Now that I am unemployed, I am a bit less encumbered in topics I can write about. However, I want to be clear, the note below is based entirely on public information and my experience in China. Nothing here comes from my previous employer.
For investors in Qualcomm the past year has been marred by the company’s troubles in China. They are under investigation on multiple fronts, their employees have been held in custody, and then two quarters ago they had to admit (PDF) they were not being paid royalties on a very large number of phones built in China. This matters because a large and growing share of the world’s 3G and 4G smartphones are coming from China – from the branded majors like ZTE, Xiaomi, Lenovo and Huawei to the unbranded ‘shanzhai’. This is also the ‘home base’ of Qualcomm’s largest baseband rivals Mediatek (of Taiwan) and Spreadtrum.
I recently had a chance to talk to a couple contacts in China, and it seems that Qualcomm has turned a corner there. One contact characterized their conversation with the government as no longer being hostile, having moved “from argument to negotiation”.
My first trip to China was almost 30 years ago, and in the years I have been working in or around China, I have seen this situation many times. Companies run afoul of something there, and then slowly work their way out. The typical pattern is the company admits some form of wrong-doing (aka self-criticism), pays a fine and moves on. After a decent interval, they announce a major investment in China – open an R&D center, endow a few university research departments, or roll out a major training program. These are usually on the scale of $1 billion (so this $40 million investment is just a start). Then after some further period of time, we start to hear about a few other headlines that are kept out of the spotlight.
If I had to guess (and this is just a guess), I imagine Qualcomm will have to pay something like a $1 billion fine, and then another multi-hundred million dollar investment (all using offshore cash). Then over time, we will learn that Qualcomm has lowered the royalty rates it charges China companies for their handset royalties.
My sense is that most investors see the situation in a similar light. I wanted to post on this because my telecoms contacts outlined current conditions that sound just like this, confirming my guess to some degree.
So that is the good news, there is an end in sight.
However, there are a few pieces of bad news.
First, the timing of any settlement is still very unclear, it could take months before an announcement. My contacts at Qualcomm all pointed this out. Ultimately, the decision to announce probably rests with domestic China political considerations, which are impossible for outsiders to grasp. (To get a sense of that, go back and look at how long the industry waited for China’s 3G licensing to play out. There is no predicting these things.) So investors hoping for imminent news will likely be disappointed.
Second, one of the key points still being negotiated seems to be the royalty rate Qualcomm can charge. Some people believe their average royalty rate in China will go from 5% to 3%, with everyone getting a new contract. Most people on the Street expect this scenario. It is worth noting that there is another alternative. That Qualcomm will be permitted to keep its 5% rate, but will no longer be able to charge that 5% to the wholesale (transfer) price of the phone, instead they will only be able to charge against the printed circuit board (PCB) on which their chips sit. So in very rough numbers that is 3% of a $200 phone or 5% of a $100 board. The math gets more complicated than that, but the PCB option almost always ends up being worth considerably less. If this happens, it would be below where investors expect. The PCB option also opens up the door to endless wrangling about what goes on the board, with design houses working rapidly to split the phone into multiple boards and take many components off PCB entirely.
Now to be clear, nothing is certain here. The situation is fluid, and highly opaque to most everyone. So conditions could change.
There is also a big open question as to what phones will be covered. I say open in the sense that no one I spoke with was clear as to the status of these negotiations or what proposals are on the table. Will Qualcomm be able to charge a royalty for TDD LTE phones, that is phones using China’s domestic TD standard? Will they be able to charge royalties on phones sold solely for domestic consumption? What audit rights will they have? These are big questions with no clear answer.
In all of this, it is important to remember that Qualcomm has many supporters in China. There are many companies who have benefited from their partnership with Qualcomm. And many will rely on the company as they expand international sales. Overall, I think the big winners here will be the China handset companies who should be able to compete more effectively on the global stage.
Overall, I think this is also good news for Qualcomm, as we will at some point be removing a great big overhang. I would not rush out to buy the stock, because there is still the potential for some ‘disappointing’ conditions being attached to any agreement. Nonetheless, a move to settlement will put the company on a clearer footing.