The key to making money in stocks is not to get scared out of them. – Peter Lynch Founded in 1985 in San Diego, California, Qualcomm (QCOM) is the world’s leading chip designer for wireless technologies, including 3G and 4G/LTE. The company also has ambitions to be the leader in 5G. The emphasis here is on designer, because unlike traditional chip manufacturers such as Intel (INTC) and Samsung (OTC:SSNLF) (OTC:SSNNF), Qualcomm does not (yet) have its own manufacturing facilities and has its chips produced by contract manufacturers such as Taiwan Semiconductors (TSM), or provides licenses to produce and use its intellectual property in smartphones, tablets and smartwatches, for example (so-called “fabless production model”). As a sign of its technology leadership, companies that manufacture or use chips in their devices in the above-mentioned mobile communications areas are said to be required to obtain a patent license from Qualcomm. So it’s no wonder that Qualcomm’s customers include global technology leaders and smartphone manufacturers such as Apple (AAPL), Samsung, Huawei, LG, Oppo, Sony (SNE) and Xiaomi (OTCPK:XIACF) (OTCPK:XIACY). Qualcomm speaks in its Annual Report of over 210 companies using Qualcomm technologies in their products and paying royalties to Qualcomm.
In addition, Qualcomm’s Snapdragon LTE modem is widely recognized as the most powerful chip in the LTE market. An attempt by Apple in iPhone 7 production to replace Qualcomm chips with Intel chips to solve its dependency on Qualcomm resulted in performance problems for many iPhones. To avoid this performance problem in its LTE-enabled Apple Watch Series 3, Apple fully relied on Qualcomm’s Snapdragon chips. According to a report published last week by the Washington Post, Apple’s hardware executives used phrases like “the best” to describe Qualcomm’s engineering. Another Apple memo characterizes Qualcomm as having a “unique patent share.” Qualcomm’s business consists of the three segments QCT (Qualcomm CDMA Technologies), QTL (Qualcomm Technology Licensing) and QSI (Qualcomm Strategic Initiatives). QCT and QTL are the revenue generating segments, while QSI makes strategic investments and can be ignored in this context. The majority of Qualcomm’s revenues are generated from the sale of mobile communications chips (QCT). The majority of the profits are generated by the higher-margin business with patent rights and licenses of Qualcomm’s 3G, 4G/LTE and 5G technology (QTL). Depending on the source, QTL revenues account for approximately 3-7% of the wholesale price of a smartphone sold worldwide. While the QCT segment contributed 76% of revenues in fiscal 2018, the QTL segment accounted for 54% or more than half of pre-tax earnings (EBT) (see following chart). Qualcomm’s segment results in FY 2016-2018. Source: 2018 Annual Report of Form 10-K Qualcomm faced headwinds in various court cases that have been going on since 2014, alleging that the company abused its monopoly position to inflate prices.
On the one hand, Qualcomm has been exposed to numerous lawsuits with Apple and its suppliers, as well as Huawei, which have suspended royalty payments until the lawsuits are over. On the other hand, Qualcomm has been fined billions of dollars as a result of various global court orders. All of these factors have resulted in a decline in Qualcomm’s revenues and profits over the past five years, and the share price has come under massive pressure for fear of further revenue declines. Nevertheless, the shareholders were remunerated with a dividend of around five percent during this period. The last five years of the stock are literally like a roller-coaster ride (see figure below): Qualcomm’s stock chart for the period from April 2014 to April 2019. Source: YCharts. A short review Most recently, on May 3, 2018, I published an article about Qualcomm on Seeking Alpha, “Why It’s A Bargain Right Now,” and presented two scenarios for short-term and long-term investors. On the one hand, I discussed the long-term prospects in connection with a potential takeover of NXP (NASDAQ:NXPI), according to which a leading chip company in the areas of mobile communications technology, the automotive industry, and digital payment solutions will be created. On the other hand, I spoke about the upside potential of the stock price in the context of an announcement of a tremendous share buyback program in the amount of $20 to $30 billion which would correspond to 27-40% of the market capitalization at that time. At the same time, I discussed the sense and nonsense of this potential share buyback program. While the NXP acquisition was cancelled due to a delay in the approval process by the Chinese regulatory authorities, the company announced a $30-billion share buyback program on July 25, 2018 (of which $7.8 billion was still pending as of December 31, 2018).
This announcement of the share buyback program catapulted the stock from $59 to $74 within a few days (representing a 25% rise in the share price). In the course of the general stock market correction, the uncertainties surrounding a trade deal with China and the legal dispute with Apple, the stock bottomed again at around $49 at the end of January 2019. Furthermore, in my article of May 3, 2018, I added that Qualcomm’s management aims to resolve the license disputes with Apple by the end of the year and preferably out of court. In this context, it was also announced that the Qualcomm licensing model was revised. The price cap for calculating royalties was dropped from the original $500 to $400 per device (smartphone manufacturers must provide a given percentage of the device price to Qualcomm). In this context, I added that the revision of the licensing model should help to resolve the current licensing disputes with Apple and Huawei in a timely manner, and also prevent further license disputes and legal disputes with other Licensees. Therefore, assuming a positive development of the points already outlined, the Qualcomm course should arise from its Sleeping Beauty sleep. I assumed that the price rises that we have seen during the Broadcom takeover battle have been a little preview of what the actual worth of Qualcomm is. So what happened recently? On April 16, 2019, it was announced that Apple and Qualcomm agreed to dismiss all litigation worldwide in a settlement that involves Apple paying Qualcomm. The companies also have reached a six-year license agreement, effective as of April 1, 2019, including a two-year option to extend and a multiyear chipset supply agreement. As a result of this announcement, Qualcomm’s share price exploded again, rising by around 45 percent within a few days (see chart below):
Qualcomm’s share price soars following announcement of agreement with Apple. Source: YCharts. While no information has been provided about the amount of the actual payment, UBS analyst Timothy Arcuri estimates that Apple paid $5 to $6 billion to Qualcomm to settle the global litigation. In a regulatory filing related to the agreement, Qualcomm reveals it expects incremental EPS of about $2 as product shipments ramp. This expectation is in line with the 2019 guidance announced by Qualcomm in April 2018. As a result, the settlement of the licensing dispute with Apple would have a positive impact of $1.50 to $2.25 on Non-GAAP EPS (see following figure). Fiscal 2019 EPS guidance. Source: Qualcomm Inc. 2018 Q2 – Results – Earnings Call Slides At the same time, Intel has announced that it drops 5G smartphone modem business after Qualcomm-Apple truce. Instead, Intel will focus on 4G and 5G modems for PCs, IoT, and other data-centric devices. This should make it obvious that the 5G modems for the iPhones (as well as probably for the iPads and Apple Watches) will be delivered by Qualcomm from 2020. In any case, Qualcomm is considered the leading designer of 5G modems and already has a 5G modem in its portfolio, the so-called Snapdragon X50. As expected, the settlement of the Apple-Qualcomm dispute resulted in numerous analyst upgrades. First, Stifel leaves Qualcomm’s sidelines for a Buy rating ($100 PT) and says management’s $2/share earnings increase projection suggests no or only a slight discount to Qualcomm’s licensing fee. Second, Evercore steps from In-Line to Outperform calling Qualcomm shares “investable” again after the Apple settlement. The firm raises its target from $60 to $90.
Third, JPMorgan (NYSE:JPM) cites Qualcomm’s “strong 5G positioning” in its move from Neutral to Overweight. I assume that further analysts will follow with bullish comments. How attractive is Qualcomm’s current valuation? While it is currently difficult to make a valuation based on cash flows without additional guidance from management, the EPS guidance for the fiscal year can be used to make a current valuation compared to the peer group. As mentioned earlier, Qualcomm management expects earnings per share of $4.47 to $5.22 for fiscal 2019. As the licensing dispute with Huawei is still pending, I take a conservative approach to the valuation basis and expect a GAAP EPS of $5. Based on the closing price of $79.89 from Thursday last week, the P/E ratio would be 16 for fiscal year 2019. Based on the non-GAAP EPS cap of $7.50, the P/E ratio of 10.65 is even lower. Looking at the peer group valuation, it is noticeable that despite Qualcomm’s market leadership and quasi-monopoly position in the 5G sector, the licensing disputes with Apple and Huawei caused it to trade at a discount. For example, Texas Instruments (TXN) (22.04), Taiwan Semiconductor Manufacturing (22.13) and Xilinx (XLNX) (34.88) have a P/E ratio at least 37.5% higher than Qualcomm. On the other hand, companies such as Intel (INTC) (12.98) and Micron (MU) (6.82) have lower P/E ratios. However, this is not surprising, as Micron produces rather inferior chips with NAND and DRAM in comparison to Qualcomm, and Intel generates its sales predominantly in the PC sector, which is losing more and more importance. In addition, the results of these two companies are influenced by factors such as the slowdown in China and weakening NAND and DRAM demand. In contrast, the 5G segment is still in the starting stages, so Qualcomm’s future earnings do not yet appear to have been included in the current valuation. This could mean, among other things, that the stock is currently attractively priced, despite the recent stock price rally.
The following figure illustrates the peer group valuation. P/E ratios im Peer Group Vergleich. Source: YCharts. In order to evaluate how attractively Qualcomm is currently valued, assumptions must first be made. According to Q1 2019 results, management expects a 5% increase in 3G/4G/5G device shipments in 2019. The year 2019 will also be the roll-out year for 5G (see following figure). Qualcomm’s global 3G/4G/5G device shipment estimates. Source: Qualcomm Inc. 2019 Q1 – Results – Earnings Call Slides If it is now assumed that device shipments will experience acceleration from 2020 and grow by 10%, Qualcomm’s results will be affected accordingly. Let’s say Qualcomm’s results would grow by only 10% per year over the next five years for the sake of simplicity (I assume that Qualcomm’s results will be boosted by the 5G rollout and the settlement of the Apple and Huawei dispute, but we need a basis to make a useful valuation with the information available). I have prepared two valuation models for this scenario. In the first valuation model, earnings per share for the next five years are discounted at 8% and a terminal value is calculated. In this model, no growth is assumed from last year onwards. Since the chip sector is subject to cycles, this approach can make sense. Finally, the fair value is determined on the basis of earnings per share for the next five years and the terminal value.
In the second valuation model, earnings per share for the next five years are also discounted at 8%. In comparison to the first model, however, no terminal value is calculated, but the result of the fifth year is multiplied by the average P/E ratio of the last five years, which according to Morningstar is 19.4 (see red mark in the following figure). Qualcomm’s valuation as of April 19, 2019. Source: Morningstar. Based on the first valuation method, the fair value is $120.68, which corresponds to an undervaluation of the stock of 51% (see figure below). Fair value calculation, method I. Source: Author’s calculation. Based on the second valuation method, the fair value is $96.65, which corresponds to an undervaluation of the stock of 21% (see figure below). Fair value calculation, method II. Source: Author’s calculation. Regardless of which model is used as the valuation basis, it should be noted that Qualcomm has a pending $7.8 billion share buyback program as of December 2018 (see following figure).
Qualcomm’s stock repurchases since FY 2003. Source: Qualcomm Inc. 2019 Q1 – Results – Earnings Call Slides. In addition, Qualcomm had short and long-term debt totaling $16.39 billion as of Q1 2019. In contrast, cash and marketable securities totaled $10.32 billion. If the $5-6 billion proceeds from Apple are added to this, Qualcomm has a net debt-free balance sheet (see following figure). Qualcomm’s key figures as of December 2018. Source: Qualcomm Inc. 2019 Q1 – Results – Earnings Call Slides. Furthermore, investors are rewarded with a dividend yield of currently 3.10% on Thursday’s closing price (most recently increased from $0.54 by 9% to $0.62 per share and quarter). Nevertheless, until two years ago the dividend was increased by double-digit growth rates. Now that the legal dispute with Apple has been settled, I assume that the legal dispute with Huawei will also be resolved in the short term and that Qualcomm will again increase the dividend by double-digit growth rates in the future. The following chart illustrates Qualcomm’s dividend performance since 2009: Qualcomm’s quarterly dividend payments since FY 2009. Source: Qualcomm Inc. 2019 Q1 – Results – Earnings Call Slides. What additional growth factors could Qualcomm have? 1) The semiconductor sector in general Nowadays, almost every electronic device contains chips, no matter whether television, smartphone, tablet, smartwatch, automobile or coffee machine. But they are not just simple chips. The technology is now so mature that these devices have to communicate with each other and are becoming increasingly powerful (keyword: “Internet of Things”).
In my view, the semiconductor sector is almost a consumer goods market that will grow even faster in the future, driven by developments such as electric cars, autonomous driving, robotics, artificial intelligence and wearables. My assumption is confirmed by an article in the German-language magazine Focus Money, according to which the global semiconductor market will grow by 16.8% to more than 400 billion dollars. The share of semiconductors in electronic devices is expected to rise to a record 28.1% and beyond (Focus Money, Issue No. 43/2017). An additional boost is coming from emerging markets such as China and India. For example, 41.5% of all semiconductors were installed in China in 2015 (Focus Money, Issue No. 34/2017). The chart below shows that after the financial crisis broke out in 2007, there was only a small drop in semiconductor sales, but in 2010 there was a strong recovery, confirming my thesis. Revenues in the semiconductor industry worldwide. Source: taken from Focus Money, Issue No. 43/2017. 2) Broad product range in future-oriented markets According to Qualcomm management, commercial deployment of the 5G technology is expected to begin in the first half of 2019. 5G is a key technology on the way to the age of the “Internet of Things”, such as autonomous driving, “Internet of Things” and the increasing digitalization of areas of life. At the same time, 5G will contribute to the spread of ultra-high definition (4K) video streaming and virtual reality. It is certainly understandable what immense potential lies behind 5G technology and Qualcomm as the designer and beneficiary of this technology. A competitive advantage of Qualcomm, in addition to its strong positioning in mobile communications, is its broad product range in future-oriented markets such as augmented reality and virtual reality.
The areas of Virtual Reality and Augmented Reality offer immense potential and represent a huge future market. Qualcomm’s new and most powerful chip “Snapdragon 845,” unveiled in December 2017, can be used in VR/AR headsets as well as smartphones. Qualcomm has developed a reference headset for this purpose, which was presented at the Mobile World Congress held in Barcelona from February 26 to March 1, 2018. The first customers in the AR/VR headset segment are Oculus (a Facebook company) and HTC, which are also among the largest suppliers in this segment. Thus Qualcomm is represented not only on 5G and Internet of Things, but also in the future markets of Virtual Reality and Augmented Reality. 3) Increasing expansion of mobile communications technologies in emerging markets Demand for 3G and 4G/LTE is growing, particularly in emerging markets such as China and India. In India, Qualcomm has entered into a cooperation with Reliance Industries Limited, the most valuable Indian company in terms of market capitalization. Mukesh Ambani, CEO of Reliance Industries Limited, has set himself the goal of providing mobile communications throughout India. To this end, in 2016 he launched the telecoms group “Jio” and acquired more than 100 million customers within ten months. Within the next few months, the customer base is expected to grow to 250-300 million customers. This means that in addition to China, more and more people in India will be turning to smart devices. In addition, the in-house “Jio Phone,” launched in September 2017 and designed to be an affordable smartphone for the Indian population, is equipped with Qualcomm’s 4G technology, which should have an impact on Qualcomm’s revenues in the coming quarters. India has a population of 1.3 billion. Assuming you equip only half of India’s population with smartphones and Qualcomm earns the lower limit of 3% of the retail price on each device at an average retail price of USD 300 per device, this would be an additional $5.85 billion in revenue for Qualcomm. This, in turn, would mean a 25% increase in revenue based on 2018 revenue. This example only applies to smartphones. This calculation does not take into account the fact that more and more smart devices are being equipped with LTE and 5G modems in future. The price of USD 300 is very realistic, even relatively low, since Apple in India, for example, offers refurbished iPhones at this price.
Qualcomm also has a strong presence in the Chinese smartphone market, the largest in the world. The vendors Huawei, Oppo and Vivo, which are competing head-to-head in China with market shares of 19%, 18% and 17%, respectively, closely followed by Xiaomi and Apple, are all Qualcomm customers. All of these factors represent Qualcomm’s technological leadership and “moat” in the current marketplace, while at the same time indicating its likely role in the increasingly digitized and networked world of the future. 4) Potential acquisition of Dutch chip manufacturer NXP Semiconductors Qualcomm CEO Steve Mollenkopf gave an interview on CNBC after settling the dispute with Apple. He was confronted with the question of whether a potential acquisition of NXP Semiconductors was still in the pipeline, as China would have given the go-ahead for a potential acquisition during negotiations with the US government. Steve Mollenkopf commented: “We’re grateful to learn of it, but the time has passed. The clock has run out.” While at first glance it looks as if the CEO has closed the doors, this could also be a negotiation tactic. In my opinion, Qualcomm could use the money available on the balance sheet and the Apple deal inflows to acquire NXPI. This acquisition could make sense for a number of reasons. NXPI is one of the largest European chip manufacturers and, with a market share of over 14%, the market leader in the automotive sector for connected and autonomous cars, ahead of the German company Infineon (OTCQX:IFNNF). Market shares of semiconductor manufacturers in the automotive sector. Source: Statista. Furthermore, NXPI’s Mifare smart card technology is considered as one of the most widely used contactless smart card technologies in the world. According to NXPI, it has sold over 10 billion cards and over 150 million card readers. In terms of market share, NXP ranks second behind Infineon, but ahead of Samsung.
The combination of Qualcomm and NXPI would achieve annual revenues of more than USD 30 billion and a leadership position in markets such as mobile communications, the Internet of Things, security solutions, and the automotive industry. The total volume of these markets is expected to reach USD 138 billion by 2020, providing ample growth potential. In addition, the NXP acquisition will enable Qualcomm to achieve greater diversification of its revenue sources, reduce its dependence on the smartphone business and even have its own manufacturing facilities. As a result, Qualcomm will be less dependent on individual sectors and will be able to create synergies and reduce costs through in-house production, which may result in higher margins in the QCT business. In this way, profits have further growth potential. Another key competitive advantage of the NXP acquisition would be that Qualcomm could better protect its technologies and thus its competitive advantage by eliminating contract manufacturers and allowing chips to be manufactured in its own manufacturing facilities. 5) A potential trade deal with China A potential trade deal with China could give the Qualcomm shares another boost, as 67% of revenues in 2018 were generated with Chinese partners (see chart below). Regional breakdown of Qualcomm revenues in FY 2018. Source: 2018 Annual Report of Form 10-K At this point it is worth mentioning that in China the vendors Huawei, Oppo and Vivo deliver a head-to-head race with market shares of 19%, 18% and 17%, respectively, closely followed by Xiaomi and Apple. Excitingly, these companies are all Qualcomm customers. Furthermore, a trade deal could help Qualcomm and Huawei to settle their license dispute and allow Qualcomm management to focus fully on operations in the future.
This deal could also help Qualcomm better protect its intellectual property in the future and maintain its market leadership in various sectors. All the above mentioned potential growth factors represent Qualcomm’s technological leadership and “moat” in the current environment and at the same time demonstrate its likely role in the increasingly digital and networked world of the future. Conclusion Know what you own and why you own it. – Peter Lynch The largest price gains are often made in a short period of time, as was recently the case with Qualcomm. So it’s important to make assumptions and be patient until the assumptions come true. In my opinion, this is one of the key factors for success on the stock market. The legal dispute with Apple – one of Qualcomm’s most prestigious and important customers – has now been resolved, allowing the company to focus fully on operational performance in the future. The 5G generation in mobile communications is currently in the roll-out phase, so that it can be assumed that profits and cash flows will increase after the second half of 2019. Irrespective of this, Qualcomm continues to have solid fundamentals at the moment. Further growth potential is offered by its strong positioning in the areas of the Internet of Things and Augmented/ Virtual Reality. The increasing expansion of mobile devices in emerging markets should also boost growth. A potential trade deal between the US and China could drive the stock higher, as currently more than 60% of Qualcomm’s revenues come from Chinese partners. Qualcomm has a favourable valuation compared to the peer group and is fundamentally undervalued by over 20% despite the share price rally due to the Apple settlement. In addition, there is a pending share buyback program of around $7.8 billion as well as the dividend yield of currently over 3%, which also speak for an attractive shareholder value in the future. In connection with the dividend, it is worth mentioning that it grew at double-digit rates until two years ago. Now that the legal disputes have been settled and as a result cash flows should increase, it can be assumed that the dividend will again grow at double-digit rates in the future.
This makes Qualcomm interesting not only for value investors, but also for dividend income investors. Wish you much success with your investments!
Disclosure: I am/we are long QCOM, AAPL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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