Qualcomm (QCOM) is a provider of digital telecommunications products, including wireless chipsets for smartphones and the Snapdragon line of mobile processors. Qualcomm currently commands a 65% share of the wireless chipset market, and collects royalties on every device that utilizes its wireless technology, such as CDMA.
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Qualcomm stock has risen significantly since the end of 2011, reaching a 52-week high of $68.87 recently. After issuing weak guidance for the rest of the year, the stock fell to the current price of $62.25.
This drop in price may represent an opportunity to buy shares of Qualcomm at a discount. Let's take a look at the recent financial results.
| (In Million $) | 2007 | 2008 | 2009 | 2010 | 2011 |
|---|---|---|---|---|---|
| Revenue | $8,871 | $11,142 | $10,416 | $10,982 | $14,957 |
| Operating Cash Flow | $3,811 | $3,558 | $7,172 | $4,076 | $4,900 |
| Capital Expenditure | $-818 | $-1,397 | $-761 | $-426 | $-593 |
| Free Cash Flow | $2,993 | $2,161 | $6,411 | $3,650 | $4,307 |
Revenue in 2011 jumped by 36% while free cash flow increased by 18%.
Owner Earnings
Owner earnings is a better measure for valuation purposes than free cash flow. Warren Buffett defines Owner earnings as follows:
These represent (1) reported earnings plus (2) depreciation, depletion, amortization, and certain other non-cash charges ... less (3) the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume ... Our owner-earnings equation does not yield the deceptively precise figures provided by GAAP, since (3) must be a guess -- and one sometimes very difficult to make. Despite this problem, we consider the owner earnings figure, not the GAAP figure, to be the relevant item for valuation purposes.
I'll calculate owner earnings by taking the net income and adding back various non-cash items, such as depreciation, and then subtracting the five-year average capital expenditures. I'll also add interest payments adjusted for taxes, since interest is tax deductible.
| (In Million $) | 2007 | 2008 | 2009 | 2010 | 2011 |
|---|---|---|---|---|---|
| Net income | $3,303 | $3,160 | $1,592 | $3,247 | $4,242 |
| Depreciation & amortization | $383 | $456 | $635 | $666 | $1,061 |
| Investment/asset impairment charges | $0 | $0 | $763 | $0 | $114 |
| Stock based compensation | $0 | $0 | $584 | $0 | $0 |
| Other non-cash items | $101 | $650 | $-258 | $373 | $530 |
| Interest Payments | $11 | $22 | $24 | $43 | $114 |
| Avg Capital Expenditure | $-799 | $-799 | $-799 | $-799 | $-799 |
| Owner Earnings | $2,998 | $3,485 | $2,535 | $3,520 | $5,239 |
Owner earnings smooth out capital expenditures and provide a clearer picture of the profitability of the company. Let's use the owner earnings figures to determine Qualcomm's cash return on invested capital, or CROIC. This is the cash return generated by the company on invested capital, and is simply the owner earnings divided by the total invested capital. This is a better measure than ROIC because ROIC relies on earnings, which can be a poor measure of profitability.
| (In Million $) | 2007 | 2008 | 2009 | 2010 | 2011 |
|---|---|---|---|---|---|
| Owner Earnings | $2,998 | $3,485 | $2,535 | $3,520 | $5,239 |
| Invested Capital | $18,495 | $24,563 | $27,445 | $30,572 | $36,422 |
| CROIC | 16.21% | 14.19% | 9.24% | 11.52% | 14.39% |
With the exception of 2009, Qualcomm's CROIC has been fairly consistent, around 14%. This means that given, say, $1 million of invested capital (retained earnings for example) the company will generate $140,000 in cash on that investment. Qualcomm appears to be efficient at generating cash, and owner earnings have grown by more than $2 billion from 2007. Here's the most recent balance sheet.
| Cash and Cash Equivalents | $15,079 |
|---|---|
| Investments | $11,489 |
| Debt | $1,039 |
| Pension Obligations | $0 |
| Minority Interest | $16 |
| Net Cash (Debt) | $25,513 |
| Diluted Float | 1,743 |
| Cash/Share | $14.64 |
Qualcomm has a strong balance sheet, with $14.64 of net cash and investments per share. Interest payments take up an insignificant fraction of the cash flow.
Valuation
I use a discounted cash flow analysis to estimate the fair value of a company. I will use a discount rate of both 12% and 15% and use these values to define a fair value range. You can read about my view on discount rates here. I will set the initial owner earnings growth rate to 13% and allow that rate to decay over 20 years to a perpetual growth rate of 3%, as per the growth table below.
| Year | 1 | 2 | 3 | 4 | 5 | 6 | 7 | 8 | 9 | 10 |
|---|---|---|---|---|---|---|---|---|---|---|
| % | 13% | 12.5% | 12% | 11.5% | 11% | 10.5% | 10% | 9.5% | 9% | 8.5% |
| Year | 11 | 12 | 13 | 14 | 15 | 16 | 17 | 18 | 19 | 20 |
| % | 8% | 7.5% | 7% | 6.5% | 6% | 5.5% | 5% | 4.5% | 4% | 3.5% |
For reference, the average analyst estimate for the five-year earnings growth rate is 15.48%. Using these parameters I arrive at a fair value range of $61.73-$81.93 for a share of Qualcomm.
Conclusion
After the recent decline in market price Qualcomm is currently trading at the lower end of my fair value range. With increased competition from Intel (INTC) in the future, as well as from companies like Nvidia (NVDA) and Texas Instruments (TXN), Qualcomm's status as market leader in the mobile space is by no means a guarantee. But if Qualcomm stock continues to decline due to what is most likely an overreaction, it may become sufficiently undervalued to represent a solid value opportunity.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
