Are Market Factors Pushing Qualcomm Into The Penalty Box?

By Stephen D. Simpson, CFA | April 25, 2013 AAA

Financial writers often talk about overlooked or obscure stocks as though it's a bad thing to operate outside of the 24-7 glare of Wall Street attention. When it comes to stocks like Qualcomm (Nasdaq:QCOM), though, maybe a little obscurity would be a good thing. Although I can understand that investors are worried about the fundamental trends in the mobile device market, it seems like matters always get taken up a notch when it involves Qualcomm. To that end, while I wouldn't be surprised if this stock remains volatile through the summer (or the remainder of the year, for that matter), I think the underlying value here still makes it worth a look.

SEE: Equity Valuation In Good Times And Bad

Fiscal Second Quarter Results Come Up A Bit Short
Qualcomm is a stock where the demands on the company are uncommonly high, so there is typically little room for disappointment. To that end, I wouldn't say that Qualcomm's results were altogether surprising given what we'd previously heard from Apple (Nasdaq:AAPL) and Nokia (NYSE:NOK), but the guidance certainly didn't help.

Revenue rose 24% this quarter (and 2% from the prior quarter), coming in just a bit above expectations. Licensing revenue was pretty much in-line (up 20% and 17%), though stronger volumes were offset by weaker ASPs. The same was broadly true in the chip business, where revenue rose 28% and fell 5% on higher volumes and weaker pricing.

It would seem that a large part of the trouble was a mix shift towards lower-margin emerging market business. To that end, gross margin declined two and a half points versus the year-ago quarter, while operating income rose 18% and fell 9%, with operating margin falling two points and missing the sell-side average estimate by about half a point.

SEE: How To Decode A Company’s Earnings Reports

Will Margins Turn Around Soon?
With licensing margin basically okay, it was the chip business that saw the margin erosion this quarter. Some of that erosion would seem to have come from lower shipments to Apple and a higher resulting mix of lower-margin chips sold into emerging markets. It's also worth noting, then, that it doesn't look like the 28nm products are adding a lot of value yet, as they're still expensive to manufacture. While it may be a bit of a tangent, this is one of the bullish arguments for Intel (Nasdaq:INTC) ultimately gaining a larger presence in this market – that their captive fab capacity will give them a manufacturing/margin edge.

Guidance Doesn't Seem Bad, But The Details Could Worry Momentum Investors
I don't think there's anything fundamentally wrong with Qualcomm. Broadcom (Nasdaq:BRCM) and Intel represent varying levels of threat to the business, as does Nvidia (Nasdaq:NVDA) to some extent. Provided that Qualcomm doesn't get “scooped” on some major advance or turning point in its core business, this is a very good business for the long-term.

That said, the near term shows ample signs of change. Like it or not, emerging market phones are becoming a bigger talking point for all of the manufacturers, and as much margin pressure as there has been in high-margin/high-feature phones for the U.S. and Europe, that's only going to get worse in those markets. Likewise, it seems like handset growth has slowed down for the foreseeable future. Still, the changes that Qualcomm management is talking about in their outlook really doesn't seem as bad as the immediate market reaction would suggest.

SEE: Evaluating A Company’s Management

The Bottom Line
I continue to expect Qualcomm to produce free cash flow (FCF) growth in the very low double-digits over the next decade, as the company continues to develop chips and technologies that are fundamental to the operation of wireless devices. On a discounted cash flow (DCF) basis, I value that cash flow at nearly $80 per share today, making Qualcomm appear to be a high-quality tech stock trading at a bargain price. While I don't pretend that Qualcomm will be an easy stock to own, I think there's value here for long-term holders with above-average risk tolerance.

At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.

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