Qualcomm Disappoints But Remains Attractive

| About: Qualcomm Inc. (QCOM)
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Qualcomm reported mixed results with solid earnings but disappointing revenue and shipments.

Third quarter guidance was below consensus, and Qualcomm will need strong fourth quarter results in China to meet its forecast.

The company also received a wells notice from the SEC over bribery charges in China, which could prove problematic.

With $19 in cash per share and strong cash flow, shares are an attractive value despite headwinds.

Qualcomm (NASDAQ:QCOM) was one of many tech companies to report earnings after the bell on Wednesday. Unlike Apple (NASDAQ:AAPL), its earnings failed to impress Wall Street. While the company continues to be strongly profitable, revenue and guidance was unimpressive. Moreover, Qualcomm is now one of many companies currently facing US legal scrutiny over its Chinese business practices, and it faces potential action from the SEC over the Foreign Corrupt Practices Act ("FCPA"). Between disappointing results and headaches over the FCPA, it is unsurprising that Qualcomm shares were down around 4-4.5% in the after-hours session. However, this quarter does not undermine the bull thesis, and the best trade is to be long, not short, QCOM.

In the quarter, Qualcomm earned $1.31 versus estimates of $1.22 (financial and operating details available here). The EPS beat was the good news; unfortunately, other metrics were weaker. Qualcomm grew sales by 4% year over year to $6.37 billion, but analysts were looking for $6.48 billion. Qualcomm's business generates a lot of cash, and operating cash flow totaled $1.81 billion or 28% of sales. Thanks to strong cash flow, the company returned $1.59 billion to shareholders, including the repurchase of 13.4 million shares at a cost of $1 billion. In the coming two quarters, I expect Qualcomm to maintain the pace of repurchases of about $1 billion as it strives to return 75% of free cash flow to investors. In fiscal 2015, we may see an acceleration in the pace of the buyback.

During the quarter, Qualcomm shipped 188 million chips, which was at the midpoint of its guidance, though most were hoping for a figure above 190 million. This number was up a solid but not fantastic 9% year over year. In the mobile chip business, it is absolutely critical to spend aggressively on research and development to avoid the risk of being out-innovated by competitors. Importantly, QCOM continues to invest heavily in R&D. This spending is critical for Qualcomm's long-term growth prospects. In the quarter, Qualcomm spent $1.17 billion on R&D, which was up 11% year over year. R&D accounted for 18% of revenue compared to 17% last year. To increase shareholder value, Qualcomm has continued to streamline other operating expenses with SG&A dropping 19%, though one-time issues somewhat inflated last year's figure.

In the quarter, Qualcomm generated record non-GAAP EPS on solid chip shipments. However, guidance left some investors underwhelmed. Qualcomm's results tend to be second-half focused. This year, Qualcomm expects results to be even more second-half focused than normal because of China's LTE launch. The upgrading of China's network should provide Qualcomm significant growth opportunity, though some analysts fear that Qualcomm is setting the bar too high. This concern gained some credence with pretty mediocre guidance for the third fiscal quarter.

Qualcomm expects to generate $6.2-$6.8 billion in revenue. The midpoint of guidance is below the analyst consensus of $6.6 billion and would represent 4% growth. Qualcomm is also looking for non-GAAP EPS of $1.15-$1.25 compared to expectations of $1.25. The company expects to ship 198-213 million chips. These numbers are simply unspectacular, and suggest a quarter that will be weaker than Wall Street is anticipating. For the full year, Qualcomm maintained its revenue guidance of $26-$27.5 billion, but increased its EPS guidance by a nickel to $5.05-$5.25. To meet these numbers, Qualcomm will need a very strong fourth quarter, particularly in China. After the weak third quarter guidance, there may be some skepticism as to whether Qualcomm will have that strong of a fourth quarter.

At the same time, Qualcomm disclosed that it received a wells notice from the SEC (details here). Essentially, the SEC's regional office has made a preliminary determination that it will recommend the SEC file an enforcement action against the company. It alleges that Qualcomm bribed or attempted to bribe individuals associated with Chinese state-owned companies. Qualcomm would not be the first company accused of this over the past few years. Qualcomm has denied any wrongdoing, but this wells notice and potential action is an unneeded distraction for management and could result in a sizable fine down the road. Investors will need to follow any developments closely.

Finally, it is important to recognize that Qualcomm is one of many tech companies that is flush with cash. Qualcomm is working to return cash to shareholders, but its cash hoard is excessive. Cash on the balance sheet stands at $32.1 billion. Much of this cash is trapped overseas, which is why Qualcomm has only pledged to return 75% of free cash flow to investors. At some point, the company should consider tapping U.S. debt markets while rates remain low to buy back a more substantial amount of stock. Still, its buyback is working to reduce the shares outstanding with an average diluted count of 1.719 billion in the quarter compared to 1.763 billion last year. Qualcomm has about $18.67 in cash per share.

With its unparalleled patent portfolio and technical prowess, Qualcomm remains the mobile chip leader. The smartphone market has significant growth ahead, particularly in China and emerging markets. New mobile technologies like smart watches also could provide substantial growth for Qualcomm. Still, this quarter was disappointing as shipments were not as high as I would like. After a solid rally over the past few weeks, a bit of profit taking is understandable. Given the strength of the smartphone market and Qualcomm's leading position, I believe it should trade 15x earnings or $75-$78 based on my expectations for $5.10-$5.20 in fiscal 2014 earnings. If we add back Qualcomm's cash position, shares are worth $93-$97. Under $80, Qualcomm has 20% upside. This quarter was disappointing, but shares are attractively valued at current levels.

Disclosure: I am long QCOM. 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.