Companies that have built leading positions in critical smartphone components, such as San Diego's Qualcomm Inc. (Nasdaq:QCOM) and Singapore and San Jose, Calif.-based Avago Technologies Ltd. (Nasdaq:AVGO), don't get the privilege of resting on their laurels. Between worries about a high-end slowdown, competition and profitability in down-market phones, there are a host of issues swirling around Qualcomm shares. Some of this may well be due to the fact that sell-side analysts have a vested interest in stirring up debate (controversy can mean trading revenue), and the shares do look undervalued even granting the risk of end-market and competitive challenges.
Looking Back To Fiscal Q2
Qualcomm had a sluggish fiscal second-quarter report and its shares have been slowly recovering since that late April announcement. Revenue rose 4% year over year (yoy) and fell 4% quarter over quarter, missing by less than 2%. Both Qualcomm Technology Licensing (QTL) and chip revenue via Qualcomm CDMA Technologies (QCT) were weaker than expected, up 1% and 8% yoy, respectively. Qualcomm's implied royalty rate slipped about a quarter-point yoy, while chip average selling price (ASP) appears to have increased about 5%.
Qualcomm was soft on revenue, but did well on margins. Gross margin declined 60 basis points yoy and rose 200 basis points sequentially, beating expectations slightly. Operating income rose 5% and 27%, basically matching expectations despite the revenue shortfall.
Continuing To Flex Its Muscles
Qualcomm continues to leverage its technology into significant market share. The company still holds a roughly 60% share of the baseband market, with an over 90% share in 4G. Broadcom Corp. (Nasdaq:BRCM) has tried to challenge this dominance in 4G-LTE (long-term evolution), but has yet to catch on outside of a few Samsung Electronics Co., Ltd. phones, and management recently lowered full-year expectations. Intel Corp. (Nasdaq:INTC), in Santa Clara, Calif., is even more hapless thus far in baseband, while Taiwan's MediaTek Inc. has shown that it can be a worthy (and profitable) rival on the low end of the market.
The story is broadly similar in application processors, which support applications running on a mobile operating system. Due in large part to its strong baseband position, Qualcomm held an estimated 54% share of app processors in 2013 (according to Strategy Analytics), well ahead of Cupertino, Calif.-based Apple Inc. (Nasdaq:AAPL), at 16%, as well as MediaTek, Samsung, Spreadtrum Communications, Inc. and Broadcom. While Qualcomm doesn't hold much share outside of baseband-integrated processors (where Samsung has substantial share) that's not particularly relevant.
To some extent these powerful share numbers don't really tell the full story. Intel has spent billions trying to build up its mobile chip business, but the company just can't gain much traction. So, too, with Broadcom. While the acquisition of Tokyo-based Renesas Electronics Corp. assets did give the company a jump with its 4G efforts, the company doesn't appear strongly placed for multi-core processor or 64-bit. Broadcom could perhaps develop into a credible second option in 4G LTE (and phone OEMs arguably want that), but it's now a question of how much money the company is willing to lose in the process, as shareholders are already cranky about the extent to which Broadcom's losses in mobile/wireless are overshadowing the rest of the business.
There's not much competition elsewhere, at least not from my perspective. Intel may never get all that far with its efforts (enough to be viable on its own, maybe, but not a huge threat to Qualcomm) and Marvell Technology Group (Nasdaq:MRVL) is more focused on TD-LTE. The one exception is MediaTek. This company is profitable and has some pretty good offerings for the markets it targets (largely lower-end phones for markets outside the U.S.). Qualcomm and MediaTek could converge toward the middle, squeezing rivals out along the way.
What About Apple?
One of the rumors going around recently is that Apple is working on its own baseband chips, hoping to displace Qualcomm. The advantages to such an effort (no longer buying chips from Qualcomm and greater power efficiency by integrating it with its own processors) would seem to pale in comparison to the size of the engineering challenge. Apple could also choose to acquire such technology, though that seems a long-shot.
There Are Risks, But Expectations Seem Reasonable
There are some threats to Qualcomm's business to consider. There is a risk that the high end of the smartphone market has peaked and sales will slow as there is less differentiation between generations. There's a related risk that Qualcomm will not be able to profitably migrate down-market into mid-range or low-end phones. Last and not least, there's at least a theoretical risk that a rival like Broadcom or Intel will emerge as a legitimate second option in baseband and integrated processors.
The Bottom Line
Acknowledging those risks, there's still a lot going for Qualcomm. In addition to price increases in the chip business, Qualcomm should be poised to see meaningful growth in license revenue as 4G adoption grows in China. All told, look for long-term revenue growth of 5% to 6% with slightly lower free cash flow growth due to slow declines in gross margin over time. Even so, 4% free cash flow growth supports a discounted cash flow-based fair value of more than $82, while the company's margins would suggest an appropriate enterprise value/revenue multiple of 5.0x (or a target close to $88).
Disclosure: As of the time of publication, the author was long Broadcom.