Qualcomm: Buy The Dip

Nov. 7.13 | About: Qualcomm Inc. (QCOM)

Shares of Qualcomm (NASDAQ:QCOM) dropped 4% as the market digested its quarterly results and 2014 guidance. While I was disappointed by the results, I would not be a seller on the news because its long-term growth story remains intact, and it trades at a very compelling valuation. If anything, this pullback provides investors with an opportunity to go long (or add to a position) at a better price.

Turning to the actual results available here, Qualcomm reported EPS of $1.05 vs. expectations of $1.08 while revenue beat at $6.48 billion vs. $6.35 billion consensus. Revenue grew by 33% year over year and 4% sequentially, and earnings were up 18% year over year and 2% sequentially. So while analysts were hoping for more from Qualcomm, it is not as if the company saw a decline in its business. As the company is aggressively returning cash to shareholders with a growing quarterly dividend of $0.35 and significant buyback that totaled $3.3 billion, it should be noted free cash flow doubled year over year to $2.38 billion.

Revenue was strong in the quarter, and the EPS miss was really because of lower margins. CEO Paul Jacobs said those issues should be resolved in 2014. He said that operating expenses will be lower one year from now as Qualcomm is in the process of trimming costs by merging operations and potentially slimming the work force. Further, to entrench itself in emerging markets, the company has been selling lower-end chips. In 2014, the company expects lower input costs and continued ramping of production, which should bring margins back up. Management also gave some new manufacturers price discounts as they build long-term relationships. All these factors should abate in 2014.

In the quarter, it is also worth noting that the company shipped 190 million units, up a strong 35% annually and 10% sequentially. Management continues to spend heavily on research and development, which has kept its chips significantly ahead of the competition. R&D spending was up 23% year over year to $1.182 billion. However because revenue grew even more dramatically, R&D as a share of revenue actually fell from 23% to 20%. With higher revenues, I expect R&D spending to remain robust but stay below 20% of revenue, which will benefit margins in 2014.

Many investors were also concerned by the 2014 guidance, and I would like to address these concerns. First, EPS guidance assumes $4 billion in buybacks in 2014 to complete the current authorization. As noted above, the company spent $3.3 billion this quarter alone on repurchases and over $6 billion in the fiscal year. With $29 billion in cash and annual free cash flow of $11-$12 billion, I believe Qualcomm with increase its authorization by June 2014 and will repurchase in excess of $8 billion, which will increase EPS by an additional $0.12-$0.16. Under its parameters, QCOM expects 2014 EPS of $4.95-$5.15 (with my buyback expectations resulting in EPS of $5.07-$5.31). This guidance is actually better than analyst consensus of $4.93. Revenue guidance of $26-$27.5 billion was short of analyst expectations of $27.55 billion, though it would represent 5-11% growth.

It is important to note QCOM issued weak guidance for the next quarter with EPS declining year over year to $1.15 on $6.6 billion in revenue (10% annual growth) as some lingering discounts take a final bite out of margins. Analysts has been looking for $1.29 on $7 billion in revenue. Chip shipments will also grow by 7-15%. This dramatically lower guidance definitely spooked investors and was noticeably weaker than full year guidance because management expects 2014 to be especially back-end loaded. Based on the reaction in the share price, it would appear some question a back-end acceleration and that management will eventually have to cut its expectations for the later quarters. However, I believe there are specific reasons why to expect a much stronger second half of the year for Qualcomm.

First, China will be rolling out LTE in the second half of the year, which will significantly increase the number of phones sold with Qualcomm chips in that market. This new demand won't show up until after April and will increase revenue in the second half of the year. There are also several tablets being released in the second half of the fiscal year, which will also push demand for QCOM chips a little later into the year than usual. I believe the argument that the second half of the year will drive a higher proportion of earning than normal is credible and believe that management will be able to meet full year targets on the back of a smartphone market that should see a 10-15% increase in units.

While this quarter may not have been perfect, Qualcomm remains overwhelmingly cheap for a company with direct exposure to one of the top growth markets in the world, smartphones. As it sells chips to basically all phone manufacturers, it is agnostic as to whether Samsung, Apple, or Nokia-Microsoft dominate the landscape. With unparalleled intellectual property, Qualcomm has a moat that will extend for years, and I believe management was right to confirm expectations that earnings will grow by double digits for at least five years. Trading at $67, its forward P/E of 13x is very attractive as EPS should grow by 14% on the back of revenue growth and expanding buybacks. Importantly, the company also sits on $29.5 billion in cash, more than $17 per share. Excluding cash, QCOM is trading at 9.5-10x earnings, a tremendously compelling valuation. QCOM should trade at least 15x earnings ex-cash for a share price of $92, representing 37% upside. With Qualcomm poised for a strong second-half of 2014, massive capital returns to shareholders, and a cheap valuation, the drop on the quarterly report is a buying opportunity.

Disclosure: I am long QCOM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.