Is This China-Focused Smartphone Chip Maker Still a Bargain?

Sarfaraz is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Prior to releasing its first-quarter’s results, the Asia-focused baseband communication chips manufacturer Spreadtrum Communications (NASDAQ: SPRD) significantly increased its guidance for the second quarter. The company cited strong growth in low-cost smartphones in the emerging markets, particularly China. As a result, its shares rose by 21% in after-hours trading.

Spreadtrum now expects revenue for the current quarter will increase by 42.9% to 47.1% from the second quarter of 2012 to a range of $270 million to $278 million. Previously, Spreadtrum was expecting revenue of between $220 million and $228 million.

Spreadtrum’s rally has also caused a rise in shares of other wireless-chip manufacturer and sellers with exposure to emerging markets, such as Skyworks Solutions (NASDAQ: SWKS) and the largest seller of mobile-phone chips Qualcomm (NASDAQ: QCOM).

Skyworks supplies power amplifiers and front-end modules to original equipment manufacturers (OEMs), including some of the leading smartphone and tablet companies such as Samsung, Apple, HTC and Sony. Despite a solid business model, in the last 12 months, Skyworks’ shares have fallen by more than 14% while its competitors have risen by 17%.

Recent reports highlighting weakness in demand for Samsung and Apple smartphones have hurt the company's shares badly. However, I believe that the company’s fundamentals are strong and its future is very much bright. Its amplifiers and modules are present in almost every other smartphone around the world. In its recent earnings release, Skyworks beat both top- and bottom-line estimates. For the current quarter, the company’s revenue guidance came in below estimates but it remains strong on the earnings front.

Spreadtrum and TD-SCDMA

Spreadtrum is the leading supplier of TD-SCDMA and earns most of its revenue from Korea and China. The TD-SCDMA is the 3G standard which is used by China Mobile -- the biggest telecom operator of the world and the market leader in China. Sreadtrum is a primary supplier to local Chinese firms. Some other analysts have identified that Spreadtrum could be supplying to two of the biggest names in Chinese smartphone market: Huawei and ZTE.

Spreadtrum supplies mainly to the low-end of the Chinese market. I believe that this is its competitive advantage which has given it a strong foothold in the world’s biggest smartphone market. However, there is a catch here; serving this particular segment translates into lower margins.

The gross profit margins of Spreadtrum and Qualcomm are presented in the picture below. As is evident, Qualcomm earns nearly twice as much margin than Spreadtrum. The former supplies primarily to companies that cater the high-end of the market such as Samsung, HTC, and Nokia.

<img alt="" src="http://g.fool.com/editorial/images/54498/001_large.jpg" />

Low-end competition

According to the research firm IDC, the shipments to China of TD-SCDMA phones in the first quarter of 2013 reached 28 million units, showing a massive increase of 390% from the same quarter last year. Of this, four out of every five phones cost less than $200 – the low-end phones.

Spreadtrum has recently launched its dual-core 1.2GHz smartphone chipset for TD-SCDMA and EDGE. DigiTimes has highlighted the company’s dominance in TD-SCDMA. Last year, it captured almost 50% share of the TD-SCDMA market. This year, its shipments could grow by as much 300%. But will this translate into an increase in market share? Probably not. In fact, DigiTimes goes as far as to suggest a 10 percentage point drop in market share. The reason: competition.

This portion of the market, which is a high-volume low-margin operation and includes firms such as Spreadtrum, MediaTek and Allwinner Tech, has been growing quickly while growth at the higher-end has been slowing down. As a result, it has attracted attention of the bigger players, such as Qualcomm.

Heated competition

As the market grows, competition for dominance in emerging markets is intensifying as Qualcomm is now also fiercely targeting the region. Qualcomm will introduce six new Snapdragon 200s that support TD-SCDMA. The chips will also offer multiple-sim support – a feature which is popular in nearly all Asian countries, particularly in India and China. The new chips will be available as early as by the end of the current year.

However, I believe that China will be extremely challenging for Qualcomm due to fierce price competition from Spreadtrum and MediaTek. It would be difficult for the San Diego-based firm to even maintain its market share as it has to compete solely on price. The China-focused Spreadtrum and Taiwan-based MediaTek have considerable operations in emerging markets and therefore have a cost advantage over Qualcomm.

In fact, some research reports have pointed out that Qualcomm’s chip usage in China is under serious threat from Spreadtrum and MediaTek.

Meanwhile, Spreadtrum plans to release W-CDMA chips later this year. This will be Spreadtrum’s first foray into this growing market. By 2014, nearly 800 million devices will be using W-CDMA while this number will climb to 1 billion in 2015. Most of this growth will come from emerging markets.

As identified earlier, Spreadtrum’s competitive advantage lies at the low-end of the emerging markets and therefore, in the coming years, with the growth in W-CDMA, I am sure that Spreadtrum will be able to increase its revenue, even if it gets a very small share of the W-CDMA market. Add TD-SCDMA to the equation and we’ll witness a considerable increase in sales in the coming years, even if its market share in TD-SCDMA drops. 

Therefore, despite the rise in competition, these factors alone make Spreadtrum an attractive long-term investment. However, the recent buyout proposal from China’s state-owned enterprise Tsinghua for $1.4 billion, or $28.50 per share,  caused Spreadtrum’s stock to soar by 16.2% on June 21. The company’s American depositary shares are currently trading at $26.42.

Conclusion

Despite its two recent rallies, the first coming from the positive guidance and the second from the buyout, Spreadtrum is still cheaper than Qualcomm as its stock is trading at relatively lower multiples to its trailing revenue and full-year profit estimates. Spreadtrum’s ADR is currently priced 1.7 times its sales while Qualcomm’s shares are trading at 4.8 times its sales. Therefore, I believe that there is significant room for Spreadtrum’s stock to grow.

Moreover, Spreadtrum generates a return of equity of 25% while Qualcomm gives 18%. Therefore, I believe that Spreadtrum is still looking good and a potential acquisition by a Chinese government-backed organization could strengthen its position in its key market, particularly related to its ability to secure benefits and subsidies in China. 

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Sarfaraz Khan has no position in any stocks mentioned. The Motley Fool owns shares of Qualcomm. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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