Qualcomm Delivers, But Clouds Are Building On The Horizon

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

Leading wireless chip company Qualcomm (Nasdaq:QCOM) delivered a pretty good set of results for its fiscal third quarter, but that stands in contrast to growing uncertainty and anxiety about the mobile device market. Concerns that the high-end market is at or near saturation are blending in with expectations that as more companies move down-market, margins will suffer. Even against that gloomy backdrop, though, Qualcomm shares look as though they may still be undervalued.

Good Revenue, But In-Line Margins
Qualcomm reported 35% annual revenue growth for the fiscal third quarter, as well as 2% sequential growth, resulting in a 3% beat relative to the average sell-side estimate. Growth was fueled by the chip business (QCT), as revenue rose 47% and 8% on strong unit and ASP growth. Licensing revenue was mixed (up 17% and down 9%) as the company saw minimal year-on-year ASP leverage and a double-digit sequential decline in volume.

SEE: A Look At Corporate Profit Margins
Although revenue exceeded expectations, the company's mix resulted in only in-line margins. Gross margin fell more than three points from the year-ago period and 150bp from the prior quarter. Operating income did rise 19% from last year, but fell 9% sequentially, and the company's in-line operating margin was down four and a half points year-over-year and about four points sequentially.

The Window Is Still Open, But Will It Remain So?
Although Qualcomm's guidance for the next quarter was not all that strong (no sequential growth at the midpoint of the range), the next year or two could still be lucrative for the company. Apple's (Nasdaq:AAPL) iPhone 5S launch is due later this year and Broadcom's (Nasdaq:BRCM) delays in LTE should be beneficial for Qualcomm. At the same time, the company believes it has developed chips that will allow it to benefit from the growth available in lower-end devices without significantly sacrificing margins.

The question is what comes after that. High-end device adoption seems to be slowing noticeably as the market approaches saturation and the incremental advances in technology no longer excite the customer base. Moreover, competitors like Spreadtrum (Nasdaq:SPRD) have worked out how to supply low-end customers such that they can earn a profit in a situation where the ASP of the entire phone is sometimes below the price of Qualcomm chips.
If that weren't enough, Broadcom and Intel (Nasdaq:INTC) both have designs on growing their share in some of Qualcomm's key markets. Although I think Qualcomm has the technological capabilities to hold its own with Intel, the reality is that the entry of a very large competitor into a market with decelerating growth and margin pressure is not going to help the company.

Plenty Can Still Go Right
While I'm increasingly concerned about the future of the mobile device component suppliers, I'm not willing to write off Qualcomm. Not only is the company's licensing business a lucrative source of funds, but I'm not dismissing the company's ability to successfully move down-market (at least into mid-range devices). Likewise, Qualcomm's focus on front-end modules could help solidify its position in the market.

The Bottom Line
If Qualcomm can grow its revenue at a long-term rate of 7%, with similar growth in free cash flow, these shares could still be undervalued by 10% or more. I fully acknowledge that those projections will look conservative compared to many sell-side estimates, but I'm taking a more conservative approach to this market for the time being. Although I think there are better chip stories today, Qualcomm could still be a money-making idea in the middle of this increasingly twitchy market.

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