Forget Apple Vs. Samsung, Qualcomm Wins Either Way

By Stephen D. Simpson, CFA | February 01, 2013 AAA

Sometimes it makes more sense to take a side bet instead of trying to figure out the outcome of the main event. Everybody has an opinion and how the battle between Apple Inc. (Nasdaq:AAPL), Samsung Electronics Co., Ltd., and others in mobile devices will play out, but nobody knows. On the other hand, it's quite a bit harder to envision how Qualcomm Incorporated (Nasdaq:QCOM) doesn't win in any of those scenarios. While there will always be some questions surrounding QCOM (Why isn't there more operating leverage? How is Apple's unit growth tracking? Will Broadcom Corp (Nasdaq:BRCM) grab share?), I believe Qualcomm remains a very good stock to own, so long as you believe in the overriding idea of growth in the mobile device market.

Top Investment Trends For 2013: We go over a few investment trends for you to think about for 2013.

Qualcomm Delivers Again in Fiscal First Quarter
Qualcomm reported a strong start to its fiscal year, with good performance pretty much down the line.

Revenue rose by 29%, good for a slight beat relative to the average sell-side guess. Chip revenue rose 34% on even growth in shipments and ASPs, while licensing revenue rose 22% on a similar increase in global handset shipments and a 6% increase in average ASPs (the two do not add up to the licensing revenue growth rate, due to varying royalty/license rates).

Qualcomm not only generated more sales this quarter, but the company did so more profitably. Gross margin was slightly improved on last year (about 20bp), but more than a point better than analysts expected. Operating income rose almost one-third, even with high ongoing R&D investment rates.

Second Quarter Looks a Bit More Challenging
Qualcomm management doesn't usually get too aggressive with its guidance, so it may well prove to be the case that they were conservative again after this quarter. Even so, the company did guide slightly above the prior estimate for fiscal Q2 revenue and EPS.

I do expect there to be some concerns about Qualcomm's operating leverage. It looks like gross margin is going to come under pressure next quarter, as handset prices reset and the company sees some diseconomies of scale tied to new manufacturing runs. Likewise, the company remains committed to funneling a substantial portion of profits back into the business through R&D.

SEE: R&D Spending And Profitability: What's The Link?

It Will Always Be Something with Qualcomm
Few companies have managed to create a business like Qualcomm. Because of the company's dominant IP in CDMA and LTE, they are a toll-taker in the mobile world and collect 3% or more of the value of handsets from licensees. At the same time, they are a powerful player in the chips themselves, with nearly 50% share in baseband chips.

That doesn't immunize the company from investor worries. From time to time there are concerns that the company may be supplanted by new technology/standards or lose its edge in the transition between generations - there were worries (now looking largely unfounded) at one point that the company's position in 4G might not be as strong.

Likewise, there are worries tied to competition and execution. Broadcom very much wants to be a player and they have the IP quality to be a threat. Likewise, Intel Corporation (Nasdaq:INTC) may not be quite as formidable on the IP side, but they have manufacturing expertise and capacity. To that end, it's worth noting that Qualcomm does not control its own manufacturing and has had some challenges (like the yield and supply issues with 28nm chips earlier in 2012).

SEE: A Primer On Investing In The Tech Industry

The Bottom Line
I can understand if investors are concerned that lower handset ASPs may reduce Qualcomm's licensing revenue without a corresponding increase in unit growth, but I think that the mobile market (on balance) remains a good place to be for the foreseeable future. Likewise, while I do believe Broadcom will become a bigger player, I think that ought to be a bigger worry to Intel, Marvell Technology Group (Nasdaq:MRVL) or STMicroelectronics NV (NYSE:STM) than Qualcomm. As for the operating leverage issue, I frankly have no worries here - Qualcomm generates ample cash flow already and if heavy R&D reinvestment is the cost of maintaining share, then so be it.

I model long-term revenue growth of 8% for Qualcomm, and while I think there could be some year-to-year choppiness in operating margins and free cash flow (FCF) generation, I think the company will continue to improve its conversion rates in the years ahead. Overall, I think Qualcomm can continue to grow free cash flow at a low double-digit rate, and that supports a fair value in the low-to-mid $80s.

At these prices, I'm very tempted to buy Qualcomm shares for my own account, and I think they are an appealing investment option for investors still looking to gain exposure to mobile device growth.

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

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