Seeking Alpha
Long/short equity, contrarian, independent research, tech
Profile| Send Message|
( followers)  

I have been quite bullish on shares of Qualcomm (NASDAQ:QCOM). In addition to a solid balance sheet, strong financial performance, and a clear technological lead in the communications processor market, the company has been a solid "sentiment" trade. Go to your local Verizon (NYSE:VZ) or AT&T (NYSE:T) store and pick up a smartphone. Any smartphone. The odds are good that if you live anywhere in which LTE is popular, the phone has a Qualcomm chip in it. Most contain both a Qualcomm apps processor as well as a Qualcomm modem, although high end designs such as the Apple (NASDAQ:AAPL) iPhone 5 will use an in-house apps processor coupled with a Qualcomm modem.

Make no mistake: Qualcomm "won" this round because of its lead in LTE. Nvidia (NASDAQ:NVDA), Intel (NASDAQ:INTC), and Broadcom (NASDAQ:BRCM) all essentially had to sit this generation of phones out because they didn't have LTE solutions ready to ship. Further, Qualcomm is able to subsidize its significant R&D spend in this area thanks to the enormous portion of its net income that it generates from 3G/CDMA licensing. To put this in perspective, consider the following excerpt from the most recent earnings release:

(click to enlarge)

While all of the brouhaha surrounding the "Snapdragon" chip (QCT division) in the smartphones likely drives Qualcomm's multiple, the majority of the earnings actually comes from QTL (3G/CDMA patent licensing). In fact, if Qualcomm were simply a modem/smartphone chip company, it would have earned $2.3B before tax, or a mere 30% of its FY2012 income. With a diluted share count of 1.72B, this would come out to an EBIT/Share of $1.33. Even at a generous 20x Price/EBIT, shares would trade at about $38/share.

With that perspective in mind, I would now like to draw your attention to this recent downgrade from JPMorgan. The reasons for the downgrade are as follows:

  • 3G device ASPs are expected to decline (and Qualcomm recognizes licensing revenue as a % of device cost)
  • "Rapidly slowing" smartphone adoption

While I actually concur with JPMorgan that there will be a fundamental mix shift to lower end phones (as the hardware for lower end phones becomes "good enough" to satisfy the smartphone users at feature phone prices), I don't think this is actually the "right" reason to downgrade the stock as unit volumes will continue to march up for the forseeable future, more than offsetting ASP declines. The real problem is that in addition to the alleged smartphone adoption slowdown, other major players will start to make inroads in the LTE space.

The New Kids On The Block

While Qualcomm's LTE lead kept competitors out of the race, the lead was destined to be an ephemeral one. A slew of (powerful) competitors planning to throw their chips into the LTE ring will make it much more difficult for Qualcomm to hold its commanding lead in the US based, LTE smartphone market. In particular, the major competitors that will be ready to compete in 2014 will be:

  • Broadcom just announced that it is currently sampling a 28nm 4G baseband modem for smartphones & tablets with production scheduled in early 2014
  • Nvidia is also sampling its 4G LTE modem also set to be launched in the early part of 2014
  • Intel CEO Paul Otellini noted on the most recent earnings call that it is currently shipping single mode LTE baseband to customers now, and expects to deliver multimode data and voice LTE modems to customers throughout 2013, presumably shipping in devices in early 2014 as well.

Further, for the low end/high volume markets, all three of the above players will be shipping integrated apps processor/modem to compete with Qualcomm's integrated products. The presence of competitive pressures won't look particularly good to investors, but is now the time to bail?

Time To Bail?

While sentiment might be temporarily dinged, Qualcomm's financial results typically vindicate the company and the stock price despite these recurring worries. Expect the financial outperformance to continue throughout 2013, which will offset the stock's tendency to drift downwards on the fears of impending competition (i.e. position yourself long ahead of earnings calls).

While not going into an earnings report, the best strategy would be to start selling covered calls on pops and selling cash-secured puts on drops. While the company is solid, I believe the relatively small dividend and the likelihood of a shareholder to get "whipsawed" make it much more compelling to approach this with options. By selling puts, you can't really lose if you were planning to buy the stock that day, and by selling calls against a long position, you can potentially limit upside, but you also, again, lower your cost basis.

By the end of the year, though (September/October timeframe), I would be hestiant to hold the equity directly as it is around that time when the competitive pressures will start to become clearer and clearer. Even if they do not impact financial performance for a couple of quarters, the market is forward looking, and analysts will keep bringing it up. Expect P/E compression by the end of the year to about ~15x earnings (but EPS will be higher).

Conclusion

Qualcomm was in the driver's seat for this generation of phones and will continue to be throughout 2013. Expect solid financial performance, so try to position yourself long ahead of earnings reports, either with common stock purchases or bull put/call spreads. For the rest of the time, the volatility will be increased and there is likely to be downside bias, so sell puts to either collect premium/get a better entry point, or sell covered calls on a long position to lower cost basis/protect profits.

Source: Is Qualcomm Losing Its Luster?

Additional disclosure: I may go long QCOM or BRCM at any time.