Qualcomm's (NASDAQ:QCOM) fiscal first quarter results sent a bit of a mixed message, with the firm providing lower-than-expected fiscal second quarter guidance but a better-than-expected view for the full fiscal year. But what does that really mean for Qualcomm? How should investors interpret moderate timing differences in revenue recognition? Should they be worried?
Well, we don't worry too much about the quarterly earnings game. In fact, we think a comprehensive analysis of a firm's discounted cash-flow valuation (based on long-term expectations) and relative valuation versus industry peers (competitors if available) is the best way to identify the most attractive stocks. This process culminates in what we call our Valuentum Buying Index (VBI), which ranks stocks on a scale from 1 to 10, with 10 being the best. Let's look at what the numbers tell us about Qualcomm.
Qualcomm posts a VBI score of 6 on our scale, reflecting our "fairly valued" DCF assessment of the firm and its neutral relative valuation versus peers. Though we note that the following firms aren't direct competitors, we compare Qualcomm to industry peers Harris Corp (NYSE:HRS), JDS Uniphase (JDSU) and Tellabs (NASDAQ:TLAB) to help financial advisors gain perspective on the potential valuation opportunities across the industry. In the spirit of transparency, we show how the performance of the Valuentum Buying Index has performed per underlying score (based on the last update):
• Qualcomm earns a ValueCreation™ rating of EXCELLENT, the highest possible mark on our scale. The firm has been generating economic value for shareholders for the past few years, a track record we view very positively. We expect the firm's return on invested capital (excluding goodwill) to expand to 150.7% from 74.8% during the next two years.
• Qualcomm has revolutionized the mobile phone industry. Through its own R&D and through partnerships with other firms, the company develops breakthrough technology and then licenses it across the wireless industry.
• Qualcomm has an excellent combination of strong free cash flow generation and low financial leverage. We expect the firm's free cash flow margin to average about 32.9% in coming years, and the firm had no debt as of last quarter.
• Qualcomm is better positioned than most in its industry. The company owns a strong patent portfolio in CDMA and OFDMA (among others), and its licensing model continues to generate elevated margins and strong returns on capital.
• Backing out Qualcomm's net cash per share, the firm is trading at a very, very attractive multiple of fiscal 2014 non-GAAP earnings. Based on the company's rapid expected growth rate and cash-rich, licensing business model, the market has Qualcomm priced wrong, and we expect valuation upside to more than $80 per share on the basis of our fair value estimate. The company's financial strength is simply remarkable.
Economic Profit Analysis
The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital - ROIC - with its weighted average cost of capital - WACC. The gap or difference between ROIC and WACC is called the firm's economic profit spread. Qualcomm's 3-year historical return on invested capital (without goodwill) is 73.4%, which is above the estimate of its cost of capital of 10.8%. As such, we assign the firm a ValueCreation rating of EXCELLENT. In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid gray line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.
Cash Flow Analysis
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Qualcomm's free cash flow margin has averaged about 28.2% during the past 3 years. As such, we think the firm's cash flow generation is relatively STRONG. The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. At Qualcomm, cash flow from operations increased about 28% from levels registered two years ago, while capital expenditures expanded about 201% over the same time period.
The estimated fair value of $81 per share represents a price-to-earnings (P/E) ratio of about 26.4 times last year's earnings and an implied EV/EBITDA multiple of about 19.3 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 11.7% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 22.4%. Our model reflects a 5-year projected average operating margin of 39.2%, which is above Qualcomm's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 3.7% for the next 15 years and 3% in perpetuity. For Qualcomm, we use a 10.8% weighted average cost of capital to discount future free cash flows.
Margin of Safety Analysis
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $81 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values. Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph below, we show this probable range of fair values for Qualcomm. We think the firm is attractive below $61 per share (the green line), but quite expensive above $101 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Future Path of Fair Value
We estimate Qualcomm's fair value at this point in time to be about $81 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart below compares the firm's current share price with the path of Qualcomm's expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change. The expected fair value of $105 per share in Year 3 represents our existing fair value per share of $81 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.
Pro Forma Financial Statements
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.