Not So Fast Qualcomm Bulls, Spreadtrum Is The Value Play

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With a strong third quarter showing, Qualcomm (NASDAQ:QCOM) appears to be in a solid position to benefit from record adds in the emerging markets. Only around a tenth of China is part of 3G and penetration is proceeding strongly with support from the government. Asian OEMs are gaining ground and the S4-series chipsets now have many more accessible markets than just a short time ago. Add strong royalty rates to the mix and you have a company that will likely perform operationally well, at least in the near future.

At the third-quarter earnings call, CEO Dr. Paul Jacobs noted the stellar performance:

Our revenues grew to a record $15 billion in fiscal 2011, and we delivered record earnings and MSM chipset volumes. Looking forward, we expect strong revenue and earnings growth again in fiscal 2012. In the coming year, we expect continued healthy growth in CDMA-based device shipments despite the macroeconomic slowdown. Smartphones will lead the way, along with the continued global adoption of 3G and accelerating consumer demand for wireless data.

We had a number highlights this year. We had strong growth in our Licensing business, delivering both record revenues and earnings. We successfully resolved 2 licensee disputes and completed the last of the WCDMA subscriber unit renewals we highlighted some years ago. We now have over 200 royalty-bearing 3G licenses and 13 single-mode OFDM licensees around the world.

During fiscal 2011, we also continued to expand our licensee base in China, adding more than 20 new Chinese licensees. Through our licensing program, we continue to foster innovation and support the ecosystem that benefits wireless consumers worldwide.

I previously argued that the company was a "strong buy" given the significant Chinese demand and fundamentals. This was - and still is - a sentiment shared by the Street. In being more critical, however, I want to raise the point that more attractive tech companies are available from a risk/reward perspective. The communications company may have good exposure to emerging markets, but how does this compare with a peer?

From a multiples perspective, the company is the second most expensive compared with its competition. It trades at a respective 19.1x and 13x past and forward earnings while offering a dividend yield of 1.66%. Spreadtrum Communications (NASDAQ:SPRD), a fabless semiconductor company, trades at only a respective 10.3x and 9.2x past and forward earnings (although the dividend yield is 85 basis points less than Qualcomm). The company produces solutions for mobile and wireless communications with a specialization in Asia. It has a higher beta than Qualcomm and thus, in my view, is likely to generate higher risk-adjusted returns since there is significant market optimism in emerging markets communications.

Spreadtrum is performing spectacularly well in handsets, while quickly locking out the market. Initiations with EDGE, WCDMA, and TD-SCDMA all look very favorable - the last of which, Spreadtrum now has a majority of the market and rising. TD-S may be less mature than WCDMA, but I view this more as a catalyst than anything else since a much greater rise in demand is likely than the opposite case. This is so, largely because there is strong support from the Chinese government and competition does not appear too challenging. More generally, the company has solutions that are applicable in an LTE future.

Assuming a multiple of 13x and a conservative 2012 EPS of $2.80, the rough intrinsic value of SPRD is $36.40. This implies a greater than 50% margin of safety, 8.6x future 2012 earnings, and more than justifies calling the stock a "value play."

The same cannot be said for Qualcomm. Consensus estimates for Qualcomm's EPS are that it will increase by 12.2% to $3.59 in 2012, and then by 10.9% and 13.6% more in the following years. Of the 37 revisions to EPS, the vast majority, 33, have gone up for a net change of 2.9%. Even still, assuming a multiple of 16x - lower than the current one, but still at a premium to peers - and a conservative 2012 EPS estimate of $3.84, the rough intrinsic value of QCOM is $61.44. This implies only a 13.9% margin of safety. Thus, in conclusion, while I believe that Qualcomm's fundamentals are strong, I am not anticipating greater returns to shareholder value than for Spreadtrum, which has a higher beta and a greater niche grasp on China.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in SPRD over the next 72 hours.