Following market close on July 22, mobile chip giant Qualcomm (NASDAQ:QCOM) reported its fiscal third-quarter results. It also announced that it would be implementing a "strategic realignment plan" designed to lower the company's overall operating costs and improve operating margins.
For the third quarter, Qualcomm's results were essentially in line with analyst expectations, with revenue slightly below Wall Street consensus and earnings per share slightly above. However, the company's revenue guidance of between $4.7 billion and $5.7 billion for its fourth fiscal quarter were sharply below Street consensus of $6.13 billion.
Is this a short-term blip that Qualcomm will eventually weather or are there deeper fundamental problems with the business?
Understanding the light revenue guidance
During its conference call, management lowered its expectations for its chip business, blaming its reduced expectations on three major factors, all of which are centered on the company's high-end smartphone chip business.
The first issue is that high-end devices using Qualcomm's Snapdragon processors are losing share to devices using non-Qualcomm chips. Since Qualcomm's customers weren't able to sell through as many phones as they had expected, those vendors now need to "draw down" their own inventory levels in the current quarter, meaning that Qualcomm will be selling those vendors fewer-than-expected chips this quarter.
The next issue discussed was a weakness in demand for Qualcomm's high-end chips from a "vertical customer" as a result of "a change in the mix of devices that are selling through." This customer in this case is probably Samsung, and this might refer to the latter selling more smartphones with Samsung Exynos applications processors than Qualcomm had expected.
Finally, Qualcomm's management said that it saw "lower than expected sell through in China of certain handset models using [its] premium tier chipsets."
Is it time for doom and gloom?
The financial performance of Qualcomm's chip business was less than stellar last quarter, with sales down 22% year over year and operating margin down to just 7.5%. Things get worse this quarter as the significantly lower-than-expected sales levels are expected to yield operating margins of just 2%-4% in the company's chip business.
The bad news is that it seems that with Apple having gained significant share (and it's hard to see Apple losing share) and with Samsung seemingly going more vertically integrated, it will be rough sailing for Qualcomm's high-end chip business.
The good news is that Qualcomm is responding to this by significantly reducing its operating cost structure. Even assuming an operating environment that is as difficult as the one that Qualcomm has seen during the second half of 2015, the company expects that its "strategic realignment plan" should allow the company's chip business to deliver 16% operating margins by the fourth quarter of the coming fiscal year.
Furthermore, given that Qualcomm has indicated that it plans to cut costs while keeping its research and development pipeline strong. This implies that Qualcomm management believes that there is meaningful "bloat" in its operating expenses. Reducing this bloat should allow for improved operating performance in tough conditions and amplify good performance in more favorable conditions.
Qualcomm faces challenges, but it can weather them
There's little doubt that Qualcomm faces significant challenges in its chip business and in the near term, the business is likely to remain tough. However, I continue to believe that Qualcomm is an extremely well-run company with a strong management team.
The smartphone market is large and should continue to grow nicely, and it would be a shock to me if Qualcomm weren't able to capitalize further on this opportunity and deliver solid returns to its shareholders over the long term.