China casts dark shadow over Qualcomm's outlook July 24 2014

Chip giant beats Wall Street forecasts with quarterly results, but warns of licensing shortfalls in China

By Caroline Gabriel

Qualcomm's quarterly cycle this year is becoming predictable - it warns of problems ahead in China, then delivers strong results anyway. Three months ago, it reported solid performance for its fiscal second quarter, but disappointed Wall Street with a downbeat forecast, largely because of uncertainties in the Chinese market. It predicted fiscal Q3 revenues at the low end of analyst expectations, between $6.2bn and $6.8bn, but in fact, has turned in a sales figure of $6.81bn, up 9% year-on-year. Net income was $2.24bn or $1.31 a share, while non-GAAP earnings were $1.44 a share.

The figures comfortably exceeded Wall Street estimates - analysts had targeted non-GAAP earnings of $1.22 a share on revenue of $6.52bn. However, this was only the second time since 2010 that Qualcomm had reported less than 10% year-on-year revenue growth in any quarter, a sign of the growing competition in its core smartphone processor space.

The cycle of warnings followed by over-achievement is not, in this case, just a corporate tendency to manage Wall Street expectations but a genuine sign of the unpredictability of the Chinese market, on which - like most companies in the mobile food chain - Qualcomm is dangerously reliant. "The company's guidance is becoming harder to achieve given the apparent delays in the roll-out of LTE in China," Bill Kreher, an analyst at Edward Jones & Co, told Bloomberg in April. "In the near term, results may be choppy."

His predictions are proving right, and Qualcomm CEO Steve Mollenkopf admits: "The launch of LTE in China is very important to Qualcomm, and it's difficult to predict." The company is particularly eager to see China Mobile's base convert to 4G, as it has created a TD-LTE iPhone for the carrier, but also because it has effectively been excluded from royalty revenues in the operator's 3G technology, TD-SCDMA.

There are other issues in China however, including probes by the NDRC government body into antitrust and corruption - seen by some as part of a broader assault on the US firm's market and IPR position - and difficulties in getting full revenues out of the complex customer base. In its new quarterly statement, Qualcomm reduced its outlook for the current fiscal Q4, because some Chinese licensees "are not fully complying with their contractual obligations to report their sales of licensed products to us".

It cited "certain licensees under-reporting a portion of their 3G/4G device sales and a dispute with a licensee" as well as possible delays in signing new licences while the NDRC investigation is ongoing.

The gap is significant - while Qualcomm expects 1.3bn 3G/4G devices to ship in calendar 2014, the number that will be reported to it for licensing purposes will be between 1.04bn and 1.13bn, because of "units that we believe may not be reported to us, are in dispute or are currently unlicensed. We are taking steps to address these issues."

Qualcomm president Derek Aberle said on the analyst call that "we are experiencing some near-term challenges in the licensing business, particularly related to China. This is something that we will take care of. "But he added, echoing other unknowables in the Chinese business, "the timing is pretty uncertain".

Licences deliver the bulk (at least two-thirds) of Qualcomm's profits and shortfalls in that area cannot be fully offset by any strong trends in chip sales, which have far lower margins. So the disputes will hit the current quarter - net income in the quarter ending in September will be $1.03 to $1.18 a share, Qualcomm forecast, disappointing analysts, who had looked for $1.23.

However, chips account for most of the firm's revenues and rising sales of high end chips will propel revenues in fiscal Q4 to between $6.5bn and $7.4bn, in line with consensus Wall Street predictions of $7.13bn. In fiscal Q3, Qualcomm shipped a record 225m chips, up 31% on the year-ago period, and the number could rise as high as 245m in the current quarter, which would be a 29% increase. New launches from its two largest customers, Apple and Samsung, as well as Chinese LTE, should boost the second half of the year, though there are fears of those handset giants losing share to lower cost vendors, which may not be Qualcomm customers - especially Chinese manufacturers, which often turn to local suppliers such as MediaTek.

Those competitive shifts, and a general move towards lower cost smartphones, are challenging to Qualcomm and will accelerate its efforts to expand in other markets such as the WiFi home and the internet of things. But those trends are fairly well understood and have been factored into analysis of the US giant for some time. By contrast, the Chinese market, especially the licensing and antitrust issues, are creating nervousness with their unpredictability.

Suji De Silva, an analyst at Topeka Capital Markets, told Bloomberg: "Qualcomm told investors that they had the China customers under contract, that it's all worked out. Now we're getting a sense that it's still a challenge. Qualcomm is trying to monetize its technology and China is a more challenging market."

Qualcomm has been investing heavily in China to build a local ecosystem and strengthen its ties with the big three operators there. Simultaneously with its results statement, it announced a commitment to plow up to $150m into Chinese start-ups at various stages, in the important growth areas of ecommerce, semiconductors, education and health. The activity will be managed by Qualcomm Ventures and the first recipients of funding are Cambridge WoWo and Boohee, in mobile education and healthcare respectively.

The vendor was keen to stress its long term engagement in the Chinese market and said it has had several Chinese investments with successful exits (such as Enorbus (acquired by Walt Disney); Aicent (acquired by TA Associates); and NetQin. Other investments in the country include rising handset star Xiaomi, as well as Thundersoft, MadHouse, CooTek, Yongche, Dolphin Browser, Alo7 and Hawkeye.

With a clear nod to the antitrust investigators, Mollenkopf said in a statement: "Since first introducing our technology and products in China well over a decade ago, Qualcomm has contributed to China's wireless industry through investing in research and development, licensing our advanced technologies, and providing the most advanced chipsets to Chinese companies. Our strategic collaboration with and technical support of the Chinese wireless industry has helped this vibrant ecosystem, helped drive direct and indirect employment, and contributed to economic growth in the entire Chinese wireless industry."