The Semi-Conductor Space - Part 1: Focus Qualcomm

| About: Qualcomm Inc. (QCOM)


We look at companies, and try to see how they are perceived by different stock selection styles adopted by market participants.

We look at companies, and try to see how they are perceived by different capital allocation styles adopted by market participants.

We look for good companies at a good price. That is companies priced at a level which offers an opportunity to capture potential alpha.

I recently ran posts on several stocks in the energy sector, which focused on exploration & production companies and the offshore drilling industry. I will be running a series on oilfield services companies next. But to give myself a break from energy, I decided to have a look at the semi-conductor space, which is looking quite attractive. And I'd like to establish if some of them, in my view, still represent good value.

In this post, I will present some information on Qualcomm (NASDAQ:QCOM), Taiwan Semiconductor Manufacturing (NYSE:TSM), Texas Instruments (NYSE:TXN), Marvell (NASDAQ:MRVL), Intel (NASDAQ:INTC), Nvidia (NASDAQ:NVDA) and Advanced Micro (NYSE:AMD). And then present the value case for Qualcomm in this post and Intel in part 2 of this series.

At present, I am long Intel, and follow Qualcomm. I own Intel because I like to receive at fairly substantial part of my return through dividends: that makes me responsible for the allocation of my capital, and so reduces the risk of bad capital allocation by the company. I like Qualcomm too and am often perplexed as to why I don't own it. The reason is simple: I can't possibly own every stock I like. Of the rest, having had a quick look at Taiwan Semiconductor, I like what I see, but I don't follow it simply because I don't have the time. The others, I shy away from companies which don't display annualized nominal sales growth of over 5% over the past five years, unless they are challengers through the process of new disruptive innovation: that is not to say that they are not good companies, just that they are not quite what I am looking for.

Quantitative analysis of the behavior of market participants

A couple of years ago, I had written some code to facilitate stock selection. It would help if you read about the build-out of that system here, as that will allow you to appreciate the model output later in this post better. Recently, some of the output of the Alpha Omega Mathematica [AOM] model is being published online, and you can see a list of the top and bottom 20, large, mid, and small cap stocks here. You can view additional information for any specific stock here. You may find differences between the data displayed below in this post and the data on the website: this is because I run the model for a coverage universe of all stocks listed in US with a market capitalization of over $100 million, whereas the website uses a different coverage universe.

I am presenting data and the model output for Qualcomm, Taiwan Semiconductor, Texas Instruments, Intel, Marvell, Nvidia, and Advanced Micro. And at the end of the post, I have run through how I value Qualcomm.

Let's start with some AOM Over-all Scores. As you can see, the AOM model likes Qualcomm, Taiwan Semiconductor, Texas Instruments, Intel, and Marvell, and is relatively less impressed by Nvidia, and Advanced Micro.

In the table below, you can have a look at the data to determine how you feel about each company relative to the others.

Source: MaxKapital Archives using data from Financial Visualizations

Qualcomm AOM Overview

People select stocks to a personal style bias and so we have value, growth, momentum, balanced and agnostic (those with no stock selection style bias) styled investors. This table below gives you information to help you determine whether your stock selection style bias is satisfied by the stock in question.

For Qualcomm the stock selection style model suggests that the quality of returns and profits is impeccable. It also suggests the stock is well valued, has sound ownership quality, momentum and growth prospects. My big concern here is that while the stock may run up short term as momentum gathers steam, in the medium term, with a score of 92%, there are chances of a decline. In the long run, in my view the prospects remain positive. The big decision is whether to buy now for the long term, or to buy the dip should it come.

Source: MaxKapital Archives

Some investors like to select what they see as the best stock in a sector. Others prefer to select what they see as the best stock in an industry. And there are yet others, who simply want to own what they see as the best stock available, without regard to the sector or industry in which it operates. These are the three main capital allocation styles. This table below helps you determine if the stock in question allows you to satisfy your capital allocation style.

For Qualcomm, the capital allocation style model output suggests that the stock is very attractive to growth, value and balanced investors, regardless of whether they allocate their capital using a sector, industry, or a sector/industry unbiased allocation strategy. The stock is also attractive to momentum investors. The stock is very attractive to the agnostic investor (the one who weights all types of indicators equally), who allocates capital at industry level, and attractive to stock selection style agnostic investors who allocate capital at sector or with no sector/industry bias.

When there is such broad-based interest in a company, the risk of lower levels of interest from one of the several stock selection and capital allocation combinations is high.

Source: MaxKapital Archives

Intel AOM Overview

For Intel, the stock selection style model indicates that the value and return quality is impeccable, while growth and momentum scores are somewhat disturbing. Ownership quality is sound with substantial institutional holdings, but insider ownership is low. Intel has been hurt by the absence of a strong entry into the mobile space. And skepticism on whether they will be able to make in-roads into this market remain. There is also concern that going ahead, the return quality will deteriorate as margins shrink. Much of this is priced.

Intel has also been hurt by the deterioration in the PC market. What is not priced is that the rate of deceleration is decreasing. The PC has been disrupted and displaced in homes. However, the PC remains critical for industry. That smaller market continues to exist and grow. Once the decline in the Home PC market stops, earnings will grow from a smaller base, and the slowing in the rate of declaration in that market suggests that the end is near. Ultimately, in my view, Intel's earnings are near a trough from which they will grow. In addition, there is upside first from Broadwell, and next from Cherry Trail: don't write Intel off. I guess what I am saying, is that Intel's over-all AOM score has potential to rise a lot further as growth expectations get realistic, and momentum returns in anticipation of that change.

Source: MaxKapital Archives

For Intel, the capital allocation style model output suggests that the stock is very attractive for value investors, particularly those allocating capital at sector, or coverage universe level. It is also attractive to balanced investors allocating capital at sector or with no sector/industry bias, and to value investors allocating capital at industry level. For the rest it is a hold.

With the main interest in the stock being from value style stock selectors, there is plenty of scope for the stock to gain interest from the several stock selection and capital allocation combinations available. And as a stock gains buyer interest, sometimes interesting things can happen to the price.

Could we see Intel follow Microsoft, into changing from a widely hated stock, to one which is very appreciated by all market participants? Today, AOM says everyone loves Microsoft, with some affection being held back by growth investors who allocate capital at industry or coverage universe level. Yesterday, the story was quite different.

Source: MaxKapital Archives

Texas Instruments AOM Overview

For Texas Instruments, the stock selection style model suggests that the stock represents decent value, with good quality returns. Momentum is okay as is ownership quality, while growth scores are subdued.

Source: MaxKapital Archives

For Texas Instruments, the capital allocation style model output suggests that the stock is unattractive to value and style agnostic investors, seeking to allocate capital at industry level. However, the stock is attractive to very attractive to all kinds of stock selectors, who allocate capital using sector or sector/industry unbiased strategy.

Source: MaxKapital Archives

Taiwan Semi's AOM Overview

For Taiwan Semi's the stock selection style model suggests that the quality of returns and profits and value metrics are sound. Momentum and growth are okay too. The ownership quality is scored low, because the data on institutional and insider ownership is not available on the system. So that is something a person interested in buying Taiwan Semi's might want to look at.

Source: MaxKapital Archives

For Taiwan Semi's, the capital allocation style model output suggests that the stock is attractive to very attractive to all stock selection styles who allocate capital using a sector or sector/industry unbiased strategy. The allocators at industry level who focus on growth and value like it too. Stock selection style agnostic, momentum and balanced investors allocating capital at industry level remain neutral.

Source: MaxKapital Archives

Marvell AOM Overview

For Marvell, the stock selection style model scores it very well on ownership quality and momentum, and well on value. The growth score is satisfactory. The disappointing score is on return quality. I can't get too excited on a low score on return quality in a single year, particularly when insider and institutional ownership quality remains strong.

Source: MaxKapital Archives

For Marvell, the capital allocation style model output suggests that all styles of stock selection, allocating at industry level remain neutral, while all styles of stock selection, allocating with no sector or industry bias are attracted to the stock. Stock selectors allocating capital at sector level are attracted to the stock, with the exception of growth investors, who remain neutral.

Source: MaxKapital Archives

Nvidia AOM Overview

For Nvidia, in the stock selection style model, we see a strong value score, coupled with good momentum. We see disappointing growth and return and profit quality scores. Scores for ownership quality are neutral.

Source: MaxKapital Archives

For Nvidia, the capital allocation style model output suggests that the stock might be of interest to momentum and stock selection style agnostic investors allocating capital to a sector, or with no sector/industry bias in their capital allocation. It might also be of interest to value investors allocating capital at sector level. All other stock selection and capital allocation styles remain neutral.

Source: MaxKapital Archives

Advanced Micro AOM Overview

For Advanced Micro, the stock selection style model output signals an acceptable result for value and growth, and is mildly positive on momentum. The low score on ownership and return quality is worrying and certainly requires a closer look before an investment decision can be made.

Source: MaxKapital Archives

For Advanced Micro, the capital allocation style model output that the stock is a hold across the board.

Source: MaxKapital Archives

The Case for Qualcomm:

Why look at Qualcomm now?

Firstly, Qualcomm is a mega-cap stock. This gives it a defensive character, which appeals to me when I perceive the markets are expensive. Secondly, the stock has a low beta. This adds to the defensive characteristics and protects downside during weak markets. Thirdly, following its recent 20% dividend hike to $0.42 per quarter, the stock delivers a yield of 2.2%, which is a premium to the market yield. This too adds defensive characteristics to the stock. Finally, Qualcomm as recently priced, includes potential alpha. Alpha is the difference between actual returns and risk adjusted returns an investor should expect from a stock. When a low beta stock includes potential alpha, downside protection is provided by the low beta, while upside total return potential is not compromised, because we earn returns from alpha in addition to the lower upside beta driven gains associated with low beta stocks.

However, I believe that we are now either in, or fast approaching the late or mature phase stage of the economic expansion. As I mentioned in a recent post, during such periods, the technology sector has displayed a historic tendency toward under-performance: it might make sense to wait. Having said that, this time might be different - the technology valuations outside a small band of internet-based companies are quite reasonable.

Analyst price expectations

Recently Qualcomm traded at $76.81. From Yahoo Finance we know that thirty-five analysts expect an average price target of $81.20 (median $84), with a high target of $90 and a low target of $50. This is a pretty wide dispersion in expectations. So far the bulls are winning with Qualcomm regularly hitting 52 week highs. But the wide dispersion in high and low price estimates suggests that the risk is somewhat high. Having said that, with the average lying below the mean, it looks like the low estimate might be a one off outlier.


We might believe that Qualcomm is attractive. But thus far its attractiveness has been viewed relative to other stocks in its sector, industry, or the coverage universe. We do not know whether the stock is priced to deliver a long-term return in line with our expectations.

Mathematically, the worth of Qualcomm is estimated as [1 + Long-term Growth Rate] * Sustainable Earnings * Adjusted Payout Ratio / [Long-term Return Expectation-Long-term Growth Rate].

What is our long-term return expectation for a stock with a beta of 0.85, a long-term risk free rate of 4.50% and an equity risk premium of 5.75%? This beta of 0.85 differs from the beta on table 1 of this post, because it is based on a five-year regression of weekly closing prices of the stock, relative to weekly closing prices of the market, adjusted for beta's tendency to converge toward one. You can read more about where I get my estimates for long-term market returns and equity risk premium here. It is calculated as Risk Free Rate plus Beta Multiplied by Market Return less Risk Free Rate. Thus for Qualcomm, we should be targeting a long-term return of 9.3875%. Is the stock priced to deliver that return?

Earnings tend to be volatile from year-to-year over the course of the economic cycle. When I speak of sustainable earnings, I mean the level of earnings that can be expected to occur over the course of an economic cycle, which can be grown at estimated growth rates over a long period of time. I believe sustainable earnings can be estimated as the six-year median earnings per share. Thus cyclically adjusted earnings per share of $2.48, is an estimate of sustainable earnings for Qualcomm. However, while Qualcomm's earnings have been influenced by the economic cycle, earnings have grown at a faster than market pace these last few years. Thus it is likely that six-year median earnings, is a low estimate of sustainable earnings. A better estimate might be $3.52, which represents one standard deviation over the median six-year earnings. I will go with $3.52.

The adjusted payout potential is that part of sustainable earnings that we can expect the company to return to shareholders via dividends and buybacks, net of dilution. I expect Qualcomm will payout approximately 55% of earnings via dividends and buybacks (35% to 40% via dividends and another 15% to 20% via buybacks) over the long term.

If we use a very long-term growth expectation of 6.7%, Qualcomm is worth $76.81. Qualcomm Value = [1 + Long-term Growth Rate] * Sustainable Earnings * Adjusted Payout Ratio / [Long-term Return Expectation-Long-term Growth Rate] = 106.7% * $3.52 * 55% / (9.3875%-6.7%) = $76.81. At this price it is likely that an investor with a return expectation of 9.3875% will be satisfied.

The growth estimate implied by the current market price of 6.7% is low. In my view, Qualcomm can be expected to grow at a faster rate: an 8% growth rate in line with potential real Global GDP growth of 4.2% and global inflation of 3.8% should be achievable. If I am right, the spread between the 6.63% growth priced by markets, and an 8% growth expectation, is 1.3%: this represents potential long-term alpha. Alpha is the difference between actual returns and the risk adjusted return expectation. Since we have a risk adjusted return expectation of 9.3875% for Qualcomm, a long-term investor targeting a risk adjusted return of 9.3875% will end up earning a return of 10.6875%.

An investor with a shorter time horizon might do quite well too. A price target of $90 implies confidence in long-term earnings growth rising to 7.08% from 6.7% at present. Qualcomm Value = [1 + Long-term Growth Rate] * Sustainable Earnings * Adjusted Payout Ratio / [Long-term Return Expectation-Long-term Growth Rate] = 107.08% * $3.52 * 55% / (9.3875%-7.08%) = $90.

The formula above helps to compute a fair value for a stock. It is simple, and you can use it to calculate a value based on your expectations, as opposed to mine. But if you do so, be cautious.

If you alter your risk free rate assumptions, you will need to evaluate how that will impact market return expectations, and the equity risk premium. You will also need to think about how the risk free rates will impact long-term growth. If you alter the adjusted pay-out assumptions, think about how that might impact the growth assumption and the capital structure. For instance, higher growth may signal a need for fresh equity or debt. And if the capital structure changes, so will beta. When you alter growth assumptions, think about how it might change the operational mix, and the impact that might have on the stocks beta, and stock return expectations.

There is a high degree of inter-connectivity between beta, growth, adjusted pay-out ratios, risk free rates, and market and stock return expectations. And reading the inter-connectivity wrong will result in an answer that ranges from absurd to obscene: this model comes with warts. To avoid falling into this trap, here are some ideas which I hope will help.

1. Since valuation is about what you are willing to pay for a stock, perhaps the most important consideration is the growth risk premium: that is Long-term Return Expectation minus Long-term Growth Rate. The question to ask yourself is that if you expect a stock to grow at a certain rate, how much over and above that growth would you want by way of a stock return expectation, to compensate you for the risk that the long-term growth rate might not be in line with your expectations. This spread will be low for a fast growing stock, where there is great confidence in forward growth expectations, and higher for stocks where the confidence in growth is low. In the very-long term, the growth risk premium has tended towards 4.5% for the market.

2. When you look at sustainable earnings for a growth stock, you need to look at where you expect earnings to be a few years down the road. And then discount that number to its present value using your stock return expectations to obtain today's sustainable earnings

3. When you look at long-term growth rates, remember it is not the next years' growth, or the next five years growth you are looking for. You are looking for a composite long-term growth rate expected over the life of the company. This will be made up of foreseeable growth rate for some years, reversion to market growth rates, and finally a terminal growth rate. The terminal growth rate used by many is the risk free rate. I tend to use the very long-term market growth rates, since if the terminal growth rate is below market growth rates, I as an investor have the option to exit and enter the broad market. The life-expectancy of a typical Fortune 500 company is 40 to 50 years: you can read more about this here. So we can consider using a five-year forward rate, and then assume growth shall revert to being in line with market growth expectations for the following 45 years. What this signals is that I am willing to pay a premium for currently foreseeable growth expectations, but after that period, I expect to share fully in the reward of growth over market growth rates. On excel you can calculate a composite growth rate for a company growing at 15% per year for five years, followed by growth at 8% for the following 45 years as 8.68% [=POWER(1/1*115%^5*108%^45,1/50)-1].

4. Test your adjusted payout expectations. Take your growth rate and divide it by 1 minus the pay-out ratio. The result will estimate the return on equity implied in the model for the company. Review the return on equity to see if it is broadly consistent with the return on equity for the industry over the long term. If it is high, review the return on equity in the context of the leverage employed by the company. A levered company will have a higher return on equity, and so a high return on equity for a company may be perfectly justifiable in some circumstances. However, higher than industry leverage implies higher financial risk and this implies a higher beta, and a higher market return expectation. If you see a low beta with higher than industry leverage, you may want to compute a bottom up beta for the company, instead of one generated using regression analysis.

Disclosure: I am long INTC. 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.