A previous article presented the investment opportunity in InterDigital (IDCC) based on the significant discount of the current price of the stock to its fundamental value. Here I compare IDCC with Qualcomm (QCOM).
QCOM was chosen for comparison because it is an investment alternative in mobile wireless growth. Like IDCC, QCOM is engaged in the development of advanced wireless broadband technology. Both companies are leaders in global LTE patent portfolio, and are well positioned to benefit from the strong demand for smart phones, the secular growth of new mobile product categories, and from related emerging technologies.
Unlike IDCC ($2 billion market cap), QCOM is a much larger ($89 billion market cap) and more mature company. Its business model integrates technology development with the more prominent integrated circuit development and delivery business.
This study compares business activities, structural attributes, financial performance, and risk. The scope is multiyear financial results; context is free cash flow, a principal driver in fundamental value. Also discussed is market opportunity. Metrics selected for analysis are those relevant to fundamental value.
The summary presents the investment opportunity in both stocks based on the discount of price to fundamental value.
Comparison of Activities
IDCC focuses on the development of intellectual property in cellular technologies. It holds a significant worldwide portfolio of CDMA patents and patent applications for licensing to clients ($392.0 million in revenues are estimated for FYE 12/10).
Development encompasses various access schemes for cellular systems, including CDMA, TDMA (of which GSM is the primary commercial form), OFDMA and MIMO technologies. A number of TDMA-based and CDMA-based inventions are being used in all 2G, 2.5G, and 3G wireless networks and mobile terminal devices.
QCOM, in turn, operates two principal businesses: Intellectual property licensing (QTL segment) and development of CDMA-based integrated circuits (QCT segment). CDMA, one of the main technologies currently used in digital wireless communication networks, was introduced by QCOM in 1989; the other technology is TDMA/GSM.
One-third of QCOM revenues ($10,991.0 million in total FYE 9/10 revenues) are from licenses to use its intellectual wireless product portfolio; two-thirds derive from integrated circuits.
QCOM grants licenses to use its intellectual property portfolio, which includes patent rights essential to and/or useful in the manufacture and sale of certain wireless products. Licensees include competitors of the integrated circuits segment such as Broadcom (BRCM), Fujitsu (FJTSY.PK), Infineon (IFNNY.PK)/Intel (INTC), NEC (NELTY.PK), and Texas Instruments (TXN). Generally, agreements with such parties entail reciprocal exchange of technology rights. Like IDCC, QCOM collects license fees and royalties in consideration for such licenses.
In the integrated circuits business, QCOM develops and supplies CDMA-based integrated circuits (also incorporating other wireless standards) and system software for various wireless voice and data communications purposes. Products and software are used in wireless devices, particularly mobile phones, tablets, laptops, data modules, handheld wireless computers, data cards and infrastructure equipment.
Infrastructure equipment, integrated circuits and system software for use in the wireless operator’s base station equipment are sold to many of the world’s leading wireless device and infrastructure equipment manufacturers. The goal is to help clients reduce the costs and size of their products, simplify their design processes, and enable more wireless devices and services.
Both companies work and collaborate with standard development organizations, such as the International Telecommunications Union (ITU) and the European Telecommunications Standards Institute (ETSI). Such organizations have responsibility for the development and administration of wireless communication standards and provide specifications for wireless communication products. These standards are adopted with each new generation of products, ensuring compatibility with products from previous generations and convergence in telecommunications services.
Typically, standard development organizations are informed by the patent developers that their technology might be essential to the applicable standards, and that they commit to license their patents on a fair and reasonable basis free from unfair discrimination.
Both QCOM and IDCC are clear leaders in global LTE patent portfolio, with 21% and 19% respective market share of the total number of patents; followed by Huawei (9%), Samsung (SSNLF.PK) (8%), and Nokia (NOK), LG (LGERF.PK), and Ericsson (ERIC), each with 7%.
QCOM is the largest fabless semiconductor company; number one in wireless.
The nature of these wholesale businesses and the prominence of leading device manufacturers contribute to the concentration of IDCC's and QCOM’s revenues in relatively few clients. Four licensees accounted for over 60% of IDCC’s YTD 9/10 revenues (Samsung, LG, Casio Hitachi Mobile (CSIOY.PK), and Sharp (SHCAY.PK)).
Two QCOM clients accounted for 15% and 10% of total revenues in FYE 9/10. Meanwhile, accounts receivable from three customers comprised 42% of gross accounts receivable.
Comparison of Attributes
Three financial attributes are examined here: Capital efficiency; the ability to create shareholder wealth by generating a return in invested capital (ROIC) that exceeds the cost of capital; and the appropriateness of the firm’s capital structure and financial policies.
Comparative metrics are shown in Tables A, below.
NOPAT = Net Operating Profits after Taxes = EBIT (1 – Tax Rate)
NOWC = Net Operating Working Capital
OLTA = Operating Long Term Assets
Operating Capital = NOWC + OLTA
FCF = Free Cash Flow = NOPAT - Net Investment in Operating Capital (in the period)
ROIC = Return on Invested Capital = NOPAT / Operating Capital
WACC = Weighted Average Cost of Capital
Enterprise Value = Present Value of future FCF discounted at WACC
Equity Value (Fundamental) = Enterprise Value + Surplus Cash – Debt
|InterDigital Table A -- Selected Metrics|
|(Amounts in millions of US$, unless otherwise noted)||FYE 12/08||FYE 12/09||YTD 9/10|
|NOPAT / Revenues||11%||29%||40%|
|NOWC / Revenues||-112%||-158%||-218%|
|Op. Cap. / Revenues||-40%||-88%||-104%|
|Cash & Market.Secs.||138.73||408.75||563.04|
|Cash&Mkt / Total Assets||34%||45%||62%|
|Qualcomm Table A --Selected Metrics|
|(Amounts in millions of US$, unless otherwise noted)||FYE 9/08||FYE 9/09||FYE 9/10|
|NOPAT / Revenues||28%||16%||24%|
|NOWC / Revenues||-9%||-47%||-45%|
|Op. Cap. / Revenues||55%||24%||32%|
|Cash & Market.Secs.||11,269.00||17,742.00||17,316.00|
|Cash&Mkt / Total Assets||46%||65%||57%|
NOWC is a source of significant financing for the two firms. In the case of IDCC, NOWC generates $2.18 for every $1.00 of revenues. For QCOM, NOWC generates 45 cents for every $1.00 of revenues (see Tables A).
The reason for the greater generation in IDCC is that technology licensing, the source of deferred revenues (cash received in anticipation of revenues recognized), is 100% IDCC’s focus. In contrast, technology licensing only represents 33% of revenues for QCOM. The remaining 67% is largely accounted for by the integrated circuits segment.
Information in QCOM’s FYE 9/10 10 k suggests that NOWC for QCOM’s integrated circuits business is a user of funds, instead of a net source of financing -- 28% of the assets allocated to QCOM’s segments were allocated to integrated circuits, while only less than 1% were allocated to technology licensing. (71% were allocated to the Strategic Initiatives segment, which generated minimal revenues and negative $436.0 million EBT contribution.)
By virtue of its 100% focus on technology licensing, IDCC is a more efficient user of capital than QCOM. IDCC’s Operating Capital generates $1.04 for every $1.00 of revenues. In comparison, QCOM’s Operating Capital uses 32 cents of capital per $1.00 of revenues.
Capital efficiency is a defining attribute in two important aspects. First, it leverages stockholders’ investment into robust ROIC; second, it enables rapid growth as efficient users of capital self-finance operationally without the need to use debt or to issue secondary equity. This is particularly important in the face of major opportunities for rapid growth in the wireless mobile communications market.
Return on Invested Capital
Both firms generate attractive ROIC. ROIC in excess of WACC creates shareholder wealth.
Since IDCC’s Operating Capital is financed by operational stakeholders, its ROIC is extremely high. QCOM, in comparison, deploys some Operating Capital of its own. ROIC, nonetheless, is very high; way above the firm’s WACC.
QCOM’s ROIC is significantly influenced by lower EBT margin contribution ($1,693.00 million in EBT, or 25% EBT margin) from integrated circuits business, the largest segment in terms of revenues ($6,695.00 million, or 61% of FYE 9/10 total revenues). Technology licensing, the other principal segment, accounts for $3,659.00 million in revenues, or 33% of total revenues; and $3,020.00 million in EBT, or 83% EBT margin.
In comparison, 100% of IDCC’s revenues derive from high-margin technology licensing.
Substantial ROIC is achieved by both companies even while holding a large percentage of total assets in cash.
Both firms have a capital structure that mitigates operational risk (more on risk later). For all practical purposes neither firm uses debt as a source of financing (on FYE 9/10 QCOM had $17,316 million in cash, net of $1,086.00 million in opportunistic debt financing related to a purchase in India).
Both companies have significant operational liquidity as measured by robust NOPAT margins and relatively modest Operating Capital requirements.
Such capital structure and liquidity provide staying power to weather the cyclicality inherent in chip making, and embedded operating volatility. Beyond buttressing survival, these attributes enable the return of capital to stockholders via equity repurchases and the firms’ dividend programs.
Comparison of Performance
Metrics in the tables B compare the performance of QCOM and IDCC.
|InterDigital Table B--Selected Metrics|
|(Amounts in millions of US$, unless otherwise noted)||FYE 12/06||FYE 12/07||FYE 12/08||FYE 12/09||FYE 12/10 Est.||FYE 12/11 Est.||5-Yr.Avg. FYE06-10|
|Revenue Growth (y-o-y)||194%||-51%||-2%||30%||32%||4%||40%|
|Revenue per Sh. ($/Sh.)||8.61||4.77||4.99||6.75||8.82||9.13||6.79|
|EBIT / Revenues||70%||10%||16%||38%||60%||39%|
|EBIT per Sh.($/Sh.)||6.03||0.47||0.80||2.58||5.33||3.04|
|Cash Flow from Ops.||314.81||152.73||85.81||320.69||203.93|
|CF f/Ops.Growth (y-o-y)||835%||-51%||-44%||274%||-36%||195%|
|CF f/Ops.per Sh.($/Sh.)||5.64||3.11||1.87||7.28||4.59||4.50|
|Free Cash Flow||300.19||130.73||56.96||297.82||183.00||173.8|
|FCF / Revenues||62%||56%||25%||100%||47%||43%||58%|
|FCF Growth (y-o-y)||1250%||-56%||-56%||423%||-39%||-5%||54%|
|FCF per Sh.($/Sh.)||5.38||2.66||1.24||6.76||4.12||3.90||4.03|
|Cash (& Market.Secs.)||262.4||173.75||138.73||408.75||563.04|
|Cash Growth (y-o-y)||150%||-34%||-20%||195%||38%||66%|
|Cash per Sh.($/Sh.)||4.70||3.54||3.03||9.27||12.66||6.64|
|# Shares Growth (y-o-y)||14%||-12%||-7%||-4%||1%||0%||-2%|
|Revenues per Sh./PPS||0.183||0.190|
|EBIT per Sh./PPS||0.111|
|CF f/Ops. per Sh./PPS||0.095|
|Free CF per Sh./PPS||0.085||0.081|
|Cash per Sh./PPS||0.263|
|Qualcomm Table B--Selected Metrics|
|(Amounts in millions of US$, unless otherwise noted)||FYE 9/06||FYE 9/07||FYE 9/08||FYE 9/09||FYE 9/10||FYE9/11 Est.||5-Yr.Avg. FYE06-10|
|Revenue Growth (y-o-y)||33%||18%||26%||-7%||6%||26%||15%|
|Revenue per Sh.($/Sh.)||4.40||5.24||6.71||6.23||6.63||8.38||5.84|
|EBIT / Revenues||36%||32%||33%||21%||30%||31%|
|EBIT per Sh.($/Sh.)||1.57||1.70||2.25||1.33||1.98||1.77|
|Cash Flow from Ops.||3,253.00||3,811.00||3,558.00||7,172.00||4,076.00|
|CF f/Ops. Growth (y-o-y)||21%||17%||-7%||102%||-43%||18%|
|CF f/Ops per Sh.($/Sh.)||1.90||2.25||2.14||4.29||2.46||2.61|
|Free Cash Flow||2,981.00||3,428.00||3,102.00||6,537.00||3,410.00||5,284.00|
|FCF / Revenues||40%||39%||28%||63%||31%||38%||40%|
|FCF Growth (y-o-y)||21%||15%||-10%||111%||-48%||55%||18%|
|FCF per Sh.($/Sh.)||1.74||2.02||1.87||3.91||2.06||3.19||2.32|
|Cash (and Market.Secs.)||9,949.00||11,815.00||11,269.00||17,742.00||17,316.00|
|Cash Growth (y-o-y)||15%||19%||-5%||57%||-2%||17%|
|Cash per Sh.($/Sh.)||5.81||6.98||6.79||10.60||10.44||8.13|
|# Shares Growth (y-oy)||1%||-1%||-2%||1%||-1%||0%||0%|
|Revenues per Sh./PPS||0.122||0.155|
|EBIT per Sh./PPS||0.037|
|CF f/Ops.per Sh./PPS||0.045|
|Free CF per Sh./PPS||0.038||0.059|
|Cash per Sh./PPS||0.193|
The 5-year average column shows that Revenues, Cash Flow from Operations, FCF, and Cash (net of debt) grow faster in IDCC than for QCOM. Likewise, EBIT margins for IDCC are higher than those for QCOM.
The lower section in each table B shows various performance metrics per $1.00 of stock price.
Each dollar of IDCC’s stock price buys 18.3 cents of revenues, 11.1 cents EBIT, 9.5 cents cash flow from operations, 8.5 cents FCF, and 26.3 cents of cash.
Each dollar of QCOM’s stock price buys 12.2 cents of revenues, 3.7 cents EBIT, 4.5 cents cash flow from operations, 3.8 cents FCF, and 19.3 cents of cash.
Notice that each dollar of stock price buys 8.5 cents of IDCC FCF, and only 3.8 cents of QCOM FCF. Conversely, the price per dollar of IDCC FCF is $11.76 (1/0.085 = 11.63) vs. $25.00 (1/0.038 = 26.32) per Dollar of QCOM FCF.
Thus, the price of a unit of QCOM FCF is 2.26 times the price of a unit of IDCC FCF.
If we apply the richer price investors pay for QCOM’s FCF to IDCC’s FCF, the price of IDCC’s stock would be over $100.00/share ($48.15 x 2.26 = $108.82), instead of $48.15/share.
The comparison of activities, attributes, and performance, between the two firms, do not explain the large discrepancy in the prices investors pay for FCF. In fact, the comparisons tilt in favor of IDCC, suggesting that, other things being equal, IDCC’s FCF should at least be priced equally than QCOM's, instead of lower.
Business risk is the combination of operational risk (inherent in business operations; NOWC and OLTA investment activities) and financial risk (related to capital structure).
Operational risk, as measured (post facto) by medium term volatility of FCF, is high particularly for IDCC. The range of variation in annual FCF growth is much greater for IDCC (from +1,250% in 2006 to -56% in 2008) than QCOM (from+111% in FYE 9/2009 to -48% in FYE 9/10). Expanded volatility implies reduced certainty in prospective FCF. Uncertainty negatively impacts fundamental value.
Elevated volatility in IDCC’s FCF explains to some extent the higher price that investors are willing to pay for QCOM’s FCF, implicit in the price of the stock, relative to IDCC FCF (see Comparison of Performance).
Financial risk, figuratively additive to operational risk, is to some extent elective in business. For both firms, financial risk is negligible; there is no debt, and surplus cash is abundant.
Thus, the relatively high risk inherent in technology development and in integrated circuits is mitigated by appropriately conservative, minimal risk, financial policies. These provide the means of support in dealing with unfavorable market conditions or operating shortcomings, and in buttressing for survival. However, conservative financial policy does not guaranty operational performance, or preclude unfavorable stock price action in financial markets.
The nature of wholesale mobile wireless is such that specific transactions (read: large licensees, large retroactive past-sales settlements, and large legal settlements) can have major positive or negative impact on earnings and FCF in any one accounting period.
Such impact can be particularly outsized on IDCC’s revenues and FCF because of its relative small size. As a corollary, only a small number of major, new contract wins can quickly translate in major shareholder benefit, well above those implicit in the fundamental value estimate.
All in all, high operational risk in both firms is mitigated by appropriately conservative financial policies. Such policies translate into very stable and solid balance sheets that virtually ensure survival (in finance no bankruptcy is possible without debt). They, however, do not prevent volatile FCF performance.
QCOM’s FYE 9/10 10K reports indicates that according to Wireless Intelligence estimates as of 11/1/10, the number of worldwide mobile connections is expected to grow from 5.3 billion by the end of 2010 to almost 7.0 billion in 2014.
Growth in wireless communications is rapidly evolving from making voice calls in a mobile environment to the need to also access data services. This is evidenced by the continued transition from 2G to 3G services. According to Wireless Intelligence, in 3/10, a significant milestone was reached in the industry by surpassing one billion 3G connections, on its way 2.8 billion by 2014.
Among the drivers for 3G growth are consumer demand for smart-phone devices and for emerging new data services, mature 3G networks with high data rates, and growth in emerging regions. Applications such as email, access to the mobile Internet, downloading of videos and social networking are driving the demand for 3G services and more capable phones.
Approximately 85% of the world’s wireless networks now support 3G, a sign that operators are making network investments and upgrading their networks to address the growing demand for wireless data. With support for higher data rates and increased capacity, networks will keep up with the growing demand for wireless data.
Cisco (CSCO) anticipates that mobile data demand will outpace current network capacity by up to twenty times in 2014. Such an impending bandwith crunch caused by the expansion of smart phones and such emerging devices is forcing carriers globally to invest into LTE/4G networks.
As of 12/09, IDCC had entered into patent license agreements covering over one-half of all 3G mobile devices sold worldwide.
Worldwide shipments of 3G-enabled phones, which amounted to 450 million units in 2010 (or 35% of the market in 2010), are predicted to increase to 900 million in 2013 (or 60% of the market). Meanwhile, 4G-enabled shipments are expected near 100 million units in 2013.
From a different company perspective, if we add up the addressable markets, not only in handsets ($180 billion in 2010) but also including infrastructure, data services, and wireless consumer electronics, the magnitude of the addressable market expands to $1,336 billion in 2014, potentially seven times the current addressable handset market.
QCOM sees the growth drivers as a combination of 2G to 3G migration, emerging regions, smart phones, new device categories, and advanced technology.
3G subscriptions are expected to grow from 1.15 billion in 2010 to 2.8 billion in 2014.
2.5 billion smart phones are forecast to be shipped in 2011 to 2014, with the percentage of smart phone shipments to total handsets growing from less than 15% in 2009 to more than 45% in 2014.
Growth of non-handset mobile device shipments, including e-readers, tablets, and other data devices, is expected to grow at 25-40% CAGR from 2009 to 2014.
It is widely accepted that market opportunity is broad, sizeable, rapidly growing, and secular in nature. Mutually supportive are the continuing desire for greater mobility, increased data usage, and richer multimedia experience, on one hand; and inventions driving new devices, efficient networks, and expanding data services, on the other hand.
QCOM’s two principal businesses (QCT and QTL segments) address such large market opportunity by integrating all the pieces required for communication business systems; leveraging invention and design into development, and delivery. Breadth and depth; encompassing platforms covering a range of segments and device categories, a wide range of relationships (device manufacturers, network equipment companies, carriers, data providers), throughout the world.
IDCC‘s only segment, technology licensing, focuses on invention and technology development, the enabler of mobile wireless communications.
While both QCOM and IDCC are significant industry players in their particular segment of interest, no one holds a dominant position that guarantees future performance. Nonetheless, their competence, experience, resources, and financial stability, provide a strong base to support expansion given the magnitude of market opportunity.
The present value of FCF discounted at the firm’s cost of capital (WACC) is the estimated enterprise value of IDCC.
Enterprise Value (EV) = Present Value of future FCF discounted at WACC
Free Cash Flow (FCF) = NOPAT – Net Investment in Operating Capital (in the period)
WACC = Weighted Average Cost of Capital
Equity Value (Fundamental) = Enterprise Value + Surplus Cash – Debt
Fundamental Value / Share = Equity Value / # Shares Outstanding.
The estimated fundamental value of the stocks is shown below, along with assumptions.
Fundamental Value = $81.15/share, say $81.00/share.
Base FCF = $183.35 million/yr. (annualized $146.68 million, FCF YTD 9/10; in concert with 5 yr. average)
FCF Growth Rate = 5%/yr.
WACC = 11% p.a.
Current Stock Price: $48.15/sh,
Price / Value Discount = 68% [($81.00 - 48.15) / $48.15)]
Fundamental Value = $63.94/share, say $64.00/share.
Base FCF = $5,284.00 million/yr. FCF (FYE 9/11 guided-derived figure; in concert with 5 yr. average)
FCF Growth Rate = 5%/yr.
WACC = 11% p.a.
Current Stock Price = $54.13/sh.
Price / Value Discount = 18% [($64.00 - $54.13) / $54.13]
The estimated fundamental values are conservative; the base growth rates take into account recent information and available guidance.
Base FCFs are also in harmony with historical norm (5-yr. average FCF / Revenue). Further, the assumed (low) growth rates and (high) WACC weight on both fundamental value estimates.
There would be no arguing against applying higher growth rates, given market opportunities; or lower WACC, given the liquidity on the balance sheets and the risk mitigation features discussed earlier.
Consistent with the notion that fundamental value refers to a medium/long time horizon, the inputs selected in both companies’ estimates reflect central tendencies rather than anticipated more immediate outcomes of specific, albeit major, transactions. Examples of such major transactions are the following: QCOM’s Atheros (ATHR) acquisition; QCOM’s divestiture, announced on 12/10, regarding the sale of the 700 MHz spectrum for $1.925 billion to AT&T (T); or outcomes regarding specific legal actions or settlements, such as in the IDCC/Nokia case.
A note regarding context; the medium term trend of secular growth in mobile wireless is subject to volatile revenues and FCF between accounting periods. Volatility can be substantial and well beyond the norm implicit in assumptions regarding the estimation of fundamental value.
The development of technology and the development of integrated circuits, create substantial shareholder value concurrent with significant volatility of FCF.
Mobile wireless market opportunity is secular and broad based. Technology and consumer demand mutually reinforce and energize the entire digital wireless chain; consumers, technology developers, integrated circuit manufacturers, infrastructure companies, carriers, data service providers.
QCOM leverages leadership in technology development into the development, construction, and delivery of integrated circuits for wireless communications. These two businesses are mutually supportive; together they provide broad access to synergistic opportunities along the wireless value chain.
IDCC’s concentration in technology development and more limited financial means emphasize the need for focused allocation of resources within the broad scope of wireless global market opportunity to maximize gain.
Capital efficiency is a defining and rather permanent attribute in both firms. Efficient use of capital is consistent with robust ROIC. It also enables self-financing in support of rapid growth, a particularly important attribute in view of the growing market opportunities.
Capital efficiency is the foundation of conservative capital structure in both firms; no debt (except opportunistic debt in the case of QCOM), and abundant cash. It also supports the firms’ financial policies regarding the return of capital to investors via stock repurchases and dividends.
Operational risk and NOPAT volatility embedded in technology development and in integrated circuits is on the high side. Financial policy in both firms is conservative and appropriately mitigates operational risk.
Both fundamental valuations promise attractive investor gains; 68% for IDCC and 18% for QCOM. The difference in potential gains is consistent with the apparent premium, implicit in the share price, paid by investors for QCOM FCF relative to IDCC FCF.
The inevitability of short term fluctuations within the medium term horizon implicit in fundamental valuation is part and parcel of investment risk. Providing a steadfast foothold in an uncertain world are strong secular mobile wireless trends and related opportunities, enduring technical competence, long-lasting capital efficiency, and safeguarding liquidity. InterDigital and Qualcomm garner such attributes and industry leadership to boot.
Both are worthwhile investment opportunities. You’ll be the judge.