Editor's note: This is Part 2 of Bob Faulkner's look at the issues Qualcomm faces, which was originally published on RealMoney on Aug. 3 at 3:30 p.m. EDT. It's being republished as a bonus for TheStreet.com readers.To read Part 1, which was also republished as a bonus, click here.
laid out the many ways that
falling behind in technology and how that will hurt the company. Now I'll review its shortcomings in emerging markets, and how overvalued its royalty stream is.
I have long been a believer that the majority of future handset subscribers will come from the emerging markets of Asia, Africa, Eastern Europe and Latin America. Services are already available in those markets, but most would-be consumers can't afford today's handsets.
However, as we have seen from reports out of
over the past several quarters, business in emerging markets is booming as handset prices fall.
column last December I argued that, given the growth opportunity in these markets and the price advantage on GSM-based handsets, the local CDMA carriers would be at a competitive disadvantage. Less than six weeks later, Qualcomm announced that it slashed prices on its MSM6000 chips in order to improve the competitive positioning of CDMA carriers in these markets. But at the same time there was an obvious impact on its financial performance.
Since then, there have been a couple of interesting developments.
First, Motorola and Nokia will introduce later this year new ultra-low-cost, or ULC, handsets in India that are expected to be in the $20 range at retail (vs. mid-$30s now). Both products are based upon
single-chip solution. Even
, which has eschewed the "low end" thus far, has apparently relented and is working aggressively to develop a handset based on
Qualcomm has announced that original equipment manufacturers, or OEMs, will ship handsets with its QSC-series parts in the fourth quarter but, as I previously noted, these will not be cost-competitive. The carriers will be forced to subsidize the units, which is what they have to do today to be competitive with GSM. If Qualcomm prices them to compete with true single-chips, there will be even more margin pressure.
Second, somewhat of a surprise within the past few months has been the rebellion of CDMA carriers within emerging markets, which brings into question the future of CDMA2000.
, the largest CDMA carrier in India with roughly 22 million subscribers, began publicly arguing that it was at a disadvantage because of the high costs of CDMA phones and the onerous Qualcomm royalty payments.
Reliance went so far as to apply to expand its GSM operations (it operates both technologies). Despite public denials by Qualcomm executives that other countries obtained more favorable handset royalty rates, the CEO acknowledged in a recent
interview that the company had "special" negotiations with China (i.e., China's royalty rate is lower). Hmmm!
Add to this that
, the No. 1 CDMA carrier in Brazil with roughly 28 million subscribers, announced it's installing a GSM overlay network. Antonio Viana-Baptista, CEO of Vivo's parent Telefonica Moviles, announced on a recent conference call that the "launch of GSM services will allow Vivo to have a wider range of handsets with a shorter time to market on available handsets, and significantly cheaper than the CDMA ones."
The concern is not that Reliance, Vivo and others like them will "rip out" the CDMA infrastructure in the coming months, but that the incremental phone sales will shift increasingly to GSM units. While these carriers are small compared to Verizon, they most likely represent a disproportionate share of the unit growth in the coming years. If that happens, Qualcomm begins to lose some of the volume efficiencies inherent within any semiconductor operation.
Qualcomm management has suggested that discussions with Reliance and
, the No. 2 CDMA carrier in India, will continue. However, Reliance knows it holds the stronger hand as CDMA runs the risk of being marginalized in one of the world's fastest-growing markets.
There is a fairly consistent message that runs through Qualcomm's strategy: its high-end focus.
Management would much rather discuss the latest sample of an HSUPA (high-speed uplink packet access, or 3.75G) part or which carriers have announced plans to build out an HSDPA (high-speed downlink packet access, or 3.5G) network a year or two from now.
It's not that they ignore the low-end, but the high-end plays generate the bulk of revenue and profit and enable the technical strength of CDMA to shine.
However, investors have to be cognizant of the fact that focusing on the upper half of the total available market, or TAM, pyramid can be dangerous and short-sighted.
are excellent examples of firms that focused on the high end of their markets as well.
A Royalty Pain
I have heard repeatedly that Qualcomm is really about the royalties, and I don't disagree with that. But how much are you willing to pay for a royalty stream that is of unknown duration and whose growth will begin to be diminished by the offset between units and average selling prices?
A couple of months ago, I looked at a couple of current "royalty plays" that happen to be public companies. Based on Tuesday's close, you can see from the table below that they trade at 8.3 times sales.
Qualcomm's 8.2 times sales seem in line with the median. But it's not in line with the idea that Qualcomm's entire valuation is based on its royalty business. The company's valuation soars to 20 times the revenue generated by its royalty business, Qualcomm Technology Licensing.
If Qualcomm is really all about royalties, then there is an extraordinary disconnect here. For those who have hoped for a spinout of the chip business (not happening), this should be a real wake-up call.
The bottom line of all this is that Qualcomm has been one of the Street's darlings for a number of years, and with some justification. But as a company moves from a monopoly market to a competitive market, things change. What was no big deal before, now is.
All too frequently, investors are too caught up in the momentum of the stock to look at the details. I know there are very strong differences of opinion on this stock, but let's face it, that's what makes markets.
At time of publication, Faulkner was long Texas Instruments.
Bob Faulkner has been in the investment business for 18 years with an exclusive focus on technology stocks. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Faulkner appreciates your feedback;
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