Quick Thoughts: QCOM – Now What?

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SEE LAST PAGE OF THIS REPORT Paul Sagawa / Tejas Raut Dessai

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March 19, 2018

Quick Thoughts: QCOM – Now What?

  • AVGO’s bid is over. Ex-CEO Jacobs wants an LBO. A deal for NXP requires Chinese approval. AAPL and Huawei are defying royalty demands. Investors are frustrated. What should QCOM do?
  • Close NXP – IF you can. The budding trade war may kill the NXP deal, but QCOM has experience with Chinese regulators and the support of most OEMs. Approval of the accretive deal would be a plus for QCOM.
  • Get royalty deals from AAPL and Huawei. QCOM has defended its IPR licensing program many times over 25 years vs challenges from major players in every major jurisdiction. Management is justifiably confident that it will negotiate advantageous deals this time, as well.
  • Win 5G. The 5G transition is happening faster and more broadly than many anticipated. QCOM is likely to be first and best with chips for the new standard, giving opportunity for share gains and new markets.
  • The dominant investment narrative on QCOM is far too pessimistic on each of these items. We see significant upside for the rest of 2018.

With a swipe of a pen, President Trump wiped away months of nightmares for Qualcomm management. Broadcom CEO Tan Hock had pounced at its most vulnerable moment – QCOM shares were down more than 30% from their 52-week highs after Apple had accused it of unfair trade practices in several jurisdictions and withheld all royalty payments worth billions of dollars of annual profits. Qualcomm had been through major challenges to its patent licensing program before, facing down Motorola in US courts during the late ‘90’s, Ericsson and Nokia in the EU during those companies’ peak in the early ‘00’s, and Samsung in South Korea at the end of that decade. Three years ago, Qualcomm resolved a 14-month antitrust investigation by the Chinese National Development and reform commission with an agreement that included a hefty $975M fine but allowed its licensing business to continue under very similar terms. With this history, and deep expertise in international patent law – which almost universally relies on industry precedent to evaluate the fairness of royalty rates – Qualcomm management was confident that it could wait out Apple and eventually get a favorable deal, even as Apple used its heft with the media, analysts and investors to punish QCOM shares.

Broadcom badly upset this game with its unsolicited November 6 bid. Not only did it offer shareholders $70/share, when the stock had been trading in the mid $50’s, it also suggested to Apple that it would sharply reduce patent royalty rates once it completed the transaction, bringing any hope of progress in negotiations to an end. This, in turn, emboldened Huawei to follow Apple in withholding payments in anticipation of a better deal. Broadcom’s involvement also tipped the scales in Qualcomm’s own planned acquisition of NXP. Knowing that completing that deal would make it more difficult for Broadcom to pay for Qualcomm, NXP shareholders, led by Elliot Management, held out for a higher price and got a 16% raise from management.

Thus, Qualcomm found itself heading into a March 6 investor meeting with a real risk that the vote for directors would sway the board to Broadcom’s proposed slate. Still, there were other cards to play. CFIUS (The Committee on Foreign Investment in the United States) mandated that the investor meeting be postponed for a month, perhaps after a nudge from QCOM, which also raised the very real concern that the deal would never be approved by the US, by the EU or by China. Nonetheless, the rumors suggested that Broadcom had gained the upper hand with investors, as it raced to redomicile itself in the US and in doing so, avoid CFIUS scrutiny. All this drama came to an end, as CFIUS referred the matter to President Trump, who signed an order prohibiting Broadcom from acquiring Qualcomm for national security reasons.

So Qualcomm management finds itself back at square one, looking to complete its NXP deal, resolve the dispute with Apple (and now Huawei) to its favor, and to use the faster than anticipated ramp in 5G network roll-outs to take market share with its smartphone chip solutions and to establish leadership in new markets, like connected cars and IoT, that will be made possible by 5G. These jobs may be more difficult after its 4-month odyssey fighting off Broadcom, but not as unlikely as the current dominant investment narrative around the stock suggests.

Before Broadcom, Qualcomm’s deal for NXP was nearly complete, awaiting approval from EU and Chinese regulators and a resolution of Elliot Management’s push for a higher price. Now, the EU is on board, Qualcomm has completely acquiesced to Elliot, but the Chinese have yet to approve the deal. While under ordinary circumstances this approval would be perfunctory, these are not ordinary circumstances. In blocking the deal, President Trump explicitly called out the risk that Chinese companies might fill a void left as Broadcom cut Qualcomm’s investment in long term wireless technology development. In today’s budding global trade war, approval of the NXP deal could become a diplomatic chip to be withheld. On the other hand, Qualcomm has established a good working relationship with the Chinese and with Chinese OEMS, which rely on the company for core technology. Escalation of the war on this front could hurt the China more than the US. There is a lot of uncertainty here, but approval is not an impossibility.

The Apple dispute should be management’s most pressing concern. Previously, Qualcomm had collected royalty payments for Apple phones from the OEMs in Asia who were assembling the devices. At Apple’s behest, those suppliers began to withhold more than $1B in quarterly payments at the beginning of calendar 2017. Apple’s complaints spurred investigations of Qualcomm’s royalty practices in US and in South Korea, and the company sued Qualcomm in US Federal Court. Qualcomm has followed with patent infringement suits of its own in multiple jurisdictions, asking for injunctions on iPhones sold in the US and in China. Given the possibility that a successful Broadcom bid could have delivered a win to Apple, it is very unlikely that there was any progress in negotiations after the November 6 hostile offer.

History and the central role of precedent in international patent law give the legal advantage to Qualcomm. Apple may not like Qualcomm’s terms, but everyone else in the industry have been willingly paying royalties on similar years for decades. We don’t see the FRAND (fair, reasonable and non-discriminatory) terms required for standards essential patents as a reasonable defense – Qualcomm’s royalties include rights to tens of thousands of non-standard utility patents that are immensely valuable and not covered by FRAND. Indeed, Qualcomm is suing Apple for infringing on power management and digital photography patents that are clearly not essential patents (and related to aspects of the smartphone that are beyond the “communications” subsystem that Apple argues is its only exposure). If investors are willing to give management the time and confidence to wait for the process to play out, we believe Qualcomm will win. If investors are impatient, Qualcomm can still come to an advantageous agreement that gives Apple a material benefit but defines it in a way that would not trigger most-favored-nation clauses from other licensees. Either way, the impasse will likely end quietly, with a joint press release announcing a royalty bearing agreement, terms undisclosed, and a one-time repayment of back royalties.

An agreement with Huawei is harder to call, as the rapidly escalating trade standoff between the US and China is a substantial wildcard. On one hand, Huawei is anxious to gain approval to sell its phones in the American market – something that would be impossible without a Qualcomm IPR license. On the other hand, Huawei’s prowess in 5G was called out as a primary reason to reject Broadcom’s pursuit of Qualcomm in the President’s order – the company and the country may be more reticent to validate Qualcomm’s leadership under those circumstances.

Nonetheless, Qualcomm is the technology leader in 5G. It has the most and the most important patents. It is first to market with a 5G standard compliant modem – a stand-alone part aimed at laptops, tablets and wireless routers – and almost certainly will be first with an integrated part appropriate for smartphones. Historically, Qualcomm has gained market share in its device chips with each generational transition, offering early SoC parts with better performance, lower power demand, and smaller footprint than competitors. This time, Qualcomm will also have RF solutions for the standard, expanding the range of silicon that it can address in each device. 5G will also bring substantial non-smartphone opportunities, enabling new low latency, low power IoT applications.

Qualcomm also has substantial new opportunities beyond wireless. Its processors are in trial at the top cloud hyperscale datacenter platforms, with the potential to displace Intel’s x86 architecture for multiple use cases (http://www.ssrllc.com/publication/hyperscale-semiconductors-processor-diversity-coming-to-the-cloud/). Its potential deal for NXP would help further open the automotive market for Qualcomm’s processor and sensor products.

With Qualcomm shares trading at a significant discount to the market multiple against earnings expectations that do NOT include the likelihood of a resolution to the Apple impasse, we see significant upside to the current price. During the tense negotiations with Broadcom, management asserted that QCOM was worth a considerable premium to the $82/share (later lowered to $79) that was on the table. Now is the time to show why.

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