One of the key investor concerns on Qualcomm Inc. (NASDAQ:QCOM) is the recent antitrust probe in China that reportedly may require the chip maker to pay a record fine of over $1 billion.
China's National Development and Reform Commission (NDRC) have begun a probe into Qualcomm last year and is currently holding talks with the U.S. company.
Let's look at why China matters to Qualcomm and whether the concerns are justified.
In fiscal 2013, Qualcomm generated $12.3 billion of its revenues in China, up from $8.0 billion in fiscal 2012 and $4.7 billion in fiscal 2011.
While this on the surface seems like a large revenue concentration, and the fiscal 2013 10-k mentions China as 50 percent of revenues, the bulk of this comes from Apple/Foxconn and multinational OEMs exporting phones that were made in China.
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BMO Capital Markets analyst Tim Long estimate the exposure to Chinese OEMs at only 10 percent of total revenues split between royalties and chips.
All chipset purchases from Apple Inc. (NASDAQ:AAPL) occur in China via Foxconn. Also, since Foxconn pays the royalties, all IPR payments happen in China, as well.
Long estimates that Apple/Foxconn accounted for $4.9 billion in revenues in fiscal 2013, for 40 percent of China revenue, compared with $4.1 billion / 51 percent in fiscal 2012. The EPS contribution in fiscal 2013 is estimated at $1.04.
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The second biggest piece of Qualcomm's revenues in China is for handsets made by both Chinese and multinational OEMs for shipment abroad. The chipset revenues for phones exported from China accounted for more than 25 percent of China revenues. This is up meaningfully from 19 percent of China sales in fiscal 2012.
The big jump highlights the move by international OEMs to China for manufacturing (annually, approximately 70 percent of all handsets made are produced in China), as well as the increased global presence by Chinese OEMs.
The next largest revenue chunk is for chipset shipments to Chinese and multinational vendors for sales domestically in China. The last piece, which holds the key to Qualcomm's business, is the royalty payments by Chinese OEMs for their shipments in China and abroad.
Long expects Chinese OEM royalty revenues at $1.2 billion in fiscal 2013, or 10 percent of China revenues, compared to 0.9 billion or 11 percent of China revenues in fiscal 2012.
There was a larger number of phones not paying a royalty. The vast majority of unlicensed shipments to be based on TD-SCDMA technology, and about 50 percent of China's TD-SCDMA phones were unlicensed last year.
Leading carrier China Mobile is moving more aggressively from 3G to 4G and has adopted TD-LTE (Time Division Long Term Evolution). The carrier bought two types of LTE smartphones from handset vendors in 2014. The 5-mode variety supports roaming on competitors' and international 3G and 4G networks, meaning WCDMA and FDD LTE.
The 3-mode phones only support China Mobile's TD-SCDMA and TD-LTE protocols, only allowing limited roaming on 2G networks. Such 3-mode devices are targeted at the RMB1,000 ($160) and lower retail market, and some of the vendors will likely try to avoid paying Qualcomm their royalty.
As in the 3G licensing environment, Long believes that Qualcomm should be able to collect royalties from the vast majority of 5-mode handset vendors, owing to the inclusion of WCDMA and CDMA.
Additionally, Qualcomm should be the dominant chipset supplier for 5-mode phones while the company's share in 3-mode chips will be lower, as Mediatek, Spreadtrum and others have closer ties to the low-end players.
In this scenario, 4G should result in a higher percentage of Chinese OEMS paying a royalty, but 4G in China is more of a fiscal 2015 story for Qualcomm anyway, given the quarter lag in royalty recognition.
Now we will come to NDRC, which in November of 2013 commenced an investigation of Qualcomm related to the Chinese Anti Monopoly Law (AML). In February of this year, a spokesman for the NDRC made comments stating that QCOM "abuses its dominance in the market and charges discriminatory fees."
Long said, in the royalty business, Qualcomm generally charges the Chinese higher rates than many global players. The company's agreements are generally structured with a net royalty rate. Those companies that have more patents to share with Qualcomm generally receive a lower net rate than those with limited IPR. This is a somewhat standard licensing practice.
While many of the Chinese companies probably do not like the terms, they have signed licensing deals with Qualcomm. Upholding the terms of these deals will be even more important when the Chinese OEMs look to export.
Meanwhile, the chipset business of Qualcomm has not acted like a monopoly in China. The company's gross margins for chips sold in China are 10-15 points below the margin level for non-China sales. Also, Mediatek gained major share in 3G in China in 2013, as did Spreadtrum, who is now owned by a state-run University.
Long believes a fine is one potential outcome of the investigation. More likely is a compromised royalty rate for the Chinese-focused technologies, TD-SCDMA and TD-LTE.
In addition, Qualcomm could accept a lower royalty rate for these technologies, with no impact to its current model if all vendors agree to pay it. This is similar to what transpired when CDMA first went to China more than 10 years ago.
Thus, the investors' concerns are overdone as China does represent a growth market, and there could be upside from more royalty capture. Moreover, the global move to 3G/4G, increased connectivity of other devices, and increase content per phone are more important value drivers for the stock.
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