Qualcomm: Whadda We Gotta Do to Get Some Respect Around Here!

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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.

Qualcomm – Walking in a Wireless Wonderland

Over the past decade, QCOM has grown sales by an average of 19.7% and EPS by 12.3%. Since 2010, the average top line growth has been 28%, with EPS rising at a 22.8% CAGR (Exhibits 1-2). This growth has been driven by QCOM’s tight linkage to the rise of portable devices, both through its IPR licensing program, which collects a substantial royalty on almost all devices supporting 3G WCDMA and 4G LTE, and from its mobile device semiconductor business, where it has gained global leadership in both processors and modems for smartphones. At the forefront of one most important technology areas driving the paradigm change underway in TMT, with a huge and fast growing addressable market, and with new product initiatives poised to extend its reach, QCOM management is undoubtedly confident in its prospects for the future.

Curiously, investors are skeptical, rising from two main concerns, neither of which holds up to closer scrutiny. The first is the sustainability of QCOM’s royalty rate – a topic that has led its investor meetings for more than a decade. While the company leads the patent count for IPR essential to 2G CDMA, 3G WCDMA AND 4G LTE, the gap over the second place patent holder has shrunk with each successive standard. Despite years of stability, many analysts have surmised that QCOM would be forced to accept a much smaller percentage royalty once its licensing agreements come up for renewal. We believe this assessment is misguided for five main reasons:

  1. Wireless devices will remain multimode, supporting the 3G WCDMA standard, in addition to 4G, for many more years, and requiring patent licenses for all of the technologies.
  2. QCOM’s LTE IPR leadership is particularly concentrated in technology areas crucial to device makers and central to the superior performance of the standard.
  3. QCOM’s historically successful and aggressive R&D program positions it to extend its lead in future generations of the standard, and for 5G standards, as they emerge.
  4. QCOM has considerable negotiating leverage – since it doesn’t sell devices, it does not need cross-licenses from most device makers and is not as vulnerable to injunctions.
  5. QCOM’s policy of licensing ALL of its IPR for a percentage royalty from its more than 260 licensees sets solid legal precedent and protects against patent by patent challenges.

Investors are also concerned that a shift to lower priced smartphones will stoke chip competition, bringing both share loss and margin compression for QCOM. While the success of MediaTek and Spreadstrum in the low-end is driving QCOM to offer lower priced reference designs, these products are mostly incremental, addressing GSM markets it had not served for 2G. Meanwhile, QCOM has many other growth opportunities – WiFi and RF chips, increasingly integrated SoC solutions, tablet solutions, and chips for other connected devices (wireless residential broadband, automotive, machine-to-machine, etc.) – that will not face the same low-end market price pressure.

We believe that consensus estimates for QCOM in FY14 are unduly conservative and that the current share price, which embeds even more conservative assumptions, substantially undervalues the company. Longer term, we believe QCOM will be the most important semiconductor company of the next era of the TMT segment, and see it as a fundamental core holding for investors looking to address the generational paradigm shifts that are underway.

Exh 1: Qualcomm Quarterly Revenue, 1Q 2000 – 2Q 2013

Exh 2: Qualcomm Quarterly EPS, 1Q 2000 – 2Q 2013

In the Beginning …

Qualcomm was founded in 1985 by wireless technology legend Dr. Irwin Jacobs and a handful of other engineering luminaries (Exhibit 3). The first product was a satellite-based tracking and messaging service, aimed primarily at the long-haul trucking industry and based on scientific breakthroughs that Dr. Jacobs and his compatriots had made in a digital wireless technology called “code division multiple access” or CDMA. While the concept of CDMA had been known in the esoteric corners of communications engineering, it had been considered far too computationally intensive to be commercially practical for portable wireless devices. Qualcomm’s innovations solved those technical obstacles, and by the early ‘90’s, the company was promoting CDMA as an alternative digital cellular standard to the competing TDMA – i.e. time division multiple access – based standards pushed by the industry bodies in the US and Europe. Although complex, the technique offered the promise of much higher system capacities within a given band of spectrum, with smoother cell-to-cell hand offs and superior power management. If successful, CDMA could give carriers distinct operating advantages over TDMA-based competitors.

Exh 3: Qualcomm Timeline

Qualcomm found a true believer in Pacific Telesis Cellular, later to be renamed AirTouch, which proselytized the fledgling technology to other US and foreign carriers. Ameritech, Bell Atlantic, Sprint and GTE joined AirTouch, leaving SBC, BellSouth, and a number of other carriers carrying the torch for the US TDMA standard. Meanwhile, South Korea, looking for a way for its growing telecommunications sector to leapfrog consumer wireless technology leaders in Japan and Europe, jumped on the bandwagon, mandating that its carriers use CDMA for their digital build-outs.

Qualcomm had a foothold, and the advantages of CDMA turned out to be real. While the European TDMA-based GSM standard had considerable scale advantage, CDMA carriers still flourished, and when the world’s standards bodies turned to the task of specifying a 3rd generation wireless standard with the capability of significantly faster data communications, CDMA was the obvious choice for the central technology. While these standards bodies did their best to limit Qualcomm’s influence within the new standard, the company’s fundamental IPR was central to the new WCDMA specification.

Then in the growing late ‘90’s internet bubble, Qualcomm stock skyrocketed, culminating in the famous and ill-fated PaineWebber $1,000 price target, issued at coverage launch in late December 1999. While no more outrageous than other valuations offered during those heady days, the unfortunate timing of the report has left it an icon of millennial excess. Still, while Qualcomm certainly suffered mightily from the burst of that bubble, the wireless sector rebounded far more quickly than the wireline, as 3G transition and digital build-outs in China and other emerging markets remained considerable drivers of market growth.

Qualcomm Created Wireless Patents, and Saw that They Were Good

At first, Qualcomm intended to make the wireless infrastructure equipment and mobile handsets needed for the emerging CDMA digital standard. In 1992, when it became apparent that building CDMA infrastructure might prove more difficult than it had imagined, and understanding that its carrier partners would expect to buy equipment from multiple suppliers, it licensed the technology, first to Nortel and then to Lucent, to induce them to support standard. In 1993, the US Telecommunications Industry Association (US-TIA) voted to adopt CDMA as an official alternative to TDMA, and in 1995, Qualcomm established Qualcomm Technology Licensing (QTL), a business unit with responsibility to negotiate royalty bearing licenses with device and infrastructure partners.

While Qualcomm labored under the delusions that it could become a successful infrastructure and device supplier for most of the ‘90’s, QTL, under the leadership of Steve Altman, laid the ground work for the most successful patent licensing program in the history of the telecommunications industry. Unlike most other IPR-rich technology companies, Qualcomm didn’t try to set a price for its individual patent families. Rather, QTL offered to license ALL of its patents, essential and non-essential, already issued or to be granted in the future, for a single percentage royalty. Use one patent, or use 5,000 patents, pay one price. As the US CDMA carriers and the South Korean market proceeded with plans to build out, would be equipment and handset suppliers signed on, often in open ended deals that would run in perpetuity unless explicitly terminated. Royalties on equipment were kept low to encourage carrier build outs, but rates for device licenses ran to nearly 5% of the wholesale price of the phone.

Of course several device makers, led by market leader Nokia, refused to support CDMA and bristled at Qualcomm’s royalty demands, particularly given their own substantial patent libraries. Still, as the CDMA carriers prospered and the standard gained support from new carriers in China and India, the pressure on these holdouts intensified. In addition, discussions over the specifications for the 3G standard turned decidedly toward CDMA technology, insuring an eventual patent showdown with Qualcomm. The Euro-dominated 3GPP standards body, with responsibility for establishing the 3G specification that would follow the TDMA-based GSM, tried mightily to minimize Qualcomm’s IPR contributions to the new standard, but despite those efforts, the final spec was still dominated by the company (Exhibit 4). Ericsson, and NEC settled their patent lawsuits with Qualcomm in 1999, signing royalty bearing licensing agreements covering both CDMA and WCDMA. Nokia was a bitter hold out, shipping WCDMA products without agreement with Qualcomm for years, before settling in 2008, agreeing to pay $2.3B in back royalties and an undisclosed percentage of future device sales.

Exh 4: 3G Self Claimed Essential Patent Share by Standard

Everybody Pays

Qualcomm now has 261 licensees for its IPR portfolio, including every important maker of portable devices, wireless infrastructure and network test equipment (Exhibit 5). Qualcomm has stated that the vast majority of the device agreements are for standard rates of more than 4% of the wholesale selling price applicable to any device that supports 2G CDMA, 3G WCDMA, or 4G LTE. The company acknowledges that many agreements contain caps for the price against which the royalty may be applied, allowing for the additional value added by enhancements beyond the basic communications functions of the device.

Exh 5: Select Major Qualcomm Licensees

We also note that several parties are believed to have negotiated superior rates, although the details of these agreements are tightly bound by non-disclosure commitments. For example, it is believed that the Chinese government was able to extract a significant discount for devices made by Chinese manufacturers and sold into the domestic market, in exchange for its commitment to support China Unicom’s plans to build out a CDMA-based network. It is also believed that Nokia’s 2008 agreement carries rates that are below the 4-5% range suggested by Qualcomm. Finally, Qualcomm remains in conflict with Apple over its assertion that its manufacturing partner Foxconn’s licensing agreement indemnifies it from further payments to Qualcomm, thus paying royalties only on the cost of goods sold of an iPhone, rather than the full wholesale price.

Exh 6: QTL Division Revenues and Margin, 1Q 2000 – 2Q 2013

A License to Print Money

Over the past decade, QTL royalty revenues have grown at a 22.75% CAGR, as both the total universe of wireless devices and the proportion supporting 2G CDMA, 3G WCDMA and/or 4G LTE expanded (Exhibit 6). Qualcomm benefitted also from the smartphone revolution, which saw the average price of devices supporting the more advanced wireless standards rise since the introduction of the iPhone – although we note that the benefit was mitigated somewhat by the price caps that we believe are included in some of the company’s bi-lateral agreements (Exhibit 7). QTL generated more than $6B in revenues in FY12, up 17% YoY and delivered 20.8% growth for the first half of FY13. Moreover, QTL, running with just a few dozen employees, is also hugely profitable, generating 70% of the total company’s earnings on 88% EBT margins. Given relative peace for Qualcomm on the legal front, there is no obvious reason to worry over these margins.

But investors do worry, primarily over the percentage royalty rate that Qualcomm has negotiated in each of its bilateral licensing agreements. The conventional wisdom holds that since 4G LTE is based on Orthogonal Frequency Division Multiplexing (OFDM) rather than the CDMA technology dominated by Qualcomm, it will be forced to accept much lower rates when its deals are renegotiated in the future, thus placing the QTL gravy train at risk.

Exh 7: Handset Total Shipments and ASPs, Q304-Q213

This concern is stoked, in part, by Qualcomm’s 2009 declaration that its LTE essential patents were worth 3.25% of device wholesale price, within the context of patent pooling proposal. 3.25% is obviously lower than Qualcomm’s historical 4-5% range, but does not include the value of its thousands of non-essential patents, that is, IPR that are not required to be standard compliant but offer meaningful improvement to quality of the product (Exhibit 8). Nor does the 3.25% deal entitle the licensee to use Qualcomm’s 2G or 3G essential patents, a necessity given that almost every 4G device also integrates these earlier standards in order to deliver compatibility with heterogenous carrier networks. From Qualcomm’s perspective, these multi-standard products are implicitly covered within its standard contract language, which entitles its licensees to ALL of Qualcomm’s patents, both present and future, for as long as the contract remains valid, for a single royalty rate. We also note that Qualcomm’s licenses typically include an upfront, one-time licensing fee, which can be very large in the case of negotiations that extend beyond the completion of the previous agreement. These one-time payments skew QTL revenues sharply upward in the quarters that they occur.

Exh 8: Qualcomm Quarterly Royalty Rates

Qualcomm IPR – It’s not Just for CDMA Anymore

Given this, and the fact that every major device maker (Samsung, Foxconn/Apple, HTC, LG, Nokia, and Huawei) has amended its license agreement to explicitly cover 4G within the past 5 years, with only a minor drop in royalty receipts relative to device sales that could be explained by the rise of Apple and the domestic Chinese manufacturers, the question would seem to be moot. Samsung’s agreement was reported to last until 2023, in keeping with Qualcomm’s preference for open ended or long term deals. This willingness to accept terms – none of these agreements required litigation – speaks to the strength of Qualcomm’s IPR position in LTE.

Assessing that strength from the outside in is difficult. A database of the patents that have been self-declared as essential to the LTE standard is available from the 3GPP standards body, but the information is unedited and misleading. Some companies have reported multiple patents issued by different countries for the same innovation. Some companies have reported laundry lists of patents with dubious importance to the standard. For example, a 2011 study of the 3GPP database by the Cyber Creative Institute concludes that just 55.4% of the patents reported were non-duplicative and fully matched the standard specification. Of these, highly likely essential patents, Qualcomm held 14%, ahead of number two ZTE by 200bp (Exhibit 9). A 2012 study by iRunway used a different approach, evaluating the declared essential patents that had been issued in the US, using a proprietary methodology to tease out “seminal patents” that are assumed to be the most important IPR in the data base. This analysis, although limited to US issued patents only, also concluded that Qualcomm was the leading holder with 12.5% of the “seminal” LTE patents, this time just 31bp ahead of number two Samsung (Exhibit 10).

Exh 9: Estimated Essential LTE Patent Share by Company

Exh 10: Seminal 4G LTE Patent Distribution of Top Companies

The iRunway study also broke the patent data base into categories, some with particular applicability to devices and other to network equipment. Qualcomm sports an unusually high 80% concentration of its patent portfolio in technology categories important for device makers, with critical seminal contributions in the key categories of Spectral Efficiency (MIMO) and Data Transfer Rate (OFDM). This jibes with Qualcomm’s longstanding assertions that its contributions to 4G were nearly on par with its stake in 3G despite its use of OFDM rather than CDMA for managing data transfers (Exhibit 11).

Exh 11: Distribution of 4G LTE Patents Across Categories

She Blinded Me with Science!

Qualcomm’s strength in LTE IPR comes not just from its 2006 acquisition of OFDM pioneer Flarion, but also from its market leading R&D investments focused on the elements of wireless communications science and engineering most relevant to future mobile devices. Qualcomm spent $3.9B on R&D in its FY12, running at more than 20% of its revenues and almost all of it in furthering its leadership in wireless device technology (Exhibit 12). In comparison, Qualcomm licensees, like Nokia (14.5% of sales), ZTE (10% of sales), Samsung (6% of sales), and Apple (2% of sales), devote far less of their budget to R&D, and, within that, must support a much wider variety of businesses and product lines. Moreover, Qualcomm has long been the employer of choice for the world’s most talented radio communications scientists, drawn by the legacy of excellence and a culture that makes the best engineers into rock stars. As the industry proceeds to LTE Advanced and on toward an eventual 5G specification, it seems certain that Qualcomm will remain at the center of the most important technical developments.

Exh 12: Qualcomm Annual Revenue and R&D Expenditure, 2000-2012

I Fought the Law and the Law Won

Qualcomm is also the world’s foremost expert in technology patent law. Since the beginning of its licensing program in the early ‘90’s, Qualcomm has faced challenges from an entrenched telecommunications equipment industry, increasingly threatened by the upstart with new technology and aggressive royalty demands. Qualcomm was aided in its royalty quest by the early steadfast support of the true believers at AirTouch, BellAtlantic, Ameritech, GTE and the South Korean government, which forced the hand of would-be suppliers into signing early agreements. The nature of those agreements – 4-5% royalty rates, open ended terms, full patent portfolio coverage – was designed by Steve Altman, who moved from his role as chief corporate counsel to head QTL when it was formed in 1995.

While the European firms that led the mobile phone industry in the late ‘90’s bristled at Qualcomm’s impertinence, Asian competitors, and in particular, the South Korean firms Samsung and LG, leapt at the opportunity to use CDMA as a lever into the broader world mobile phone market. By 1999, Ericsson capitulated, signing a long term licensing deal and leaving Nokia as the last remaining hold out. The history and breadth of Qualcomm’s licensing activity – the list is now 261 licensees strong – is a powerful weapon in a global legal environment that broadly favors precedent. The list of factors used in US courts to establish damages in the case of infringement – “The Georgia-Pacific Factors” – more or less focuses on what licensees have historically paid for the IPR. For Qualcomm, hundreds of licensees paying similar rates is a powerful weapon in negotiations (Exhibit 13).

Exh 13: The Georgia Pacific Factors

It helps also that Qualcomm does not list the specific patents that it is licensing, but rather offers access to ALL of its patents, both granted and to be granted in the future. This obviates the typical strategy of wearing down an IPR holder by challenging the validity of its patents, possibly eliminating certain claims and weakening the value of the portfolio. To challenge Qualcomm on this basis would mean attacking tens-of-thousands of patents, many of which have been widely cited and acknowledged to be seminal.

Qualcomm sold its internal mobile phone business to Kyocera in 2000, creating yet another advantage in patent licensing. Without the phone business, Qualcomm no longer required cross-licenses for many of the patents held by handset manufacturers. As such, it was not vulnerable to threats of injunctions or other business disruption, and could squelch demands for reductions in royalties based upon access to cross-licensed patents. This has tended to reduce Qualcomm’s exposure to litigation. Fighting Qualcomm in court has been wildly expensive for the companies that have tried it, with outcomes that have overwhelmingly favored Qualcomm. Given this history, Qualcomm has faced little litigation in recent years, despite the obvious rise in wireless industry patent lawsuits.

Watching the Tide Roll In

A second concern of investors is that the smartphone revolution is slowing, with demand growth shifting to dramatically lower price points in emerging markets. This is certainly a concern for the makers of smartphones, but likely, less of an issue for Qualcomm. First, Qualcomm’s licensing program has historically included value caps that scale back royalty payments on the highest priced devices – an automobile with an embedded mobile communications element does not carry a percentage royalty on the entire price of the car, and neither does a $700 cellular-enabled tablet. As such, lower end devices will likely carry higher average royalty rates. Second, royalties and chipset sales for low-end emerging market products are almost entirely incremental, displacing the 53% of the device market that is still GSM-only, and thus, unaddressed by Qualcomm (Exhibit 14). Emerging market carriers are beginning a push to transition their 2G users onto the more efficient 3G and 4G technologies, opening new demand for Qualcomm. Third, concerns of market saturation for mobile phones in general, and smartphones in particular, may be considerably premature, given the ongoing trajectory of sales.

Exh 14: Mobile Connections by Technology, 2011-2012

Moreover, Qualcomm has opportunities beyond smartphones. We believe that growing carrier competition will likely drive significantly lower 4G data prices and more generous usage caps. This should stimulate much greater penetration of LTE into tablets, opening significant opportunity for both royalty revenue and chip sales. We also believe that the newest 4G specification, LTE Advanced, will lead to wireless carriers competing successfully for residential broadband service before the end of the decade, another new market opportunity for Qualcomm to generate royalties and win semiconductor business. Finally, machine-to-machine communications is becoming a hot topic amongst wireless pundits, harking back to Qualcomm’s original business of providing equipment tracking services for trucking fleets. If even modestly successful, this “internet of things” could also provide a meaningful new market for Qualcomm.

All That and a Bag of Chips

Investors also seem to fear for the margins and market share Qualcomm’s semiconductor business, Qualcomm CDMA Technologies (QCT), in the face of Chinese competition (Exhibit 15). While MediaTek and Spreadstrum have been successful gaining market share in low end smartphones and feature phones within the Chinese market, QCT has the cost structure and technological superiority to effectively counter, and has begun offering turn-key reference designs for low end smartphones. Management has revealed that 170 low end smart phones have been launched using Qualcomm’s reference designs, some reaching the market in as little as 60 days, compared with the 9-12 month design lag typical of customer customized high end designs.

Exh 15: QCT Division Revenues and Margin, 1Q 2000 – 2Q 2013

These reference design semiconductor solutions are priced at less than $10 per phone, which has allowed QCT to take share from MediaTek and Spreadsrum, the price is well below the $22.64 in chip revenue that the company generates per device containing a Qualcomm modem (Exhibit 16). Still, most of these low end smartphones are selling into the 46% of the market that previously had bought 2G-only feature phones, making them truly incremental for Qualcomm. As a volume leader in a scale driven business, it is also reasonable to assume that these new customers are profitable for QCT as well. If this market is where smartphone growth will come from, Qualcomm is well positioned to participate in that growth.

Exh 16: Modem Chip Shipments and QCT Revenue per Chip, Q304-Q213

SoC it to me Baby!

QCT is accustomed to competition. In modems, Qualcomm extended its 2G CDMA dominance into 3G WCDMA without missing a beat, unseating Texas Instruments, which had been king of the GSM modem world, at the top of the heap. Qualcomm was first and best with 4G LTE capable modem chips and has already begun to ship solutions compatible with the next version, LTE Advanced. This strength in modems is buttressed by Qualcomm’s 2011 acquisition of Atheros, which adds support for WiFi, Bluetooth, Ethernet and other networks to QCT’s connectivity solutions. We believe that Qualcomm has already expanded Atheros’ share of the market for these chips, and will integrate most of the functionality into its smartphone cellular modem solutions, eliminating the need for stand-alone solutions for many of its customers.

Similarly, Qualcomm has risen to the top in mobile device application processors, investing in a proprietary version of ARM’s standard core architecture that offered superior performance and power draw in smaller footprint than competitive versions based on ARM’s own reference designs. This “Krait” proprietary design gave QCT more control over the development of its chips, allowing it to beat competitors to market with updated designs and to more readily integrate its processor and modem solutions to a single chip, known as a System-on-a-Chip (SoC).

Even with leading smartphone makers Samsung and Apple each designing their own proprietary processors, Qualcomm has gained substantial market share for its SoC products, selling its Snapdragon SoC to Samsung for LTE versions of its leading products, and supplying modems for the full line of iPhones. Qualcomm’s newest SoC products, the Snapdragon 200, 400, 600, and 800 have been designed into a wide range of the most highly regarded smartphones on the market, including the HTC One, the LG Optimus G, the Nokia Lumia 920, and the US version of the Samsung Galaxy S4, implying continued strength in the high-end smartphone market for the foreseeable future (Exhibit 17).

Exh 17: Global Mobile Phone SLI/SoC Revenue, 2010-2015

Recently, Qualcomm announced an RF chip that will support 40 different spectrum bands for 3G and 4G. This solution has the potential to be a game changer, as currently, device manufacturers must make as many as four different versions of each product to cover the frequencies in use in different markets around the world. With a single chip, Qualcomm’s RF customers would be able to make a single model, compatible with almost all carriers, enjoying considerable economies of scale and inventory flexibility. Given that QCT did not previously participate in the RF segment – 16% of the semiconductor bill of materials for the typical smartphone – we expect this product to materially increase Qualcomm’s revenue per phone (Exhibit 18). Furthermore, Qualcomm has the unique ability to integrate this RF solution into a two chip module with its SoC as a turnkey reference design for its device customers. Such an integrated System-in-a-Package has the potential to reduce power draw and footprint in the devices that use it, giving it further advantage over its would-be SoC competitors, none of whom offer RF solutions.

Exh 18: Component Composition of a Premium Smartphone

Finally, there remains a real chance that Qualcomm will use its engineering and marketing muscle to push into other component categories, such as sensors or displays. Sensors is an interesting opportunity, as the possibility of gesture controls, facial recognition, fingerprint reading, personal monitoring, and other sensor driven functions continue to show up as next generation device wish list items. Moreover, sensitive touch controls and high quality cameras are already elements of differentiation for high-end smartphones. Qualcomm could be working on solutions. We know that it has already invested in the innovative Mirasol display technology, although a year ago it dropped plans to move forward with manufacturing the displays and will look, instead, to license the technology.

Tablets and TVs

For most of its life, Qualcomm has been all about mobile phones. QTL collects few royalties on tablets, since most of them are sold as WiFi only, without 3G or 4G connectivity. This also blunts QCT’s most important competitive advantages – WiFi only tablets don’t require modems or RF, gain no benefit from integrating these functions into a SoC, and are not nearly as constrained by weight, space, and thus, power draw. As a result, QCT has been a laggard in selling processors for this class of products (Exhibit 19).

This may change. First, the excellence of Qualcomm’s Snapdragon 600 and 800 is starting to win tablet converts – the new Nexus 7 is rumored to feature the 600 and QCT VP Tim McDonough reports more than 50 design wins for the chips including tablets, keyboard equipped “convertables” and even television sets. Second, we expect that rising competition amongst wireless carriers, particularly in the US, will drive meaningful reductions in the price of wireless data service and more relaxed limits on usage. These changes could increase the proportion of tablets sold including 3G/4G connectivity to Qualcomm’s benefit.

Exh 19: Portable Device Semiconductor Content, 2012-16

Importantly, we also believe that LTE Advanced will usher in an era of seriously improved data throughput and capacity on wireless networks, allowing them to compete effectively for residential broadband. If true, the connected TVs and other home electronics could significantly increase the long term addressable market for both QTL and QCT.

The Madness of Crowds

Consensus doesn’t much like Qualcomm. Collectively, sell side analysts expect sales growth to abruptly slow from 27% in FY13 (ending in September) to just 11% in FY14, dropping to 5% average annual sales growth through FY18 (Exhibit 20). The current share price embeds assumptions that are even worse, implying growth more than 400bp below consensus at similar margin assumptions. The recent 2Q13 earnings conference call precipitated a 7% sell off, despite delivering in-line results on 25% YoY sales growth and slightly raising its guidance, which we note has typically been conservative through its history. The media line on the pessimistic response is concerns about royalty rates and cheap Chinese smartphones, issues that we believe are significantly overblown.

We believe that Qualcomm is one of the companies best positioned to prosper from the comprehensive paradigm shifts underway in the TMT sector. From the rise of portable devices built on the ARM platform central to QCT, to the pre-eminence of wireless data networking based on the 4G technologies in which QTL is the global leader, the market is moving unambiguously to Qualcomm’s favor. We believe QCOM has the potential to considerably outperform over the next year, and consider it a core holding amongst a handful of stocks that will shape the next 20 years of the TMT landscape.

Exh 20: Qualcomm Consensus Summary and Iso-Curve Analysis

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