Qualcomm Seems Frustratingly Reactive

| About: Qualcomm Inc. (QCOM)

Summary

Qualcomm has worked to shore up its licensing businesses, but iffy volume growth and ASP erosion remain real concerns.

On the chip side, MediaTek continues to gain share in the mid-market and in-sourcing by customers remains a risk, not to mention a deeper relationship between Intel and Apple.

M&A looks increasingly necessary as a means of improving the growth and margin prospects, but the long-rumored deal for NXP may still not materialize.

Qualcomm could still be almost 20% undervalued, but management's unwillingness to be bold is a real concern given the changing realities of the handset landscape.

A little over a year ago, I thought Qualcomm's (NASDAQ:QCOM) valuation was potentially interesting, but I couldn't really recommend the shares due to margin erosion and what I saw as a lack of management initiative to make meaningful changes to grow the business. The shares are basically flat since then, due in part to ongoing worries about market share, pricing, and volume in handsets, as well as a lack of movement on the M&A front.

Really very little has changed regarding my outlook and feelings about Qualcomm. I think management's targets and goals for growth outside of handsets are exceedingly ambitious, and I think the royalty issues could linger on as a perpetual concern. I do find the prospect of major M&A to be interesting (most likely NXP (NASDAQ:NXPI)), though I stand by my comment last year that Nvidia (NASDAQ:NVDA) would have been a better long-term idea. While there is some value here, quite a bit of skepticism, and opportunities to do better, Broadcom (NASDAQ:AVGO) offers similar value and what I believe is a higher-quality business and management team.

Tying Up The Loose Ends On Licensing… For Now

Back during the February Analyst Day, management talked about the success of its efforts to shore up its licensing business as it pertained to Chinese handset OEMs. Through new licensing agreements, management believed that it had reduced the instances of under-reporting to around 25% or so of volume. Since then, the company added licensing agreements with Lenovo (OTCPK:LNVGY) and Oppo and launched legal actions in China against Meizu (presently the largest Chinese OEM not signed up under terms related to the NDRC).

Qualcomm management deserves praise for what they've done to improve this business. Still, there are reasons for concern. Handset volume growth has been wobbly and volatile (down 13% yoy in the March quarter, up 11% in the June quarter) while ASP and royalty rate trajectories continue to point in a negative direction. What's more, the patent estate underpinning these royalties is getting older, with meaningful expirations over the next 10 to 15 years. I think it's a little early to worry about that as a clear-and-present danger, as I believe Qualcomm will continue to translate R&D into patents, but it is worth following.

I also can't help but notice and wonder about the recently completed deal between SoftBank (OTCPK:SFTBY) and ARM Holdings (NASDAQ:ARMH). Qualcomm elected not to split its chip and licensing businesses (I expected that they would not), but I can still speculate on what it would have looked like if the company had split and the QTL business had turned around and bought ARM Holdings, while the QCT business targeted other chipmakers.

The Chip Business Is Still Getting Squeezed

Even though it was a controversial point of debate for the last year or so, there's no longer any debate about Intel (NASDAQ:INTC) winning baseband business from Apple (NASDAQ:AAPL) - they did, and it is money out of Qualcomm's pocket. This underlines what has been a significant risk for Qualcomm for some time now - that the company's share in baseband and application processors has/had peaked and only had one direction to go as MediaTek grabbed more share in the mid-range market and OEMs like Samsung (OTC:SSNLF) looked to take more business in-house.

Qualcomm has indeed lost more share in baseband, with MediaTek climbing to around 20%, Intel winning slots in the new iPhone 7, and companies like Samsung and Huawei going internal. App processors too have come under pressure, though Samsung's internalization efforts seem more focused on the mid-range, as the real opportunity in handsets and tablets last year were well short of management's projections back in 2010.

And it could still get worse from here. I think most of Qualcomm's existing AP customers will have a hard time switching to other vendors (or in-sourcing) for their high-end phones, but most of the future handset unit growth is likely to skew down-range. Moreover, I think there's at least a theoretical risk that the relationship between Apple and Intel could get stronger and lead to an integrated baseband/app processor effort at 7nm given Intel's strength in manufacturing.

I'm also not sold on Qualcomm's ability to diversify away these issues. The company has formed a JV with TDK to improve its positioning in RF front-end modules, but I don't think Broadcom or Qorvo (NASDAQ:QRVO) have much to fear given Qualcomm's position with GaAs. Opportunities like Internet of Things, auto, networking, and data center could prove significant down the line, but I don't think Qualcomm has distinguished itself here to a point where I'd say it's likely (as opposed to "possible").

M&A To Save The Day?

Analysts and commentators like me have been trying to spend Qualcomm's money on M&A for quite a while, and not much has actually happened. Unlike Broadcom, Qualcomm has been a relatively reluctant participant in M&A and has favored smaller tuck-in deals for the most part.

As I wrote over a year ago, I thought Nvidia, Cavium (NASDAQ:CAVM), and Qorvo were the best targets. With Nvidia shares up about 200% since then, that opportunity has gone away and I don't think Qorvo is an opportunity now given the TDK joint venture. I still think Cavium would be an intriguing opportunity (and a way to really play in networking/data center), but management doesn't seem to be leaning in that direction.

For whatever rumors are worth, it looks like Qualcomm has set its sights on NXP, with many reports of negotiations around the end of September. Such a deal would cost more than $30 billion and would represent some real integration risk given that NXP's business is quite a bit different than Qualcomm's. On the other hand, "quite a bit different" is what Qualcomm arguably needs, and I think NXP's leverage to the auto market, NFC chips, and IoT would be long-term assets to Qualcomm. It also would be a very good way to utilize Qualcomm's large hoard of overseas cash in a more tax-efficient manner.

Will the deal happen? I don't know. A company like Texas Instruments (NYSE:TXN) would seem like a more natural fit for NXP, and you could likewise argue that targets like Xilinx (NASDAQ:XLNX), Cavium, and/or Mellanox (NASDAQ:MLNX) would be better fits for Qualcomm. I don't hate the prospect of a Qualcomm-NXP tie-up, but it would carry above-average integration risk and a high price tag, whereas I think Cavium (or Mellanox) would be lower-risk opportunities.

The Opportunity

I've gone on record before as saying that I don't think IoT is going to become what its most ardent supporters expect it to be - I think there's potential (smart metering, industrial communication, etc.), but there are going to be a large number of players and I believe the ASPs and margins are going to be lower than many expect (which is why I think Broadcom was willing to punt its IoT connectivity assets). Likewise, I think it's premature to assume that Qualcomm will make the sort of splash in autos, networking, data centers, and so on that management has outlined as part of its $100 million target market in 2020.

While I do believe that Qualcomm can and will see volume growth, ASP pressure is going to be a significant ongoing issue. Likewise, I think management has a delicate balance to strike between spending enough to maintain technology leadership without ruining the margin rewards for that leadership.

I'm still looking for mediocre low-to-mid single-digit long-term revenue growth, but I do think FCF growth can still come in at the high-single digits due to more restrained spending (as it becomes more apparent that high levels of R&D reinvestment won't be rewarded by market share/margin leverage). These assumptions still support a fair value range from the mid-$60s (DCF) to the mid/high-$70s (EV/revenue, via operating margins).

The Bottom Line

Broadcom and Qualcomm seem similarly priced relative to my estimates of fair value and I think Broadcom is the better-run company (and with a better, more diverse base of business). On the other hand, my underlying assumptions for Qualcomm are more pessimistic, so outperformance would offer more upside in a bull case scenario. Likewise, while I don't think Broadcom is done doing deals, Qualcomm has the current capacity to do bigger deals and I think "something" is likely (if not NXP, then maybe another target).

I think pressure continues to build on Qualcomm management to respond to the changing (for the worse) long-term outlook for this handset-focused business. That the company hasn't been more dynamic is still a mark against it in my book. While I do think the potential is here for much better results and returns, my confidence in management is such that I'm not ready to make a big bet on it with my own money.

Disclosure: I am/we are long AVGO, LNVGY.

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.