Qualcomm Incorporated (NASDAQ:QCOM) designs and manufactures digital communications products and services based on Code Division Multiple Access (CDMA) Orthogonal Frequency Division Multiplexing (OFDMA) and other technologies. Qualcomm operates in four segments: Qualcomm CDMA Technologies (QCT); Qualcomm Technology Licensing (QTL); Qualcomm Wireless & Internet (QWI), and Qualcomm Strategic Initiatives (QSI). The Company develops and supplies integrated circuits and system software based on CDMA, OFDMA and other technologies for uses in voice and data communications, networking, application processing, multimedia and global positioning system products.
QCT (Qualcomm CDMA Technologies) is a leading developer and supplier of integrated circuits and system software based on CDMA, OFDMA and other technologies for use in voice and data communications, networking, application processing, multimedia and global positioning system products. QCT's integrated circuit products and system software are sold to or licensed to manufacturers that use the Company's products in wireless devices, particularly mobile phones, tablets, laptops, data modules, handheld wireless computers and gaming devices, access points and routers, data cards and infrastructure equipment, and in wired devices, particularly broadband gateway equipment, desktop computers, televisions, set-top boxes and Blu-ray players. The MSM integrated circuits, which include the Mobile Data Modem, Qualcomm Single Chip and Qualcomm, according to the Company's 2013 10-K.
Revenue and Cost Drivers
Qualcomm derives revenues from sales of integrated circuit products, fixed license fees, ongoing royalties for using intellectual property, fees for messaging and other services and related hardware sales, software development and licensing, and related services and software hosting services. Costs and expenses primarily consist of cost of equipment and services revenues, research and development, and selling, general and administrative expenses.
In 1985, Dr. Irwin Jacobs and seven other experienced professionals including Franklin Antonio, Adelia Coffman, Andrew Cohen, Klein Gilhousen, Andrew Viterbi and Harvey Whit outlined a plan that developed into Qualcomm, a shortened version of "Quality Communications." Later in 1985, Qualcomm began work on CDMA, a unique digital wireless technology used by the U.S. military, after landing its first contract.
In 1988, the Company developed OmniTRACS, a satellite data communications system to help truck fleet operations optimized and track their vehicles. Then, on November 7, 1989 Qualcomm unveiled its progress by making a demonstration call, earning its place in wireless history. Qualcomm went public in December 1991, selling four million shares to the public, as per the Company website.
Mobile technology is a growing industry that has experienced substantial evolution since the first cell phone call in 1973. As of 2010, The International Telecommunication Union (ITU) estimated that 90% of the world's population lived in areas served by mobile network coverage. As of September 30, 2013, there were approximately 6.8 billion cellular connections worldwide, consisting of approximately 3.2 billion unique individual cellular account holders, or subscribers. Notable trends going forward include the expanding role of mobile technology as the main computing device and the shift away from desktop computing, the decrease in use of primarily voice-centric phones to data-centric (smart) phones, accommodating data usage and developing new applications and services for these data-centric devices, and the increased use of wireless technology between machines (M2M) applications, according to the Company's latest 10-K.
Consumers are choosing to use smartphones and tablets rather than personal computers such as email, web-browsing, gaming, and social networking. These advanced mobile devices are favored for their processing power and constant connectivity. This shifting consumer trend is reflected in sales trends as more than twice as many smartphones and tablets were shipped globally in 2012, compared to personal computers. Accordingly, in 2012, semiconductor industry revenues for mobile phones surpassed those for personal computers for the first time
The mobile industry is shifting to smartphones even though some feature (non-smartphones) support Internet-connectivity and other basic computing functions. In 2012, global smartphone shipments reached approximately 700 million units representing a year-over-year (y-o-y) increase of approximately 44%, and smartphone shipments are projected to reach approximately 1.8 billion in 2017. This growth is fueled by a projected compound annual growth rate of smartphone shipments of approximately 30% between 2012 and 2017 in emerging markets. Growth is these regions is not only due to rapid economic growth, but also because many people in these regions may have income levels that make purchasing a personal computer impossible. Thus, a smartphone or tablet may be the first and only device used to access the Internet and other computing functions.
It is also important to consider the power source behind these increasingly powerful smartphones and tablets. As smartphone and tablet shipments achieve increasing scale, the chipsets powering these devices are becoming an increasingly important differentiator to industry participants. Suppliers seek to balance several factors including performance, size, design, and battery life of new devices. Subsequently, there is a trend toward chipsets that integrate many of the essential components of the mobile device into a unified and optimized system-on-a-chip (SOC), which includes a modem, a central processor (CPU), a graphics processing unit (GPU), multimedia support and other components that work together.
As mentioned above, with the increase use of smartphones, there will be a significant increase in demand for data services. Mobile operators are utilizing 3G/4G (third generation/fourth generation) networks and investing to increase the performance and capacity of their networks in order to meet demand. As of September 30, 2013, the total number of 3G and multimode 3G/4G connections worldwide reached approximately 2.3 billion, which is approximately 34% of total cellular connections. By 2017, projections indicate there will be approximately 50% more, or 4.5 billion 3G and multimode 3G/4G connections. In addition, more than one million new 3G and multimode 3G/4G connections were added every day during Q3 2013. In the emerging markets, 3G and multimode 3G/4G cellular connections account for more than three times the number of fixed broadband connections, as per the Company's most recent 10-K.
Mobile technology is being incorporated into new connected devices in a growing number of sectors including the consumer electronics, automotive, health and life sciences and utilities sectors placing additional data demands on the network. Qualcomm refers to this as the "Internet of Everything," and this will be mentioned further in the future outlook for Qualcomm section. Strategies to deal with increased data demand include deploying smaller sized, lower-power cellular base stations. Another key focus is on more efficient use of spectrum. Some relief from network congestion caused by the demand for data is expected to come from the proliferation of peer-to-peer communications in which devices communicate directly with other devices without having to access the cellular network. Additional efficiencies are expected to come from the continuing evolution of 3G/4G and Wi-Fi technologies and the use of broadcast capabilities made possible by LTE broadcast technology
Along with the development of wireless communications, different wireless technologies continue to evolve. Qualcomm in particular invests in numerous cellular wireless communication technologies, including CDMA and OFDMA, mentioned above. In the wireless technology industry, continuous innovation to further improve the user experience, enable new services and increase network capacity, make use of different frequency bands and enable dense network deployments is required. Accordingly, Qualcomm has developed and acquired (and continues to develop and acquire) significant related intellectual property, with more than 250 licensees to all leading manufacturers.
Other Wireless Technologies
Qualcomm is also involved in other non-cellular wireless technologies that have also been broadly adopted in mobile cellular devices such as wireless local area networks, Bluetooth, and location positioning technologies. Wireless local area networks (WLAN, or Wi-Fi) link two or more devices using a wireless technology method and usually provide connectivity through an access point. Bluetooth is a wireless personal area network that provides wireless connectivity between devices over short distances ranging from a few centimeters to a few meters. Lastly, location positioning technologies use satellite systems to provide accurate location of devices and primarily work outdoors, when devices have a clear view of the sky.
Initially I referenced equity research analyst reports on ThomsonOne to understand the consensus guideline for sales growth. From here forward the initial guidance I used was based on consensus estimates from ThomsonOne. I decided to use 15% sales growth as this is in line with research estimates, and is moderate growth for a company with a $125 MM market capitalization. Growth in the past five years has ranged from 5.4% to 36.2%, but this includes abnormal growth to recover from the financial crisis of 2007-2008.
When forecasting COGS as a percentage of sales I used an average for the past three years (35%), and held this percentage constant for the forecast period. I utilized the same method for forecasting SG&A and D&A with 30% of sales and 4.5% of sales respectively. I also used an average of the past three years (2010-2013) to determine the tax rate (18.6%), which holds throughout the forecast period. I believe a three average was an apt choice for these items as the outputs in each of the three years does not show much variability.
Moving on to the balance sheet, for depreciation, I used an average ratio of Deprecation/PPE of 52.9%, because depreciation each year is going to be a percentage of the depreciable base, or plant, property, and equipment. Then, for short-term debt and long-term debt I employed a ratio of debt to equity as this ratio should remain fairly consistent of 2.3% and 0.3% respectively. Lastly, I used cash as my plug to balance the assets and liabilities + equity. This assumes the company does not sell additional stock, does not pay back any of its existing debt, and does not raise any more debt. All these assumptions are reasonable for QCOM as there is little debt on the balance sheet, the number of shares outstanding has been fairly consistent, and QCOM is a large company that earns consistent profits, and a substantial need for debt or equity raising should not be necessary.
To calculate WACC, I determine the cost of equity at 8.77% with QCOM's beta of 1.16, an expected market return of 7.69%, and a risk-free rate of 1.00%, the cost of equity equals 8.77%. The net debt, a sum of short-term and long-term debt is only equal to 14 million dollars. Therefore, the cost of debt has a negligible impact on weighted-average cost of capital (WACC). According to ThomsonOne, the net debt is negligible for Qualcomm so I looked at a company of comparable market capitalization and industry, Intel, to determine a cost of debt.
After analyzing Intel's debt table I decided 3.5% was a safe estimate for Qualcomm's cost of debt. As apparent below, the cost of debt impacts such a small percentage of the WACC that the cost of equity, 8.77% is equal to the WACC, 8.77%. Therefore, changing the cost of debt from any percentage in the range from 3.00% - 5.00%, does not change the WACC.
For the terminal value I employed a growth rate of 2%, and I already projected 15% growth from 2014 - 2018 based on consensus analyst estimates.
I estimated a share price of $89.86 per share, with a Hold rating. My share price is above the mean of $79.68 and median of $82.00, but below the highest estimate of $92.00. Any uncertainty in my estimate is primarily due to the growth rate of revenue, 15% for the forecasting period (2014 - 2018) and the growth rate to determine the terminal value of 2%. The 15% revenue growth affects almost every line in the income statement and balance sheet directly as most line items are estimated as a percentage of sales. In addition, the terminal value growth percentage is the largest FCF value weighing on the enterprise valuation.
Future Outlook for Qualcomm
At the 2013 Consumer Electronics Show Qualcomm focused on wireless communications outside of smartphones, even though smartphone related technologies determine a majority of Qualcomm's revenue, as referenced in this Fortune article. In the smartphone segment, Qualcomm has a market advantage due to its patents and contracts with Apple and Samsung, providing a source of income for years to come. However, as the smartphone market growth slows, Qualcomm believes the "Internet of Things" is the future of technology.
The internet of things seeks to connect objects such as toasters, refrigerators, washing machines, watches, etc. Qualcomm is working to implement its chips and intellectual property in this developing environment. If Qualcomm is able to be one of the first "Internet of Things" players, it can establish a new major source of revenue. By filing patents early, Qualcomm could position itself as a gatekeeper to the internet of things revolution, akin to its position in the smartphone market. Accordingly, my high price estimate of $89.86 affirms my belief that Qualcomm can take an early advantage in the "Internet of Things" revolution.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.