Qualcomm Offers Some Rare Outpeformance In Chips

By Stephen D. Simpson, CFA | November 07, 2012 AAA

Investors who've followed chips for a while probably won't be too surprised to see that, in a quarter largely defined by weak performance and lower guidance, Qualcomm (Nasdaq:QCOM) was one of the positive exceptions. Not only does Qualcomm continue to post impressive revenue gains, but the company's extensive spending forces rivals to up their game as well. While there are cheaper chip stocks out there right now, Qualcomm may be one of the best options in terms of its current results, future prospects and overall quality of operations.

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Fiscal Fourth Quarter Results Come in Strong
Qualcomm doesn't always outperform, but it doesn't exactly seem unusual or out of place when it do. With extensive adoption of its Snapdragon chip (and in strong-selling phones) and strong 4G LTE ramps at customers such as Apple (Nasdaq:AAPL) and Samsung, Qualcomm is definitely flexing some muscle right now.

Revenue in this fiscal fourth quarter rose 18% from last year (and 5% from the third quarter), making Qualcomm one of the relatively few semiconductor companies to offer meaningful upside to sell-side estimates. Licensing revenue rose 15% from last year (down 1% qoq) and very narrowly missed the average estimate, while chip revenue rose 21% and 9% as flat shipments (qoq) were outweighed by higher ASPs. Last but not least, wireless revenue was up modestly on both an annual and sequential basis.

Margin and profit performance was a little more mixed. Gross margin came in as expected on a non-GAAP basis (64% versus 66% a year ago and 64.4% in Q3), and was directionally similar on a GAAP basis. There was really nothing wrong here; the lower gross margin was a product of having a higher proportion of chip revenue in the mix.

At the operating line, results suffered from some huge ongoing spending in both R&D and SG&A. Non-GAAP operating expenses rose almost 20% sequentially and 37% annually. While analysts did expect some higher spending, it wasn't to this degree and Qualcomm's non-GAAP operating margin was almost a point and a half lower than expected. Even so, the company beat the average EPS estimate by a healthy amount (though lower taxes and higher other income helped).

SEE: How To Decode A Company's Earnings Reports

Is Qualcomm Buying Tomorrow's Success Today?
Although investors often freak out when companies report substantially higher operating expenses, I do wonder if Qualcomm deserves (and will get), a pass. A lot of this spending can be tied to the transition to 28nm, development of next-gen baseband products, and further development of products and technology for mobile devices using ARM Holdings' (Nasdaq:ARMH) technology.

Put differently, it is becoming increasingly difficult and expensive to compete in the integrated chipsets that customers such as Apple and Samsung increasingly demand. In fact, Texas Instruments (Nasdaq:TXN) has basically chosen to exit the mobile system-on-chip business, due (I suspect) to the cost of staying in the game today and in the future. Likewise, I suspect that companies such as Nvidia (Nasdaq:NVDA) are going to find it painfully expensive to stay involved as well - meaning that Qualcomm and Broadcom (Nasdaq:BRCM) may, in essence, be spending their competition out of the market.

The Good and Bad of Concentration
Although Qualcomm's investments in R&D should keep it well-positioned for future developments in mobile/wireless, I wouldn't say that the market is necessarily developing along the best lines for the company. Qualcomm enjoys very strong positions with both Apple and Samsung (the two strongest smartphone/tablet players today), but I'm not sure that's all for the good - Samsung has a habit of migrating to internally-developed chips and Apple is ferociously demanding on price and performance.

In other words, by no means should Qualcomm refuse or turn away from business with Apple or Samsung, but it might be in the company's best long-term interests to see other rivals such as HTC, Google (Nasdaq:GOOG), Sony (NYSE:SNE) and Nokia (NYSE:NOK) stay viable and gain back some share.

SEE: Using Porter's 5 Forces To Analyze Stocks

The Bottom Line
Qualcomm has been one of the only chip companies to actually increase its guidance for the December quarter, as management's target for the next quarter is about 10% higher than the prior average revenue estimate. Qualcomm still isn't likely to see great operating leverage next quarter, but early indications are that investors and sell-side analysts aren't overly troubled by that right now.

I am impressed by the extent to which ostensibly conservative estimates for Qualcomm still point to solid value in the shares. Mid-to-high single digit revenue growth over the next decade, coupled by a gradual return to the prior decade's average free cash flow margin, generates an overall free cash flow growth target of about 10-11%, and there could be upside on the margin side. Nevertheless, that growth estimate is sufficient for a target in the high $70s to low $80s, and that suggests that Qualcomm shares could still be a good option for new investments today.

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

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