Investors in Qualcomm (NASDAQ:QCOM) have been pleasantly surprised by a soft quarterly earnings report issued in recent times, a delay in the LTE adoption in China as well as governmental investigations.
Despite slowing growth, shares trade near their all-time highs as investors are appealed to the valuation, the very high cash balances and continued increased payouts to investors.
While many expect that current slow growth will accelerate thanks to China adopting LTE and 4G, I am worried about the long term sustainability of the company's competitive position. The incredible profitability of the firm draws phone producers and competitors towards Qualcomm's money machine.
Second Quarter Results
Qualcomm opened its books for the second quarter in the final week of April. Reported revenues of $6.37 billion were up 4% compared to last year, but fell by 4% on a sequential basis.
GAAP earnings rose by 5% to $1.96 billion and were up by four percent compared to the first quarter. Earnings per share rose by 8% on an annual basis to $1.14 per share thanks to the accretive effect of share repurchases.
MSM chip shipments were up by 9% to 188 million units, but shipments fell by 12% on a sequential basis. Reported device sales were up by 9% to $66.5 billion compared to a year ago while increasing by 8% on a sequential basis.
Cash Balances And Taxation Risks
Qualcomm has a very strong balance sheet which is much stronger than that of some of its competitors. Total cash and equivalents stand at $32.1 billion while the company has no debt outstanding.
Important to notice is that just $8.4 billion of this cash is being held domestically, which is actually down by $3 billion on the year before. The huge offshore cash balances can only be used for dividend or repurchases once repatriated which could cost shareholders dearly as seen by eBay's (NASDAQ:EBAY) shareholders recently. The name-sake marketplace and PayPal parent took a $3 billion charge on its intentions to repatriate $9 billion worth of foreign cash.
As Qualcomm reported an effective tax rate of 14% overall, it too could be eligible for a big tax bill if no tax holiday will be instated, no deal will be cut, or if the company fails to find lucrative overseas cash deployment opportunities.
Given the strong cash flow picture of the company and the rock-solid balance sheet, Qualcomm has resorted to return cash at an increasingly quicker pace to its shareholders.
During the second quarter, Qualcomm repurchased a billion worth of shares in order to retire 13.4 million shares. This implies that the company is effectively retiring 3% of its shares outstanding per year.
On top of repurchases, Qualcomm recently hiked its quarterly dividend towards $0.42 per share. This provides investors with a yield of 2.1% on top of the share repurchases. Combined, investors can expect cash return of nearly 5% per annum, or $7 billion in cold hard cash.
As a matter of fact, Qualcomm is facing multiple issues in China. The company announced that it could face civil action for violating the Foreign Corrupt Practices act for allegedly bribing Chinese state-owned officials.
While this is a serious issue and could lead to serious settlement payments the real issue remains on the revenue side of the business in China as developed market smart phone sales are stagnating.
The company is seeing disagreements over royalties on its intellectual property in China. Furthermore in anticipation of new 4G cell-phone technology and the delay of LTE, many Chinese are delaying the purchase of a smartphone ahead of the expected launch of 4G later this year by China Mobile.
For the current third quarter revenues are seen between $6.2 and $6.8 billion which compares to last year's revenues of $6.24 billion. GAAP earnings are seen between $0.98 and $1.08 per share, up from a reported $0.90 in the corresponding period last year.
Qualcomm's chip prices continue to be under pressure. Shipments are expected to rise from 172 million units to 198-213 million units which would represent growth of 13 to 24% in the number of units.
Full year revenues are now seen between $26 and $27.5 billion with GAAP earnings per share anticipated to come in between $4.37 and $4.57 per share.
With shares at $79 per share the company commands a market valuation of $133 billion. Given the solid balance sheet, net operating assets are valued at $101 billion, assuming no tax charges on the foreign cash balances. This values operating assets at 3.8 times annual revenues and 13-14 times GAAP earnings.
QCT And QTL
The major cash cow of Qualcomm continues to be the Qualcomm Technology Licensing (QTL) business which reported revenues of $2.07 billion and earnings before taxes of an incredible $1.83 billion. The business unit holds an incredible amount of really profitable licenses including more than 255 CDMA-based licenses, over 180 WSDMA/TD-SCDMA licenses and another 100 or so royalty-based OFDM/OFDMA licenses.
Shipment growth is driven by emerging markets where smart phone sell for less, putting pressure on average selling prices.
Qualcomm CDMA (QTM) is the much larger business of $4.24 billion, but earnings before taxes were much lower due to much more normal margins, coming in at $740 million.
Takeaway For Investors
All in all I am in doubt about Qualcomm. Sales could easily grow at double digit numbers again next year if a Chinese adoption of LTE and 4G becomes a success as predicted by China Mobile. A new production introduction by Apple (NASDAQ:AAPL) could be a big driver as well with many anticipating new and bigger iPhones being launched later this year.
This combined with the very strong cash balances, high payouts to investors and a valuation at 13-14 times earnings is quite appealing. That being said, shares continue to trade near all time highs after solid momentum in recent years. This is despite short term growth worries and the issues in China.
But perhaps the biggest worry are the very high margins of 89% being achieved in its QTL business, resulting in cash inflows of nearly $2 billion a quarter. This obviously draws competition, with many competitors like Intel (NASDAQ:INTC) already announced ambitions to expand into this field.
Obviously Qualcomm's licenses will remain valuable for a long time, yet in the fast changing world of mobile telecommunications you simply can't keep expecting these assets to last forever.
I remain cautious, but would be a buyer on dips.
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.