Qualcomm (QCOM) is finally getting more attractive

by admin on September 6, 2013

I currently have a small stake in Qualcomm, QCOM (0.39% of my Covestor portfolio) that I am planning on increasing in the next quarter. Since I got my first shares the stock is down -2.31%. This year though stock price has increased 7.15%, which is fairly low when compared with the Nasdaq Index, which is up 18.89% in 2013.

I initially decided to buy a small stake because it was a company I liked, but at the time the stock was expensive, so I decided to get a few shares, track the performance and wait for the right moment to go “all the way”.

That moment finally has come. The company is now clearly undervalued from historical multiples. PE ratio is now 17.64 vs. 27.05 five-year average. The company has $0 in debt and its free cash flow is at an all-time high at $6.619B TTM.

Here are some of the reasons why I believe Qualcomm is a great investment now:

  1. Gross margins are incredibly high, allowing funding for continued research and innovation
  2. Smartphone adoption is strong worldwide and the trend promises to continue for some time
  3. Qualcomm continues to benefit from adoption of new technologies such as LTE
  4. Emerging markets will contribute to the expansion of Qualcomm internationally
  5. Mirasol displays may finally take off, which has the potential to be huge for Qualcomm
  6. Qualcomm is making big bets with new technology and innovation

Of course there are also some risk factors that can impact stock price in the future, some of the most relevant are:

  1. Market share and profitability from chipsets is shrinking
  2. Royalty rate margins are under pressure
  3. The company is too dependent on Samsung

Below I expand on some of the reasons I think Qualcomm is a great investment:

Gross margins are incredibly high, allowing funding for continued research and innovation
Qualcomm has a clear advantage when compared with other technology companies. Most of its revenue comes from royalties where the margins are incredible high – this revenue doesn’t require production, sales or distribution. Royalty charges are the highest margins within Qualcomm (85-90%), but it is not only the margins they generate through royalties that matters, the company has been able to generate margins above 50% from its mobile device chipsets division as well. The mobile device chipsets division is the second largest division within Qualcomm. These incredible margins have allowed Qualcomm to invest heavily in technology and innovation.

The communications industry is characterized by rapid technological change, requiring continuous effort to enhance existing products and develop new products and technologies. Qualcomm’s research and development team has a demonstrated track record of innovation in voice and data communication technologies. Qualcomm’s research and development expenditures in fiscal 2012 totaled approximately $3.9 billion, and as a result, the company continues to expand its intellectual property portfolio. Qualcomm has research and development centers in various locations throughout the world that support its global development activities and ongoing efforts to advance CDMA, OFDMA, and a broad range of other technologies. Qualcomm’s patent portfolio is the most widely and extensively licensed portfolio in the industry with over 220 licensees. At the time most, if not all, companies in the industry recognize that any company seeking to develop, manufacture and/or sell products that use CDMA technologies will require a license or other rights to use one of Qualcomm’s patents.

As part of Qualcomm’s strategy to generate licensing revenues that continue to support its research and development investments while also increasing worldwide adoption of its CDMA technology, they provide the rights to design, manufacture, and sell products utilizing certain portions of their intellectual property to other companies. This strategy has worked fairly well for Qualcomm, helping to enable a wide range of companies in offering a broad array of wireless products and features while driving down average and low-end selling prices for 3G handsets and other wireless devices.

Free cash flow is at all-time high at $6.619B (Twelve Trailing Months). Qualcomm has never been in a better position to continue supporting research, innovation, and acquisitions. During fiscal 2012, the company acquired eight businesses for $774M.

Since 2009 Qualcomm revenues went up from $10.42B to $23.26B (TTM), and net income went from $1.59B to $6.62B (TTM)

Explore more QCOM Data at Wikinvest

Smartphone adoption is strong worldwide and the trend promises to continue for some time
Unit sales of mobile phones have increased from about 1.1B units in 2007 to about 1.72B units in 2012, and this trend will continue few years longer as developing countries continue to adopt these technologies. Qualcomm has a big share in this still expanding market. Qualcomm will have more than 65% of the market share for CDMA chipsets in 2013. Mobile devices based on Qualcomm’s technology will account for nearly 55% of the close to 1.8B mobile devices to be sold in 2013. Based on a royalty rate of 3% and an average device price of $224, the average royalty charge per device comes to around $6.80. This has the potential to be huge for Qualcomm.

The mobile device chipset market has been a turbulent one lately. Qualcomm’s share decreased from 79% in 2006 to about 65% in 2012 due in part to Samsung diversifying suppliers and using Infineon in addition to Qualcomm. 2011 saw Apple moving away from Infineon as its sole baseband chip provider and standardizing its baseband chipsets on Qualcomm’s. This moved helped Qualcomm increase its market share slightly. 2012 saw Qualcomm use its LTE superiority to grab more market share. Despite all the industry turbulence, I expect Qualcomm to continue getting more market share, although at a slower pace.

It is also important to note that penetration of mobile devices based on Qualcomm’s Technology increased from 31% in 2007 to over 50% in 2012. Qualcomm is the only seller of CDMA chipsets with 100% market share.

Qualcomm continues to benefit from adoption of new technologies such as LTE
LTE, which stands for Long Term Evolution, is the 4G technology that will enable faster data transmission speed to mobile devices. Verizon, which is in the process of upgrading its network to LTE, claims that the technology is capable of peak download speeds of 40 to 50 Mbps and peak upload speeds of 20 to 25 Mbps. This transition is ramping up especially in developed markets like the U.S. where all the major national carriers are laying out LTE networks.

In this regard, Qualcomm is leading the LTE transition, having started the commercial production of multimode chipsets that enable mobile phone users to transition from 3G to LTE technology. Moreover, it has become the first player to successfully integrate a LTE chipset on its app processor.

Operators have started to upgrade their CDMA-based technology to LTE, and Qualcomm could be at the forefront of this change. In early 2012, Qualcomm became the first to integrate a LTE modem on its Snapdragon app processor, thereby helping LTE-capable handsets become sleeker and more power-efficient at the same time.

This means that the migration to LTE networks in developed countries all around the world will continue to benefit Qualcomm as well. Although Qualcomm doesn’t hold as many LTE related patents as they do CDMA-based technology patents, they are the best-positioned company in the world to take advantage of this technological adoption.

Emerging markets will contribute to the expansion of Qualcomm internationally
Growing adoption of 3G mobile phone technology by mobile operators in emerging markets favors Qualcomm, which is the leader in the development of 3G CDMA technologies. The biggest opportunity for 3G adoption is in emerging markets, such as India and China.

3G mobile phone technology is based in large part on CDMA2000 and WCDMA protocols and is considered better than the traditional GSM technology. 3G provides faster internet access as well as increased network capacity and flexibility. The migration to 3G technology is happening very quickly in emerging markets like China and India – two of the world’s largest wireless markets. China has over a billion mobile subscribers, only around 14% of which currently subscribe to 3G. This leaves a huge potential for upside as carriers in China are increasingly promoting 3G to increase their Average Revenue Per User (ARPU) levels.

The WCDMA core network was designed specifically to be compatible with the GSM core network, making the transition very smooth for carriers.
A multimode LTE baseband chipset recently developed by Qualcomm also supports the TD-SCDMA technology that China Mobile’s network runs on. Considering that China Mobile is the largest wireless carrier in the world, the potential upside for Qualcomm in this market could be immense.
Mirasol displays may finally take off, which has the potential to be huge for Qualcomm

Although Mirasol displays comprise a small business unit for Qualcomm, it has the potential to grow if they figure it out how to improve and commercialize it. This technology is an alternative to LCD displays and works best under natural light, the problem is that most of us don’t sit and work under natural light any more.

Mirasol displays depend on an external light source to illuminate images, rather than being backlit like an LCD. If anything, this could point to a new future for smartwatches and maybe even e-readers. One of the key advantages this technology possesses is a substantially longer battery life, while displaying videos at a faster speeds. The problem is that colors of images projected indoors are not nearly as good as images on LCD devices.

Qualcomm invested in a new manufacturing facility being constructed in Taiwan to make Mirasol displays. However, despite its many advantages, manufacturing Mirasol displays in a cost-effective manner proved too daunting a task, and Qualcomm decided to shut down the manufacturing completely in 2012. The company is now partnering with Sharp to use the latter’s IGZO technology to improve Mirasol yields. If they figure it out how to improve and commercialize this technology at scale, this could become a tremendous business for Qualcomm.

Qualcomm is making big bets with new technology and innovation
Of course Qualcomm is working on innumerable research and development projects, but I am most intrigued by their mobile apps and femtocell projects.

As a big player in the mobile arena, Qualcomm is always looking to increase availability of mobile broadband and mobile applications. An increased availability of mobile high-speed data access creates opportunities for Qualcomm to provide mobile device software applications that utilize its technology. Qualcomm is betting big in mobile retail solutions. Their biggest effort thus far in this arena is Pay, a cloud-based payment service that enables consumers to make payments using their smartphone. Although they face fierce competition, something interesting may came out of it.

The other interesting product is femtocell. In telecommunications, a femtocell is a small, low-power cellular base station, typically designed for use in a home or small business. It connects to the service provider’s network via broadband (such as DSL or cable); current designs typically support two to four active mobile phones in a residential setting, and eight to 32 active mobile phones in enterprise settings. A femtocell allows service providers to extend service coverage indoors or at the cell edge, especially where access would otherwise be limited or unavailable. For a mobile operator, what is attractive about a femtocell are the improvements to both coverage and capacity, especially indoors. Consumers benefit from improved coverage and potentially better voice quality and battery life. Many operators have already launched femtocell service, including Vodafone, SFR, AT&T, Sprint Nextel, Verizon and Mobile TeleSystems.

The femtocell market is expected to experience significant growth over the next few years, as more and more users abandon landline connections in favor of mobile phones and demand for better network coverage surges. The potential of this market is huge as more mobile devices populate homes around the world.

Now let’s review some of the risks of Qualcomm

Market shares and profitability from chipsets is shrinking
The chipsets gross profit margin declined from around 63% in 2007 to about 52% in 2012. There are many reasons for this decrease. Qualcomm is now competing with Nvidia, Samsung and Texas Instruments, all of whom were new competitors that have recently emerged. This naturally put some pressure on prices and margins. Qualcomm’s Snapdragon is extensively used in Android-based smartphones and Microsoft’s Windows

Mobile smartphones, while the latest Apple iPhone uses an A5 processor and BlackBerry smartphones use TI processors.
The tablet market is expected to grow tremendously over the next few years and hence the tablet chipsets market is also heating up. Qualcomm acquired Atheros to diversify its product portfolio beyond mobile phones and include non-handset devices such as tablets and netbooks (where Wi-Fi is a very important component). Qualcomm recently came out with a quad-core Snapdragon S4 Pro chipset that will help it target the tablet as well as the Ultrabook market, in direct competition with Intel.

Mobile Device Chipset Pricing decreased from around $21 in 2007 to around $17 in 2010. 2011 saw a rebound to around $19 as multi-core and standalone chipsets became more popular as opposed to those with integrated designs, but this increase is certainly only temporarily.

With the dip in CDMA/WCDMA chipset prices, handset companies will benefit from reduced input cost, which will further help in reducing the CDMA handset prices. Cheap phones are especially important in emerging markets, and since developed countries are experiencing levels of saturation already, inevitably mobile prices will go down. Qualcomm therefore has a big incentive to keep reducing the chipset prices in order to gain more traction in emerging markets.

Royalty rate margins are under pressure
Qualcomm charges royalties on each CDMA handset sold; and one time licensing fees from CDMA chipset vendors that use its proprietary technology.

The average royalty rate of mobile devices based on Qualcomm’s technology decreased from 3.7% in 2007 to about 3.2% in 2012.

As mobile devices gain more traction, especially in developing countries, prices will inevitably go down. Since the royalty charge is typically determined as a percentage of the average sale price of a mobile device, Qualcomm will see a big decline in fees collected from royalties moving forward. However, the overall negative impact is mitigated to a large extent by the rise in the underlying market of CDMA mobile devices sold. Currently expected to be 1.8B in 2013.

The average pricing of mobile devices based on Qualcomm’s technology has decreased marginally from $214 in 2007 to $213 in 2011. The royalties’ gross profit margin has declined from 97% in 2007 to around 88% in 2012.

Royalty rates have always been a debatable issue; and the struggle between mobile device vendors and Qualcomm has escalated, as is evident in an increasing number of lawsuits against Qualcomm (the famous lawsuit filed by Nokia against Qualcomm is just one example).

Nokia filed the lawsuit against Qualcomm for over-charging on the royalty rates. While the negotiated figure is unknown, according to Trefis, it is speculated that the royalty rate would have been close to 2% – much lower than the average royalty rate enjoyed by Qualcomm to date.

According to Qualcomm, it may not achieve the same royalty revenues on OFDMA-based LTE technology as it enjoyed in CDMA-based technology. This could lower the average royalty rates for Qualcomm as well.

The company is too dependent on Samsung
Samsung and HTC constitute more than 20% of Qualcomm’s revenue, as per the company’s SEC filings. However, Samsung has diversified its business to vendors like Broadcom and Infineon. It is also reported to be developing its own line of app processors as well as chipsets for LTE and WiMAX technology. This was one of the factors that led to Qualcomm’s market share decline in the past, and could continue in the future. HTC, meanwhile has been losing market share over the past few quarters and a decline in HTC’s handset sales could negatively impact Qualcomm as well.

Motorola is another customer for Qualcomm, but it has seen a constant decline in the market share and is expected to lose further ground in future.
In my opinion, Qualcomm is too dependent on Samsung, and that is probably the biggest threat to the company.

To wrap up, I believe that Qualcomm is a good by at the current levels. Especially because we have a long way to go as a globe before we see a 100% adoption of smartphones worldwide. If other projects like Mirasol screens or femtocell growth gain traction, they may well become the next big thing for the company. Qualcomm also pays dividends, and consistently demonstrates respect for its investors. The company has no debt and is investing heavily in research and development. Cash flow is better than ever and all the fundamentals of the company are in good shape. The company has been committed to buying back its stock, especially since 2005. For all these reasons, Qualcomm continues to be a company that I expect to hold for quite some time.

QCOM Chart

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