May 1, 2013 – Qualcomm: Whadda We Gotta Do to Get Some Respect Around Here!
Consensus expects Qualcomm’s sales and earnings growth to sharply decelerate, with investors even more skeptical, worried that the company’s lucrative IPR licensing business will slow with cheaper phones and royalty rate challenges. We disagree. QCOM’s addressable market will grow with the global migration from 2G GSM, with adoption of cellular in tablets, with the rise of machine-to-machine networking, and with adoption of 4G LTE for residential broadband. We also believe that royalty rates will prove far more stable than many fear. QCOM is the largest IPR holder for LTE, with particularly profound contributions in the technologies most critical for 4G devices, with a peerless R&D program continually adding to the portfolio. We also note that Qualcomm’s innovative licensing approach has established a long-standing legal precedent for the value of its IPR, and that, as a chip maker, it has asymmetrical negotiating leverage over device makers. Finally, we believe Qualcomm’s strength in semiconductors is underappreciated – its modem and ARM-based processor designs are best-in-class, it leads in system-on-a-chip integration, and it recently announced a potentially game changing 40 band RF chip that could be integrated into a single package, turn-key solution. This technical mastery is driving market share gains, while opening more of the device bill-of-materials to Qualcomm.
Expectations for Qualcomm are extremely cautious. Despite 25% sales growth and 18% EPS growth over the past 4 quarters, consensus projects QCOM’s FY14 sales and EPS growth to slip to 11% and 8% respectively. The current share price projects an even gloomier scenario – QCOM’s iso-curve shows implicit assumptions for single digit long term sales growth with deteriorating margins. This pessimism seems to be driven by a belief that the company’s lucrative IPR licensing royalty stream could be in jeopardy. We strongly disagree.
Qualcomm’s addressed market will continue strong growth. QCOM has benefited from a long transition from 2G GSM, where it has no IPR claims and no semiconductor sales, to 3G WCDMA and 4G LTE, where it commands substantial royalties and dominates both modem and processor chips. This transition is still playing out in emerging markets, with 45% of mobile phones sold in 2012 still 2G only. While the increasing prominence of emerging market smartphones will drive average prices lower, the existence of contractual caps on the device price subject to royalty mitigates this somewhat. We also note that the large majority of tablets are currently shipped with WiFi only, but as 4G prices fall with time and competition, the percentage using QCOM IPR should rise, perhaps precipitously, also opening opportunities for semiconductors. We also believe that 4G LTE advanced will successfully compete for residential broadband before 2020, opening another new market for QCOM.
Investors worry that Qualcomm’s royalty rate could fall. Investors have long fretted over QCOM’s royalty rate, first concerned that rates on 3G would be much lower than on 2G, and now again, that they will be lower on 4G LTE. Royalty rates calculated as a strict percentage of total device sales have declined, but this is largely driven by the rise of smartphones and tablets, where royalty payments on expensive models are subject to negotiated caps, and by Apple, which contends that its partner Foxconn’s license allows it to pay royalties on its manufactured costs rather than the wholesale price. QCOM disputes this contention.
We are unconcerned about royalty rates for 5 main reasons. First, LTE has been sporadically deployed and will depend on 3G for seamless coverage for many years, meaning that 4G devices will be subject to 3G royalty rates. Second, QCOM’s patent holdings in LTE are the strongest in the industry and particularly skewed toward technologies required in devices rather than base stations. QCOM’s prodigious R&D spending and leadership in technologies core to the future roadmap of LTE, such as MIMO, position it to add to its dominance. Fourth, since QCOM does not produce devices, it gains considerable negotiating leverage vs. licensees that do, since it typically does not need a cross-license. Finally, QCOM’s 20 year program of licensing its entire portfolio of both standards essential and implementation patents at a fixed percentage royalty to 261 signed licensees is a powerful precedent in negotiations and at court. We note that QCOM has already negotiated 4G renewals with Samsung, LG, HTC, Nokia, Huawei, and Foxconn (Apple) without legal action or obvious effect on collection rates.
Qualcomm’s chip business is taking share and expanding its addressable market. Historically, QCOM has dominated the 3G baseband modem market, an advantage that it has extended into 4G LTE and enhanced with the 2011 acquisition of WiFi chip leader Atheros, and that will serve it well as 2G markets transition to 3G. QCOM has also established leadership in smartphone application processors, benefitting from Android’s share gains vs. Apple, from the design superiority of its proprietary ARM implementation, and from its head start in integrating modems and processors into a single system-on-a-chip (SoS). We expect QCOM’s newest Snapdragon SoS chips to continue gaining share, with the potential for share gains in tablets where it has been historically weaker. Finally, the recently announced 40-band RF chip could position QCOM to take meaningful share in a new segment of mobile semiconductors, with future potential from power management, sensors and displays.
We believe sales and earnings will be meaningfully higher than consensus for FY14. While the prodigious growth in the market for smartphones will slow, the proportion of devices subject to QCOM royalties and addressable by its semiconductor solutions will expand. Even taking investor caution over royalty rates seriously, it is difficult to build the case for the sharp deceleration from the 27% sales growth expected for FY13 and the 11% growth built into FY14 consensus. Given our belief that licensing revenue growth will remain on trajectory, we are also optimistic that overall margins can be sustained near current levels. We believe that the combination of likely upside surprises and revisions with a valuation that appears to be pricing in considerable downside, for a company that is at the technological center of the sector wide paradigm shift underway, is an exceptional opportunity.
For our full research notes, please visit our published research site.