Qualcomm's China Struggles Linger

Combine this with hefty pricing pressure on the Android side of the smartphone market, as high-end phone makers slash prices to keep up with Chinese firms selling high-end phones at midrange prices, and Qualcomm forecasts flattish (at best) QTL revenue for fiscal 2016. We still ultimately believe Qualcomm will collect royalties on the vast majority of 3G and 4G devices sold in the long term, but QTL's turnaround in licensing might not be a quick one. Although we're cutting our fair value estimate slightly to reflect lower near-term revenue, we still view the shares as undervalued. We maintain our wide economic moat rating.

Qualcomm failed to provide investors with its usual revenue or earnings per share outlook for fiscal 2016, which hints at a lack of visibility (if not confidence) in regaining processor market share at Samsung, retaining baseband share at Apple, or both. Management remained bullish on its technological strength, yet we still expect intense competition from both vertically integrated and merchant chipmakers that gives us little hope that Qualcomm can retain 100% share at both customers forever. We model a midteens revenue drop in chip revenue (QCT) in fiscal 2016 and remain skeptical that the firm can reach its near-term and long-term QCT operating margin targets.

For the September quarter, Qualcomm reported revenue of $5.5 billion, toward the high end of its forecast range of $4.7 billion-$5.7 billion discussed in July. QCT's results were not as gloomy as feared, as unit shipments exceeded expectations while chip prices recovered 4% sequentially; QCT operating margins reached 8%, ahead of the firm's call for 2%-4% margins. Yet while QCT exceeded a low bar of expectations, we think the 10-K filing partially highlights the firm's recent fall. Qualcomm only discloses sales to its top two customers. Revenue at one customer (probably Samsung) fell more than 30% from a year ago, with market share loss in Samsung Galaxy S6 smartphones the most likely culprit. Revenue at the other large customer (presumably Apple) rose 14%, but iPhone unit sales rose 37% during the past year, which we think implies that QCT's average selling price per baseband chip sold to Apple fell almost 40% since last year.

QTL revenue in the September quarter fell 8% sequentially, with total reported device sales rising only 2% from the year-ago quarter even though the smartphone market grew at a far faster pace. Qualcomm's slippage in China has risen substantially, as negotiations to finalize licensing deals have led to even more flagrant underreporting by some OEMs than in quarters past. We still view these collection struggles as near term in nature, but the timing of finalized deals remains uncertain. On the bright side, Qualcomm's QTL forecast appears conservative. The low end of QTL's fiscal 2016 revenue forecast of $7.3 billion of revenue (8% annual decline) implies meaningful collection improvement since last year, but only as a result of deals signed to date with firms like Huawei, ZTE, and TCL, and does not consider any new deals or catch-up royalty collections. The high end of the range, $8.0 billion (flat year over year), implies some new deals and back payments over the next year, but doesn't reflect deals with 100% of Chinese OEMs. Our updated fair value estimate implies steady collection improvement in the next two years and collections on the vast majority of worldwide 3G and 4G devices by fiscal 2018 and thereafter.

Excluding collection issues, Qualcomm shed some insight into the global smartphone market as a whole. The firm expects only modest 3G and 4G device revenue for the industry in fiscal 2016, as smartphone unit sales may rise at a 10% pace in calendar 2016, but average selling prices may decline sharply for another year as premium Android customers discount their devices to match Chinese competitors. We suspect that a strong U.S. dollar will continue to provide royalty ASP headwinds as well. The forecast is disappointing as it suggests a second straight year of ASP declines, well ahead of management's forecast of low- to mid-single-digit ASP declines. Longer term, we project mid-single-digit ASP declines, although we agree with some of the firm's comments that Chinese OEM consolidation may be inevitable and that pricing is bound to stabilize at some point as the market matures.

Finally, Qualcomm continues to assess its corporate structure and the possibility of splitting QCT and QTL into two separate companies; it expects a decision by the end of calendar 2015 while presumably shedding insight into any moves with an analyst day sometime in early 2016. While we still think Qualcomm is better off as a single entity than two, we recognize that a split remains the single-biggest catalyst for the stock while these various challenges to QCT and QTL persist.