QCOM: The Sun Comes After the Rain
Sentiment on QCOM has come a full circle back to the skepticism that plagued the stock at the time of our last detailed look in May 2013, falling to “Death Watch” quadrant of our valuation framework, signifying weak projected cash flow growth over the next 5 years AND pessimism for the likely value of the stock thereafter. We believe that near term growth will accelerate as the company moves past 3 issues: 1- enforcing recently negotiated royalty terms with Chinese manufacturers; 2- delivering 64-bit Kryo processors; and 3- adjusting to the strong dollar. Longer term, we believe investor fears are overplayed. TAM has significantly more runway based on IoT connectivity, ongoing shift to 3G/4G/5G, and growing component complexity for devices. QCOM’s IPR position for 4G/5G is very strong and royalty claims were strengthened by China deal. QCT design advantages will sustain device share dominance and capture more value per device. We see the skepticism as opportunity, and after a bumpy, transitional FY15, expect QCOM to return to strong growth and profitability.
QCOM expectations are weak in both short and long terms. Current consensus estimates project a 3-yr cash flow CAGR of just 2.3%, well below the company’s trailing 5-yr trajectory and the 11.2% median projection for all large cap TMT companies. For the longer term, QCOM’s valuation implies that the terminal value, after the next 5 years of projected cash flows have been subtracted, is just 49% of EV, again, well below the median for our universe of TMT large caps. The collapse in sentiment corresponds to an abrupt deceleration in 2014 revenues caused by a disruption in Chinese sales related to a government investigation and delays in delivering QCT’s proprietary 64-bit chip architecture
Major headwinds will subside. 1) QCOM recently reached agreement with Chinese regulators on standard royalty terms for device makers in that country. Prior to the agreement, the company was having significant difficulty collecting from Chinese manufacturers, a situation that may take a few more month to completely resolve. 2) With ARM’s shift from 32 to 64 bit architecture, QCOM was forced to temporarily implement ARM’s turnkey Cortex processor design, putting it at parity with rivals on time-to-market, footprint, and power draw. QCT will have a 64 bit version of its proprietary Krait processor implemented in its new Snapdragon SoC designs in 2H15, restoring its performance advantages.
QCOM’s TAM has plenty of runway. There are an estimated 4.5B mobile device users in the world, of which about 2B operate on 3G/4G networks, and 1.75B of these devices are smartphones. By 2019, Ericsson projects that there will be 9B device subscriptions (N.B. many users will have multiple devices), with nearly 7.5B on 3G/4G networks and 5.6B smartphones. Most of this expansion will come at sub $100 device price points, although we still expect low single digit growth from the high end segment. Given that QCOM only collects royalties and sells chipsets for 3G/4G devices, largely at the high end, this implies significant further growth in its addressable market, even with sharply declining ASPs.
QCOMs IPR position will remain strong and profitable. QCOM has 12.5% of the seminal patents in 4G LTE and a portfolio of over 50K wireless patents, many of which are not “essential” but are the state of the art for any implementation. Furthermore, QCOM’s R&D spending is overwhelmingly devoted to pushing the performance of wirelessly connected mobile devices, making its spending leadership vs. rivals with broader priorities more impressive. IPR law depends heavily on precedent to determine value, and QCOM’s longstanding and industry wide licensing program has long established the economic worth of its patents. The recent agreement with Chinese regulators recognizes this in agreeing to the company’s standard royalty terms for exports, with a 35% discount for domestic sales.
QCT’s design, scale and skills are superior. QCOM has long been dominant in leading edge modem design. This advantage is most applicable at the high end of the chipset market, where it has had a 24-month lead in integrating the most recent LTE standards releases to its Snapdragon chipsets. Add to this its superior Kryo processor design, complementary capabilities (RF, MEMS, packaging, etc.) and significant economies of scale. The Kryo-based 64 bit SoCs due in 2HCY15 will extend QCOM’s die size, integration, power draw, cost and time to market advantages vs. its merchant rivals, while introducing the innovative Zeroth deep learning technology. These strengths are also a factor in lower end solutions, driving share gains vs. MediaTek in China – business that is additive to QCOM’s dominant share of the non-Apple high end. As global volumes of low-end 3G/4G smartphones continue to multiply, we expect QCOM to gain share and profitability with time and scale.
QCOM can expand its share of BOM and address emerging opportunities. QCOM is beginning to address more functionality within mobile devices. It has already launched a successful RF product with unusually broad support for different frequency bands, and could, in the future, begin integrating that technology into its turnkey solutions. We see sensors – increasingly implemented in smartphones, but also necessary for many other connected devices – as a substantial opportunity. We also expect QCOM to play aggressively in integrated connectivity solutions for the emerging wearables, connected vehicle and “Internet of Things” (IoT) markets. We also believe that QCOM can lever its skills into future markets, such as ARM-based server CPUs, as they emerge.
Negative sentiment is a big opportunity in QCOM. QCOM has been a notable laggard amongst the stocks in our large cap model portfolio, down about 10.5% YoY in a strong tech market. This negative sentiment may turn up in coming quarters due to several factors. First, improved royalty collections, completion of the transition to 64 bit chipsets, and more stable currency should return the company to robust top and bottom line growth. Second, initiatives to take device market share, expand the share of BOM addressed, and build new businesses in adjacent emerging markets should show progress, altering the narrative toward future growth. Finally, moves to raise its dividend and increase share buybacks will reward income investors, rein in share count, and placate would-be activists. We believe QCOM is likely to beat FY15 2.8% sales growth consensus, and to significantly top expectations for 4.7% growth in FY16 with further impact to the bottom line.
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