incur some type of loss related to the investigation, but can't "reasonably" estimate how much yet. China is notorious for weak intellectual property protection laws, so it could be a challenge for Qualcomm to overcome its current woes.

The chip business
The Qualcomm CDMA Technologies , orĀ QCT, segment continues to do well, and as a hardware business, it is mostly insulated from the current risks that the QTL segment is facing in China. In fact, Chinese OEMs are a source of strength for the QCT business, with many low-cost vendors buying low-cost offerings like the Snapdragon 410.

Source: Qualcomm.

Qualcomm also recently pushed NVIDIA (NASDAQ:NVDA) out of Xiaomi's freshly unveiled Mi4. NVIDIA's Tegra 4 shared the spot with Qualcomm in the previous Mi3, but Xiaomi has gone exclusively with Qualcomm in the Mi4. It's possible that Xiaomi's production ramp ahead of the Mi4 unveiling helped boost Qualcomm's chip sales last quarter, particularly since it muscled NVIDIA out altogether.

QCT operating margin came in at 23%, topping internal expectations. Next quarter, Qualcomm expects to ship between 230 million and 245 million MSM units, thanks to strong demand within low-end and mid-tier Chinese OEMs.

The overall business
Qualcomm even raised its full-year earnings per share guidance range from $4.57 to $4.72, thanks to strength in the chip business. That's particularly impressive given the underlying trends that each business is seeing.

QTL has much higher margins than QCT, and QTL is the segment facing headwinds. So here we have Qualcomm's higher-margin business running into a speed bump while the lower-margin business is doing extremely well and the net result is that the bottom line is expected to come in even stronger. That's a testament to how well Qualcomm's chip business is doing. In fact, NVIDIA is having so much trouble selling chips into smartphones that it is creating entirely new products to put them into.

Sadly, the China narrative is creating a lot of investor pessimism and overshadowing the results. There are some very real risks within China, but overall Qualcomm's business remains as robust as ever.