Merrill Lynch take on China.
Positive developments in China
?? China Telecom restructuring L-T positive for Qualcomm
Over the past several days China’s major carriers announced plans to restructure
their operations to spur more wireless competition. The Chinese Gov’t has also
made it clear that 3G licenses would be issued after a successful completion of
the restructuring. We believe this long-awaited development is positive for
Qualcomm and highlight several points in our report.
Explaining the Chinese Telco restructuring
According to ML China Telecom Services analyst Cynthia Meng, the crux of the
restructuring will entail fixed-line operator China Telecom purchasing Unicom’s
CDMA operation (43mn subs). China Unicom will retain its GSM network (125mn
subs) and will likely acquire China Netcom, the fixed line operator. The Chinese
government has made the granting of 3G licenses conditional to Unicom’s
successful restructuring. For additional details please refer to Cynthia Meng’s
May 26 note Chinese Telecom restructuring unveils.
How will Qualcomm benefit from 3G deployments?
We expect the restructuring to be followed by renewed investments in networks.
We foresee migration to all types of 3G networks, including CDMA (EV-DO),
WCDMA and TD-SCDMA playing out as follows: (1) China Telecom is expected
to restart investing in CDMA, deploying EV-DO technology. China Telecom will
also likely transition its 50+mn PHS subs to CDMA over time. (2) We expect
WCDMA networks to be deployed at China Unicom GSM. (3) We believe that the
Government will also promote and encourage carriers to deploy the Chinese
home-grown standard, TD-SCDMA, which was tested extensively over the last
two years. We expect China Mobile to be the carrier deploying TD-SCDMA.
Explaining Qualcomm’s royalty position in China
The Chinese government has never admitted publicly that Qualcomm in entitled
to receive TD-SCDMA royalties. In fact, local vendors have stressed previously
that the local industry holds over 80% of the TD-SCDMA essential patents and
therefore see Qualcomm only receiving minimal royalties. However, in practice,
the largest handset vendors in China are Nokia and Motorola (over 60% market
share), and have already committed to pay Qualcomm in their existing global
contracts (subject to the settlement of the rate dispute with Nokia). In addition,
Qualcomm has already signed royalty agreements with most of the local handset
vendors, reducing the risk of head-on contention. In the worst case, we could
envision Qualcomm mimicking the historical agreements seen in Korea and
China, allowing the local vendors to sell phones locally at a reduced rate, with a
full rate charged on exports.
P&L puts and takes
We note that prices on 3G handsets in China are expected to be lower than in the
rest of the world, especially given the high proportion of sales in Japan and
Korea. Nevertheless, we expect the company to benefit from a 3G cycle in
China, both on the royalty and semiconductor sides of its business. We note that
Qualcomm does not have a TD-SCDMA chip, but is expected to be a significant
player in the CDMA (effectively 100% share) and WCDMA markets. We note that
our model does not include any deployment of 3G in China, and deployment
plans will therefore be incremental to our estimates.
Expect next steps to be announced in coming months
As Cynthia writes in her note, transaction details of the restructuring are expected
within 21 days of May 25, or on June 15 according to HK exchange rules.
Shareholder approval of the restructuring also needs to take place. As such,
Cynthia estimates that it will take 3 to 6 months for all of the deals to be finalized.
Price objective basis & risk
QUALCOMM (QCOM)
Our royalty rate scenario analysis and our DCF model suggests a valuation range
for the stock of $48 to $71, assuming that Qualcomm finally settles with Nokia on
a royalty rate between 2.5%-4.0%, and matches this rate to all its other licensees.
We believe that this is a reasonable range for the eventual settlement level, if not
conservative, given that about 140 licensees have agreed to pay in excess of the
4% royalty rate, with Nokia being the only vendor challenging it. Note that the
2.5% we are utilizing in our valuation work, not only assumes Nokia would get a
discount, but also assumes that all other vendors would get a similar discount,
which in our view, is a very conservative assumption. Assuming an effective
royalty rate of 3.5%, we derive an EPS estimate of $2.51 (excluding options) for
F2009E. Applying a 21x P/E multiple to this assumed F2009 EPS, we derive our
$53 price objective.
Risks to our price objective
Qualcomm's EPS is highly reliant on the royalty rate the company charges
licensees for its patents. Should the royalty rate fall below 2.5%, the theoretical
fair value of the share price could be significantly lower.
Other general risks are: 1) low adoption rate of WCDMA worldwide despite high
expectations; 2) WCDMA pricing environment worsening; 3) ability of
Qualcomm's main chip customers (LG and Samsung) to maintain and grow their
share in the global handset market; 4) additional competition potentially impacting
chip pricing negatively; 5) ability to maintain the royalty rate the company charges
other vendors to license its technology in the face of competitive pressure to have
it reduced. |
