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Qualcomm's Mixed Signals

By Olga Kharif Chalk up Qualcomm's declining stock price as another victim of SARS (severe acute respiratory syndrome). The epidemic has caused havoc in Asia, which had been one of the telecom chipmaker's fastest-growing markets. With fearful Chinese venturing out of their homes only when absolutely necessary, sales of phones that use Qualcomm's chips have dropped through the floor. As Blaylock & Partners analyst Rick Black notes, local carrier China Unicom has reduced sales promotions in response to the epidemic and other local factors that have affected demand.

Other problems have emerged recently as well, pushing Qualcomm's (QCOM) shares down 11%, to $32.08, since the beginning of April. A local dispute has delayed wireless-service rollout in India, which is partly to blame for Qualcomm's wireless-network customers carrying high inventories. And Qualcomm is seeing more competition as the market for its proprietary digital wireless technology used in wireless networks and cell phones builds.

These short-term glitches may present a buying opportunity for long-term investors, but the risk level of this telecom survivor's stock strikes many observers as fairly high. Michael Mahoney, managing director at the EGM Capital hedge fund in San Francisco, sold Qualcomm's shares a little over a month ago, but he says he would buy it again when the SARS epidemic recedes and inventory levels return to normal.

INVENTORY GLUT. The stock is trading at a price-to-2004 earnings (p-e) ratio of 22.5, lower than that of rival chipmakers Intel and Texas Instruments, which have p-e ratios of 24.4 and 28, respectively. And Qualcomm is trading 25% below the 52-week high of $42.89 it hit in December. The current price is too high for the tastes of Deutsche Bank Securities analyst Brian Modoff, who has a hold rating on the stock. In his view, it would be much more attractive below $30.

Qualcomm's revenues -- derived from chip sales and the licensing of its proprietary technology, which digitizes speech for easy transmission -- are increasing. Alan Nogee, an analyst with market consultancy Cahners In-Stat, estimates that of the 450 million cell phones expected to be sold worldwide in 2003, close to 20% will be based on Qualcomm's proprietary technology, known as code division multiple access (CDMA). "We've seen [very high cell-phone] replacement rates in Japan, the U.S., and Korea," says Anthony Thornley, Qualcomm's president and chief operating officer.

The outfit's sales have risen by 50% year-over-year, to $1 billion, in the quarter ended Mar. 31. Earnings rose 135%, to $103 million, vs. the year-ago quarter. Peter Friedland, an analyst with WR Hambrecht, has a hold rating on the stock and believes Qualcomm will show 33% revenue growth and 42% earnings growth in 2003 -- not bad in today's economy. But an inventory glut could make the next two quarters flat, even though that would still represent substantial improvement over the year-ago quarters.

NOKIA'S GAMBIT. SARS and the rollout glitch in India are temporary concerns and pose less of a threat than competition from the likes of Nokia (NOK), the world's largest cell-phone maker, and Samsung, now Qualcomm's largest customer. Samsung has devoted years to developing its own chips, but it has never used them in any significant volume. However, in April it announced plans to rely more on its own products -- although analysts believe Qualcomm will continue to satisfy the bulk of the South Korean giant's chip needs.

Nokia has been making chips for its CDMA phones since 1997, but until recently they were low end and supported few functions. In the fourth quarter of 2003, however, it will introduce the Nokia 6585, a CDMA phone with a full-color display and multimedia messaging capabilities that has been designed to appeal to the fashion-conscious crowd. "Nokia sees a unique opportunity for growing its market share in this technology area," says Adam Gould, vice-president for technology at Nokia's CDMA business.

With a 38% share of the world's cell-phone market, Nokia could see its CDMA share rise to about 15% in a few years, says Friedland. However, rivals would still have to pay royalties to Qualcomm on the CDMA technology, Thornley says, meaning that Qualcomm would continue to dominate the CDMA market, of which it now controls 90%.

SHARPER CHIPS. Qualcomm's Thornley believes that despite Nokia's latest move with the 6585 model, it will eventually follow in the lead of No. 2 cell-phone maker Motorola (MOT), which stopped producing its own chips and turned to Qualcomm -- a move that accounts for much of Qualcomm's revenue boost this year. Nokia has yet to make any overtures, but Qualcomm has expertise and enjoys greater economies of scale, Thornley says.

Qualcomm hopes to maintain a competitive advantage by expanding its chips' capabilities. Later in 2003, it will introduce a chip that incorporates several wireless networking technologies, including its own unique product. "We think this is going to have a significant benefit for operators like China Unicom, Vodafone, and Verizon Wireless," says Thornley. "We are doing that at a low cost, and others don't have that capability."

He also believes that offering a common software platform for its chips is an advantage. Adds Thornley: "That makes phones much easier to support, much faster to introduce -- and time-to-market in this business is absolutely critical."

THE PROMISE OF ASIA. Qualcomm's other rivals, Texas Instruments (TXN) and Intel (INTC), are targeting the next generation of these special chips -- wideband (WCDMA). That market is expected to grow within five years from 2 million chips in 2003 to 40 million in 2007, estimates Nogee. But Qualcomm is hardly standing still here. It's "one of the most competent manufacturers of WCDMA," notes Nogee. One reason: Qualcomm has been investing a third of its research-and-development budget into WCDMA, which it sees as a growth market, especially in Europe.

Undoubtedly, increasing competition in current and next-generation products offers some daunting challenges for Qualcomm -- a conclusion reinforced on May 6, when Texas Instruments announced plans to gear up for CDMA chip production. Some analysts fear that the Qualcomm's margins could come under pressure, despite its dominance in CDMA. And in 2004, it could see slower growth -- perhaps 7% annually, vs. 9% growth in 2002 -- because this year's rate growth was boosted by the new business from Motorola, says Friedland.

Yet Qualcomm insists that the odds are in its favor. According to Thornley, Qualcomm sees India, Thailand, Malaysia, and Indonesia as big growth markets, and it's enjoying increased demand in Australia and New Zealand. While Qualcomm has its work cut out for it, "we've got a huge amount of momentum everywhere," Thornley says. And that means the stock may warrant consideration by investors who can see beyond the short-term hiccups. Kharif covers telecom for BusinessWeek Online

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