Qualcomm Still Adds Up

By Stephen D. Simpson, CFA | November 08, 2011 AAA

When tech titans are talked about, names like Microsoft (Nasdaq:MSFT), Intel (Nasdaq:INTC), Cisco (Nasdaq:CSCO) and more recently Apple (Nasdaq:AAPL) seem to reliably come up. Given its central role in wireless communication (first phones, now smartphones, tablets and other devices), it is a little strange that Qualcomm (Nasdaq:QCOM) doesn't come up in that conversation. With its fingers in over 300 million devices shipped in the third quarter, this is a chip company still worth a look from most investors. (For more on the tech industry, read A Primer On Investing In The Tech Industry.)

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A Strong Close to the Year
Unlike so many chip stocks, that rise and fall with the success of particular phones or manufacturers, Qualcomm seems to have a firmer footing. Revenue rose nearly 40% this quarter (and up about 14% sequentially), with 39% growth in its core chip business, 48% growth in its licensing revenue and a 5% decline in its small wireless and internet segment.

Earnings were not quite as strong. Gross margin slid five points from the year ago level, and operating income growth trailed revenue growth at 29% versus last year, and 11% versus last quarter. Nevertheless, that still translates to an operating margin of over 30%, despite the fact that Qualcomm spends a whopping 20% of its revenue on research and development (R&D).

The Tech Everyone Wants
It's a fairly narrow list of successful handset developers that do not cut a regular check to Qualcomm for chips or technology. It supports phones that run operating systems from Apple, Microsoft and Google (Nasdaq:GOOG), and its chips are used by the likes of Apple, Nokia (NYSE:NOK), Research In Motion (Nasdaq:RIMM) and Samsung.

That huge ongoing investment in R&D continues to pay dividends for this company. The company's Snapdragon processor platform is looking fairly strong, and could be a real headache for the likes of Nvidia (Nasdaq:NVDA). Not only did Qualcomm displace Intel in the next iPhone, but it has already signed up numerous vendors for 4G supply or licensing deals. Speaking of licensing, Qualcomm collected licensing fees amounting to about 3.5% of the handset price from nearly 190 million devices in the third quarter. (To learn the effect R&D has on a business, see R&D Spending And Profitability: What's The Link?)

Margin Erosion and Competition
Qualcomm is not without a few challenges. Broadcom and Texas Instruments (NYSE:TXN) would love to chew into Qualcomm's leadership, and other chip makers like Intel and Nvidia have explicitly targeted mobile platforms like smartphones and tablets as important markets.

Listening to management's guidance, it is also clear that margin pressures are still very real. Handset average selling prices have generally been trending down, and that saps some momentum from that lucrative licensing business. What's more, Samsung has taken some high-end business in-house - while this is not something that most of Qualcomm's customers can follow (Nokia doesn't make chips), there is that threat of swapping out for cheaper options.

The Bottom Line
Simply put, Qualcomm has a great business, and management continues to funnel a large amount of money back into the business - forcing rivals like Broadcom to keep spending as well. Moreover, the mobile market just does not seem to be running out of steam; even as nearly everyone seems to have a phone already, many of them want the new, new thing.

I frankly wish Qualcomm wasn't so popular. Out of the 42 analysts listed on Thomson, 31 have Buy/Strong Buy ratings. Still, even with that huge popularity, the stock actually looks undervalued right now, on a cash flow basis. There is no shortage of attractively-priced chip stocks today, but Qualcomm absolutely deserves at least some consideration for investors looking to buy into tech today. (If you would like to learn more about the sector as a whole, check out Technology Sector Funds.)

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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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