TMF Post: Discussion of Q3 Earnings
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growing margins of success
Unrealized losses in Leap Wireless (LWIN)-- Was that the dirty secret that had leaked before the earnings release and helped drive the price down? Because it sure wasn’t the chips, it wasn’t the handset figures or ASP’s, it wasn’t reduced guidance, and it sure wasn’t erosion of the company’s profit margins. One could not have asked for a stronger report on the company’s performance in its core business operations— the numbers are to behold under any environment. In the current world of generalized business malaise and economic gloom, these numbers give patient investors the reaffirmation that they have bought into the right business—one that gently dominates a growing high end segment in a still highly promising yet treacherous sector (contrast Qualcomm’s strong growth against the declines reported by the GSM technology providers). And as the company’s management enthusiastically reported their investor-pleasing numbers of their performance in the marketplace, one could sense even more enthusiasm about the significance of the technological and logistical breakthroughs—of seeing one’s vision of anytime, anywhere high capacity communication turn to reality in one country after another. Differentiation was certainly a key theme of the conference presentation (which one can still access at qualcomm.com. Differentiation in data rates, in handset availability, in cool handset features and functionality, in growing data ARPU’s, in maintaining profit margins through aggressive introduction of devices and services with high consumer appeal, and the confidence that CDMA 1X is the right technology for the right time.
Another area of differentiation, which should be noted, is that Dr. J. started the conference call by stating his personal and his company’s strong endorsement of certification of earnings reports by the company’s executive officers. We need more CEO’s with the kind of commanding moral authority of Dr. J’s science to stand up and reaffirm that ethical behavior is the norm and not an aberration.
Let’s get the unpleasant stuff out of the way, like they did in the earnings release. The charge against earnings to reflect the lower value of QCOM’s investment in LWIN, is not part of pro-forma, hence is not a part of core operations. That’s why there is the QSI division in the first place, and why it is not part of pro-forma. For those new to the company, LWIN was a spin-off of Qualcomm; in the early days, to promote CDMA, Qualcomm had to be the technology developer, the infrastructure vendor, the chipset designer and manufacturer, the handset maker as well as the service provider (carrier). As the technology spread, the company started moving towards sharpening its focus on its role as technology powerhouse (incl. software platforms and business model) and chipset designer and (virtual) manufacturer— LWIN was one of the first businesses to be divested by spinning it off the public. Of course the company retained some equity, and held some long term loans that go back to the initial spin off arrangement. It was an excellent move, because in addition to getting a carrier off its books, Qualcomm undoubtedly realized some value (and possibly actual gains, though I’m not sure—at one point LWIN stock was trading at $60). It is now at about $1, along with all the wireless service providers. But I think they will likely bounce back. Qcom made it clear that the charge taken is for unrealized losses—in many ways, this strikes me as medicine against future doubts about valuation and scrutiny by the Schilits of the world who might question entries on the company’s balance sheet that are inconsistent with market value.
Is this charge a nasty surprise? Not to anyone who knows the content of QSI’s portfolio, posted prominently on the company’s web site (and in earnings releases and annual reports) for the world to see. Is the timing of the charge a nasty surprise? Again, not to anyone who has any inkling of what has been going on in the market for the past few months. Is this charge a major concern for the company and its shareholders? I am more concerned about poor LWIN… they pioneered an excellent down-to-earth service concept that made wireless affordable for everyday people. They leveraged CDMA’s efficiency to keep costs down for consumers. I believe they are likely to be consolidated into a bigger player (Alltel would be a likely suitor, on both geographic, technology and culture factors). For Qualcomm, the magnitude of the charge is relatively small, certainly when viewed in the context of the deteriorating environment for the telecom industry—with typical vendor financing deals of considerably greater magnitude turning sour. On the other side of the ledger, the deal with Telefonica over Qualcomm’s stake in Vesper is a bright spot for QSI and the company. The amounts at stake there are considerably greater than with LWIN, and QSi has negotiated a favorable agreement that includes over $200 Million in cash from Telefonica as well as for the latter to secure the company’s debt to Qualcomm. One was looking at over a $ 1B involvement there, at risk of default, now converted to cash and secured debt.
Again, QSI’s performance has to be gauged from a long-term perspective, which is exactly why it’s been separated from pro forma.
The core operations
Last quarter, here is the guidance the company gave us about the quarter just reported:
Third Quarter Fiscal 2002
Based on the current business outlook, we expect third fiscal quarter pro forma revenues to increase by approximately 3-6 percent compared to the second quarter of fiscal 2002. We expect third fiscal quarter pro forma earnings per share to be approximately $0.21- $0.23. This estimate assumes shipments of approximately 15-16 million MSM phone chips during the quarter, including approximately 10 million 3G CDMA2000 1X MSM phone chips.
They sure delivered, and very convincingly. Instead of the 3-6%, which some analysts felt was aggressive and unrealistic, revenues came in at 9.41% greater than Q2’02! That’s more than 50% greater than the top end of the range, and over 100% more than the midpoint of the guided range.
And of course we’ve all now heard that earnings per share came in at $0.24 per share, a two-penny “surprise” above the consensus estimate, and without gimmickry. Earnings were clearly propelled by hard chipset sales, over 16 million MSM phone chips, including 11 million 3G 1X chipsets.
(For the record, in my discussion of last quarter’s numbers and guidance, I wrote I would not be surprised if the upper end of the range is again reached, and possibly exceeded, with another bonus million 1X chipsets raising the total to 11M.).
This is the single most important story in the numbers: the chipset business is simply rocking! As we’ve discussed all year, QCT was where Qualcomm had to grow the business, and it is outperforming on all fronts. A glance at the time series of QCT revenues and earnings tells the whole story (using the restated numbers for the past two years, at qualcomm.com, along with the newly released earnings).
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QCT
Revenues Earnings margin (%)
Q100 352395 127690 36
Q200 279186 89977 32
Q300 338132 109573 32
Q400 268989 64281 24
Q101 330632 84180 25
Q201 364059 84866 23
Q301 333115 70582 21
Q401 336881 65917 20
Q102 359144 86941 24
Q202 343815 77724 23
Q302 404253 117524 29
An 18% quarter-over-quarter increase in revenues in the semiconductor industry is no minor feat in this business climate. Even more impressive is that the corresponding increase in earnings in this segment is an eye-catching 51%! So revenues increase 18%, while earnings go up 51% suggests that the company is in some sort of sweet spot in the production curve, in terms of the volume and mix of product. The result is a very pleasing 29% margin in chipsets! Looking at the above table, one has to go back two years ago to see margins of this magnitude! Don Shrock indicated, in response to an analyst’s question during the conference call, that he expects these margins to hold steady for the foreseeable future.
I also ran the 3-quarter moving average for the QCT revenues (i.e. the average of the current quarter with the last two preceding ones), to smooth out quarterly fluctuations:
Q300 323238
Q400 295436
Q101 312584
Q201 321227
Q301 342602
Q401 344685
Q102 343047
Q202 346613
Q302 369071
The numbers give a clear indication of the magnitude of the last quarterly increase on the overall trend—a definite leg up in the charts.
The company seems confidently bullish about demand for next quarter, and beyond, as updated Q4 guidance assumes shipments of approximately 18-19 million MSM phone chips during the quarter, including approximately 15 million 3G CDMA2000 1X MSM phone chips.
Is this too aggressive, like some analysts had claimed before earnings release? Shrock clearly indicated that the company has already booked over 95% of its guidance for chipsets for Q4.
One analyst asked specifically about the “inventory overhang of about 3M chipsets”. Shrock basically said that there is nothing unusual with the inventory situation at handset manufacturers; he did not think there was any particular push to get the chipsets out into the channels prematurely, faster than the manufacturers or the carriers could absorb them. He went through and accounted for how the chipset numbers are in fact consistent with their guidance on handsets.
That the company executed and delivered, and is predicting more of the same for the rest of the year speaks volumes about the inherent strength of the business.
Now for the QTL, technology licensing segment, aka known as the gravy train.
Below is the time series, for the past 11 quarters, of the revenues, earnings, and MARGINS of this segment. This is clearly not an aberration; it’s solid, quarter after quarter.
QTL
Revenues Earnings margin (%)
Q100 183845 168890 92
Q200 157197 139968 89
Q300 161301 139440 86
Q400 165568 147466 89
Q101 186824 174139 93
Q201 225646 206663 92
Q301 180129 152890 85
Q401 189340 172102 91
Q102 210803 188688 90
Q202 193955 171535 88
Q302 198853 174450 88
One thing I learned is that QTL revenues tend to lag actual sales of handsets. When asked about handset trends in the past quarter, all Thornley could address was the situation up to the March quarter, as handset vendors had not yet reported for the current quarter (there is a certain schedule for when royalty payments are due, and that’s when the information gets updated). He did indicate that about 70% of all handset sold appear to be replacement handsets, vs. 30% new subscribers. He confirmed that average selling prices (ASP’s) are showing little erosion because of new features that consumers are willing to pay for. He repeatedly mentioned GPSOne location capabilities as being an important differentiator.
The 3-quarter moving average of the QTL revenues is shown below:
Q300 167448
Q400 161355
Q101 171231
Q201 192679
Q301 197533
Q401 198372
Q102 193424
Q202 198033
Q302 201204
This places the current values in perspective, and shows a steady increasing trend the past two quarters, as well as a record high value in the series (reached at the end of Q401). Of course the major news on the licensing front, which did not yet impact revenues, is that Alcatel has signed. The French company was one of the last major holdouts in the GSM world to give in and accept that there is no getting around QCOM’s rights. This leaves Siemens as the lone major non-licensed player with WCDMA aspirations. It will likely happen the next quarter if Siemens has any WCDMA contracts to deliver on. They may also be hoping that TD-SCDMA might gain some credibility so they could trade QCOM some IPR of their own. That is not likely to happen. They will just have to pay to play.
It does not hurt to have this quarterly reminder that this royalty stream is still the best deal going among any large-cap technology company, and the essence of the long-term genius of this company: quarter after quarter of steady licensing/royalty revenues converting into profits at an average margin of near 90%.
Other Issues
Last quarter, the Korean subsidy ban was an issue—the evidence suggests that demand in Korea has remained unabated. China Unicom was, and continues to some extent to be an issue, though there seems to be greater confidence about meeting the 3 to 4 million subscribers by the end of the year. If anything, the somewhat slower initial take up of the service has accelerated the move to CDMA 1X in China, giving Unicom a tremendous advantage over the competition, and opening up that market to the enhanced functionality that has been so well received in Korea and Japan.
The big question next is the US, with Sprint’s promised and long-awaited launch of its 1X network and services. Of course, Sprint has already sold over 1.8 Million handsets equipped with 1X chipsets, and has an exciting line-up of handsets and PDA’s in conjunction with the new service. All indications suggest that the new functionalities will accelerate the replacement rate. In addition, Virgin Mobile has launched on Sprint’s network, so that should add some new subscribers in a different market segment. All indications are that Verizon is also ready to take advantage of its BREW services, and design a marketing campaign around it.
For the Record: Guidance
I have pasted below the officially stated earnings guidance provided by management, for ease of reference.
Fourth Quarter Fiscal 2002
Based on the current business outlook, we expect fourth fiscal quarter pro forma
revenues to increase by approximately 10-13 percent compared to the third quarter of
fiscal 2002. We expect fourth fiscal quarter pro forma earnings per share to be
approximately $0.26-$0.27. This estimate assumes shipments of approximately 18-19
million MSM phone chips during the quarter, including approximately 15 million 3G
CDMA2000 1X MSM phone chips.
Fiscal 2002 Given Last Quarter
Based on the current business outlook, we expect revenue growth for fiscal 2002 to be approximately 4-8 percent and pro forma earnings per share to be in the range of $0.90- $0.95. This estimate assumes growth of the CDMA2000 1X market in the second half of fiscal 2002, and is based on the sale of 80-85 million CDMA phones in calendar 2002 with a 5-10 percent annual decrease in average selling prices of CDMA phones, upon which royalties are calculated.
Updated Fiscal 2002
Based on the current business outlook, we expect pro forma revenue growth for fiscal
2002 to be approximately 7-8 percent and pro forma earnings per share to be
approximately $0.93-$0.94.
When asked specifically about handset sales, Thornley reiterated previous guidance about the 80-85 million range, and the limited decrease in the ASP of CDMA handsets.
In closing, this quarter calls for no apologies! It reflects admirable execution on a brilliant vision based on a powerful and reliable technology, and a deep understanding of how consumers can benefit from wireless telecommunication services. The claims we had heard from the company and the CDG for several years about CDMA 2000 1X have proven their validity. While the competition continues to postpone and delay its 3G and data offerings, and to introduce incremental stop-gap gadgetry, Qualcomm’s CDMA operators have real networks delivering high data rates in a reliable and economical manner. Their customers are enjoying feature-rich handsets at affordable prices. This in turn is delivering growing revenues that convert into earnings at outstandingly consistent margins on the technology licensing side, and at surprisingly improving margins on the chipset side. But, don’t take my word for it, read the report, and let the numbers tell their story.
BRational
For those who did not see it posted elsewhere, the earnings report is available at: qualcomm.com. Read it! |
