Qualcomm: How Appealing Is The Mobile Dominance?

Aug.11.14 | About: Qualcomm Inc. (QCOM)

Summary

QCOM has a lower P/E than the S&P 500 - is that fair-value?

Market leader in chip sets, extensive intellectual property and commitment to R&D offer QCOM a competitive advantage.

QCOM growth will slow, but don't let that scare you away.

What if I told you there was a company with past growth above 25% that was trading below the S&P 500 P/E multiple? It seems unlikely, but Qualcomm (NASDAQ:QCOM) is exactly that.

Qualcomm is trading at 16.5x trailing earnings which is below the S&P 500's valuation. Is the company's future earnings power that bad?

The two revenue streams for QCOM are the chip sets - integrated circuits - for smart phones, and licensing fees. The chip sales are two-thirds of total revenue, but only 32.7% of EBIT. Licensing generates one-third of revenue and 67.3% of EBIT.

Revenue EBIT
Chip (Integrated Circuits) $16.7B $3.2B
Licensing $7.5B $6.6B
Click to enlarge

*FY13 Figures (excluding corporate overhead)

Competitive Advantages:

  • Market leader in chip/equipment for mobile devices.

    • Hundreds of smartphones use QCOM hardware while the nearest competitor, Intel (NASDAQ:INTC), has hardware in only a handful. The emerging LTE market also is dominated by QCOM which holds 66% market share with the nearest competitor, MediaTek, at 12%.

  • Tollbooth operator on 3G highway.

    • The licensing segment is essentially a monopoly on 3G phones. The intellectual property garners a fee of 3-5% on 3G phones' wholesale price. QCOM designed the mobile data highway (its IP). As the designer, QCOM has the right to "tax" the users of the 3G highway. So QCOM is, as Warren Buffett would say, a tollbooth operator in the 3G space.

  • As a market leader and tollbooth operator, QCOM generates significant cash which it put to use defending its market position via massive R&D investments.

Mobile Landscape:

In 2013, there were 3.2B mobile account holders and 6.8B mobile subscribers/users. New connections grew 6%. Of this total one-third of users used 3G networks.

Projections for 2017

  • 8.5B mobile connections - 7.7% CAGR

  • 4.5B 3G connections - 25.1% CAGR

  • 1.1B 4G connections - 12.9% CAGR

These projections for 2017 indicate 3G phones will still only account for 52.9% of the mobile device market. If these projections hold, QCOM will continue to generate strong licensing revenues. Beyond phones, 3G/4G connections are needed for tablets, smart watches, cars and potentially a number of other devices as the internet of things - IoT - emerges.

Source: GSMA Intelligence

Future Outlook:

The 3G market has significant room to grow, but most growth will be in emerging markets. This means smartphone ASPs will decline, thus, a lower royalty fee for QCOM. Management projects a 2-3% decline in unit royalties.

A concern for QCOM is what happens when the 3G market does reach saturation. QCOM is making strides in 4G with hardware licensing deals* with LG, Nokia (NYSE:NOK), Samsung (OTC:SSNLF) and ZTE. QCOM will need a good deal more IP to claim tollbooth status in 4G.

*These deals are not the same as QCOM's all encompassing 3G licensing.

China Mobile designed its own proprietary 3G highway, limiting QCOM's royalty base, but decided not to pursue a similar 4G network. This creates an opportunity for QCOM to gain a wider royalty base to grow from.

It is inevitable that unit royalty fees will decrease, but opportunities to broaden licensing into the future should create cautious optimism for QCOM investors.

Valuation:

Recent results and guidance from QCOM indicate soft licensing growth in 2014 - high-single digits. This short-term performance is well below long-term 3G connection growth. Balancing lower ASP for 3G devices, 2014 performance, and long-term trends, QCOM should grow licensing revenue in the low-teens over the next 5 years.

Chip sales were up 31% in the latest earnings report. Since 2011, this segment grew 36%. This high growth is near impossible to sustain moving forward, but QCOM should experience healthy growth - 18-22% - over the next five years.

Conservatively estimating licensing growth at 10% and chips at 18% results in total earnings growth of 12% assuming no margin movements.

At 12% growth, 3.5% LT growth, and 8% discount; QCOM has a fair value of $116.5 - roughly 58% margin of safety.

Based on valuation multiples, QCOM is trading at 16.8x trailing earnings while averaging a P/E of 24.3x over the past 8 years. The current EV/EBIT multiple is 14.6x with an average of 21.1x over past 8 years.

QCOM is trading at 16.8x trailing earnings and 14.6x EBIT compared against 8-year averages of 24.3x and 21.1x, respectively. QCOM's size limits future growth accounting for the lower multiples. The other side is future growth warrants a valuation multiple above that of the S&P - 19.1x earnings.

To further add value, management has increased dividends 18% in the past 5 years with a 2% yield currently plus a $1B share buy-back plan in place to help boost shareholder returns.

Conclusion:

The QCOM tollbooth will prove profitable into the future while its expertise and commitment to R&D will keep the company highly competitive. The lower cell phone ASP and company size will slow growth, but not enough to warrant the current valuation. QCOM is a "buy" as mobile connections continue to grow.

Risk:

  • While phone makers "outsource" design and production of chip sets, Apple (OTC:APPL) or Google (NASDAQ:GOOG)(NASDAQ:GOOGL) may decide to bring this in-house via their own R&D or an acquisition.
  • A large percentage of 2G mobile device users bypass 3G and move directly into 4G phones. This would significantly hurt QCOM's high margin licensing business.
  • QCOM may be unable to gain enough IP to sustain its licensing business into 4G - or the royalty fee is significantly less in 4G.
  • QCOM recently stated its concern over Chinese companies not complying with licensing agreements. If QCOM cannot solve this issue, a solid stream of revenue will be lost.

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.