Quick Thoughts: QCOM – Are We There Yet?

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SEE LAST PAGE OF THIS REPORT Paul Sagawa / Artur Pylak

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November 5, 2015

Quick Thoughts: QCOM – Are We There Yet?

QCOM traded off 15% on Thursday, despite beating tempered expectations, after providing gloomy guidance for 1QFY16. For investors it was the same old story. Chipset shipments were ahead of expectations but down YoY on socket losses from the disappointing Snapdragon 810. Royalty payments missed expectations, as management struggles to negotiate new agreements and back payments from Chinese manufacturers, representing some 9% of global sales, after settling with the government in February. Neither of these problems is new, but the acknowledgement that they will continue to weigh heavily on December earnings was obviously unwelcome. The supposedly fantastic Snapdragon 820 has apparently been designed into some 60 smartphones for 2016 – announcements released this quarter, particularly from Samsung, could generate some upside movement, although shipments won’t hit results until March. The guidance is pessimistic for meaningful progress on unpaid royalties for 1QFY16, but any collections in future quarters would be further impetus for the stock. Given the size of the sell-off, we are buyers of QCOM with the potential for these catalysts and the valuation of the stock outweighing the extreme negative sentiment.

QCOM shares took a nasty move down right form the open yesterday, turning a (5%) premarket indication into a (15%) rout. The reasons for the bad reaction were familiar to anyone who has been following the stock over the past year. First, Qualcomm’s QTC chipset business saw shipments down YoY, although ahead of guidance and expectations, due to a maturing high-end smartphone market, share gains by Apple (which buys only modems rather than the more expensive Snapdragon SoCs), and share loss from the poorly received Snapdragon 810 product, which had to rely on a stock processor design from ARM because Qualcomm’s proprietary designs were not yet ready. Second, Qualcomm settled an antitrust dispute with the Chinese Government in February, but numerous Chinese device manufacturers, who had used that dispute as cover to resist paying patent royalties, have been slow to come to terms over back payments and future rates. Qualcomm management acknowledged through its guidance and comments that both problems would continue to weigh on the company’s results through at least December. BAM! Shares down 15%.

Altogether, Qualcomm is down more than a third from a relative high a year ago, and trades at a less than 10x forward multiple (8X ex cash) and a 3.15% dividend yield. This is a comeuppance for a one time growth star, and an indicator of the lack of faith that Wall Street has in the company. Total reported 3G/4G device sales, the basis for Qualcomm’s royalty collections, were up 3% YoY, while further sales, accounting for 9% or more of the total, went unreported, primarily by the recalcitrant Chinese manufacturers. We believe that Qualcomm is in strong position to collect these royalties, given the agreement by Chinese authorities and political pressure from the larger manufacturers in the country who are already paying royalties. Signing agreements could result in significant one-time bumps in royalty revenue for future quarters along with relatively higher recurring payments. Longer term, we believe that this extremely lucrative business can generate modest 3-4% growth, as the device market shifts from 23% 2G only (not addressable by Qualcomm) to nearly 100% 3G/4G over the next few years.

The chipset business should also get a near term boost with ramp of the new Snapdragon 820 flagship SoC. The 820 features an all new proprietary 64 bit processor architecture, code named Kyro, that is reputed to drive 50% faster processing than the Samsung Exynos 7420 found in the Galaxy 6 and Note 5 devices. The South Korean publication Electronic Times reported that Samsung would adopt the Snapdragon 820 for its upcoming Galaxy 7 flagship in the US and Canadian markets. Overall, Qualcomm counts 60 design wins for the 820 in new products. Official announcements for specific devices should begin to roll out in 1QFY16 with initial shipments hitting the P&L in the March quarter. Longer term, the benefits of the processor redesign should filter down to Qualcomm’s lower end chipsets over the next few years, conferring performance benefit across the whole product line.

We also believe that Qualcomm is well positioned for future opportunities. It continues to integrate broader functionality into its SoC designs, absorbing value from formerly discrete components and adding new value from expanded functionality, such as sensors. It also can apply its designs and expertise to emerging markets, such as autonomous vehicles, drones, small cells, and connected appliances. Qualcomm is also very well positioned as network solutions based 5G technology begin deployment before the end of the decade. Traditionally, as new, more technically complicated standards are implemented, Qualcomm, with its deep IP holdings and long experience, gains advantage and this should be no exception.

Back to the current situation. Given potential catalysts ahead – Snapdragon design win announcements, shipments beginning in 2QFY16, and initial agreements with the Chinese manufacturers – the risk-reward suggests Qualcomm at its 52 week low is a buy.

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