Qualcomm: A Cheap Stock In An Expensive Market

| About: Qualcomm Inc. (QCOM)

Summary

The recent Apple and FTC lawsuit against Qualcomm is more of a negotiating tactic than a threat to Qualcomm's licensing business model.

We feel the most likely outcome in the dispute between Qualcomm and Apple is a reduction in royalty rates (already priced in).

In our discussion with analysts and legal experts, Qualcomm’s licensing business model and potentially a portion of QCT is perceived to be in jeopardy.

Overlooked is the definitive merger agreement between NXP and Qualcomm, which would be immediately accretive and create the third largest chip company in the world - behind only Intel and Samsung.

Qualcomm (NASDAQ:QCOM) is a global leader in the design, manufacturing, and marketing of digital communications products and services. The company operates in three segments: Qualcomm CDMA Technologies (QCT), Qualcomm Technology Licensing (QTL), and Qualcomm Strategic Initiatives (QSI) - only two of which are significant to the business: QCT and QTL.

As of the last full fiscal year, QCT and QTL made up 65% and 33% of revenues, respectively. While QCT receives a lot of discussion and sell-side coverage based on its modems and Snapdragon processors, QTL generates most of the profitability. For example, on a 2016 revenue run-rate of $7.6bn, QTL had EBT margins of 85%, whereas QCT had $15.4bn in sales with only a 12% EBT margin. During the past four years, QTL has represented, on average, 70% of total pretax income, while QCT has represented 29%.

On the chip side of the business, QCT sells modems and application processors (Snapdragon line-up) that are, in some capacity, in virtually every leading Smartphone. QCT competes with Intel (NASDAQ:INTC), MediaTek, Spreadtrum, and Huawei in the baseband modem business. Intel has recently made some inroads with Apple (NASDAQ:AAPL) on its modem chip, taking share from Qualcomm. The QCT business also has some headwinds from less expensive chips from companies such as Mediatek, who are sacrificing margins for market share gains. That being said, QCT remains a market leader with its modems and application processors outperforming the competition on performance in almost every category (reference Snapdragon 835 10nm FinFET architecture & X50 5G Modem).

Qualcomm's licensing business, QTL, has a monopoly-like business model derived from a large portfolio of standard essential patents for 3G and 4G LTE, with the lion's share of royalties coming from legacy 3G technologies. While 4G royalty rates are lower for single mode 4G products, multi-mode 3G & 4G LTE smartphones are backward compatible, so Qualcomm still gets the premium 3G royalty combo on a 4G multi-mode smartphone. There is a long runway for 3G+4G multi-mode phones due to structural reasons within the wireless networks. Roughly 98% of LTE smartphones (capable of operating on at least one 3G tech) are multi-mode, which is expected to last many years into the future. For a network operator to replace a multi-billion dollar 3G network fully with 4G LTE would be a very costly endeavor; thus, a 3G network is sticky even though it is a legacy technology. From the network operator's perspective, the legacy 3G networks still provide additional capacity and coverage for users at little to no incremental costs. The user, in turn, gets a more consistent experience and coverage by seamlessly switching between 3G and 4G LTE. The growth in emerging market smartphones as well as high penetration of multi-mode handsets underpin QTL's long-term royalty stream.

Qualcomm currently has 335 CDMA-based licensees and 220 LTE/OFDMA-based-only licensees not using any CDMA standards - an increase of almost 5% (Q/Q) due to additional Chinese OEMs signed during the quarter. Qualcomm has over 120,000 patents and pending patent applications worldwide. Since 1985, Qualcomm has invested $41bn in cumulative R&D investments with more than $33bn invested just the last decade.

Thesis:

Qualcomm has historically been a high quality, wide moat business that has grown tremendously over the past two decades. The unknowns and confusion that have occurred recently started when Apple and the FTC announced a lawsuit against Qualcomm, claiming the business is monopolistic and unlawful. QCOM lost roughly $20bn in market cap in just a few days after the announcement, implying further future damages and potentially some tie-ups with regards to the acquisition of NXP (NASDAQ:NXPI). In our discussion with analysts and legal experts, Qualcomm's licensing business model and potentially a portion of QCT is perceived to be in jeopardy. While it's clear there will certainly be some headwinds, we believe the downside scenario being priced in much worse than the likely outcome. Prior legal battles set precedence between Qualcomm and Apple that sheds some light into the likely outcome. We believe the dispute with Apple is more of a negotiating tactic rather than an attack on Qualcomm's entire business model. Considering a significant haircut to consensus EPS estimates for fiscal 2017, and the NXP deal not going through, we think there is limited downside ($47.50) from today's levels versus the corresponding upside if some things unfold in Qualcomm's favor.

Licensing Dispute

Qualcomm has a long history of favorably resolving legal battles with OEMs and regulatory agencies. So, we asked ourselves: What is Apple's motivation to pursue this legally now? We think part of the issue Apple sees down the road is potential margin pressure from component costs due to consolidation taking place within the semiconductor industry. We believe that this supplier pricing power will eventually trickle down and affect device manufacturers, transferring some of the margins to chip suppliers.

Looking at Qualcomm's royalty dispute with Apple, we feel the case that closely parallels other patent-licensing disputes that Qualcomm has had with Broadcom (NASDAQ:AVGO), LG (OTC:LGEAF), Nokia (NYSE:NOK), Samsung (OTC:SSNLF) etc. Apple made multiple legal claims against Qualcomm, bringing a suit both in China and the U.S.

Apple statement:

"For many years Qualcomm has unfairly insisted on charging royalties for technologies they have nothing to do with. The more Apple innovates with unique features such as TouchID, advanced displays, and cameras, to name just a few, the more money Qualcomm collects for no reason and the more expensive it becomes for Apple to fund these innovations. Qualcomm built its business on older, legacy, standards but reinforces its dominance through exclusionary tactics and excessive royalties. Despite being just one of over a dozen companies who contributed to basic cellular standards, Qualcomm insists on charging Apple at least five times more in payments than all the other cellular patent licensors we have agreements with combined.

To protect this business scheme Qualcomm has taken increasingly radical steps, most recently withholding nearly $1B in payments from Apple as retaliation for responding truthfully to law enforcement agencies investigating them.

Apple believes deeply in innovation and we have always been willing to pay fair and reasonable rates for patents we use. We are extremely disappointed in the way Qualcomm is conducting its business with us and unfortunately after years of disagreement over what constitutes a fair and reasonable royalty we have no choice left but to turn to the courts."

Qualcomm statement:

"While we are still in the process of reviewing the complaint in detail, it is quite clear that Apple's claims are baseless. Apple has intentionally mischaracterized our agreements and negotiations, as well as the enormity and value of the technology we have invented, contributed and shared with all mobile device makers through our licensing program. Apple has been actively encouraging regulatory attacks on Qualcomm's business in various jurisdictions around the world, as reflected in the recent KFTC decision and FTC complaint, by misrepresenting facts and withholding information. We welcome the opportunity to have these meritless claims heard in court where we will be entitled to full discovery of Apple's practices and a robust examination of the merits."

The last dispute remains with the FTC, which just days before Donald Trump's administration took over, alleged that Qualcomm had a monopoly in key semiconductor devices. Not only was the FTC suit just days before an administration change, it was announced two days before Apple's lawsuit. The timing of these "separate" lawsuits appears as if it was a concerted attack solely influenced by Apple. The odd sequence of these events even attracted a rare dissenting statement from Republican FTC commissioner Maureen K. Ohlhausen.

"My practice is not to write dissenting statements when the Commission, against my vote, authorizes litigation. That policy reflects several principles. It preserves the integrity of the agency's mission, recognizes that reasonable minds can differ, and supports the FTC's staff, who litigate demanding cases for consumers' benefit. On the rare occasion when I do write, it has been to avoid implying that I disagree with the complaint's theory of liability.

I do not depart from that policy lightly. Yet, in the Commission's 2-1 decision to sue Qualcomm, I face an extraordinary situation: an enforcement action based on a flawed legal theory (including a standalone Section 5 count) that lacks economic and evidentiary support, that was brought on the eve of a new presidential administration, and that, by its mere issuance, will undermine U.S. intellectual property rights in Asia and worldwide. These extreme circumstances compel me to voice my objections."

This unusual and strongly worded statement from Ohlhausen, perhaps, creates even more uncertainty after Trump's victory. The timing of the FTC suit coincidently is right before the organization is due for a major overhaul. Two spots on the commission are vacant and a third is due to open when Chairwoman Edith Ramirez steps down in February. Some have speculated that it was DOJ's Renata Hesse's comments that prompted the IEEE to revise its patent policy, thereby hurting IP companies like Qualcomm. The thought process around the new IEEE standards on patent policy was to avert surging litigation slowing technological innovation. These new standards were developed by licensees without input from technology creators. Many significant technology players such as, IBM (NYSE:IBM), GE (NYSE:GE), Ericsson, Siemens (OTCPK:SIEGY), Alcatel-Lucent, Philips (NYSE:PHG), Orange, BlackBerry (NASDAQ:BBRY), Panasonic (OTCPK:PCRFY), and Qualcomm challenged the policies. With Trump in the White House, the FTC will likely have a Republican majority. It appears that incoming Republican commissioners might be more receptive to objections raised by Ohlhausen than her prior Democratic colleagues.

Nokia Lawsuit Parallel

Nokia and Qualcomm ended their legal battle with a 15-year agreement that included Nokia making an upfront payment as well as on-going royalties to Qualcomm. The interesting difference between the Apple lawsuit and the Nokia dispute was that at the time, Nokia had a large portfolio of intellectual property that overlapped Qualcomm's own IP. Upon the resolution of the legal dispute, Nokia received a lower royalty rate, but also had to assign ownership of several of its patents to Qualcomm. While at the time many doubted Qualcomm's abilities to fend off Nokia, the narrative remains essentially the same as the current day case with Apple. Back then, Nokia was the largest handset maker in the world by volume and had significant pricing power and supplier negotiating abilities. Nokia and Qualcomm had a patent-licensing agreement that expired in 2007, and the legal fireworks between Nokia and Qualcomm ignited just before the end of the licensing agreement.

With regards to Apple, the exclusivity agreement with Qualcomm ended in 2016 (year-end) and the subsequent lawsuits both from the FTC and Apple have come just weeks after agreement ended, and days between each other. We feel this is clearly a negotiating tactic and not the beginning of the end for Qualcomm's business model, as some surmise.

Nokia commentary (2007):

"Nokia has said it has paid more than $1 billion to Qualcomm in royalties since the early 1990s. The Finnish company began arguing that the rates it was paying were too high -- particularly since Nokia has acquired many patents of its own that could be used to offset those of Qualcomm. Among other legal tactics, Nokia joined with five other big electronics companies in filing antitrust complaints with regulators in Europe."

Qualcomm and Nokia have been squabbling in court since the 2001 patent-licensing agreement between them expired in April 2007, causing Nokia to stop making royalty payments to Qualcomm." - Don Clark, WSJ

QCOM+NXP Deal

The definitive merger agreement between Qualcomm and NXP would be the largest ever semiconductor deal, and would create the third largest chip company in the world - behind only Intel and Samsung. The combined company would represent a powerful next generation semiconductor company with a dominating position in automotive chips as well as IoT. The tender offer is $110 per share in cash, for an estimated total consideration of $38bn. The transaction is mainly funded by cash held in foreign entities, as well as new debt ($13.6bn committed); QCOM secured financing through a $9.6bn bridge loan and a $4.0bn term loan facility. Qualcomm is targeting $500mn in synergies and total debt to EBITDA of around 2.5x. If NXP cancels the deal, the termination fee is $1.25bn; and if Qualcomm breaks the agreement, there is a $2.0bn fee.

From Qualcomm's perspective, the big bet is for a leading position in the fast-growing automotive semiconductor supplier market. Advanced Driver Assistance Systems (ADAS) components are growing at a 33.8% CAGR through 2021 with a $6.0-8.5bn TAM per Needham research. The largest segments of growth in ADAS systems will be in sensors and processors followed closely by software. Qualcomm's strategy is to accelerate the development of its leading mobile technology into other growth areas such as automotive. Qualcomm had been lagging peers in the automotive semiconductor supplier market for years, and only recently with the acquisition of CSR did Qualcomm move up from number 41 to 20. What's compelling about the combination of QCOM and NXP from a product perspective is that most of the chips are complementary; NXP produces radar and ADAS systems, while QCOM focuses on connectivity solutions and infotainment.

NXP, per Strategy Analytics, is the largest supplier of semiconductor chips to the automotive industry, garnering 14.2% share of a $27.4bn global automotive market. Of the big four ADAS companies, Qualcomm and NXP make up two of the four, with Mobileye (NYSE:MBLY) and Nvidia (NASDAQ:NVDA) rounding out the remaining. Should Qualcomm and NXP combine, it would be the dominant leader in the automotive semiconductor supplier space. Roughly 40% of NXP's sales are from auto, while Qualcomm's Snapdragon 820 Automotive SoC with an integrated LTE modem targets both infotainment and connectivity. Qualcomm is well suited to capture a large portion of the V2X/V2V (vehicle-to-everything/vehicle) market with expertise in mobile (5G) and short range communications (CSR acquisition).

Scenarios

Bull Case ($97.50): Minimal damage from the Apple lawsuit and the NXP acquisition is approved.

  • NXP is EPS accretive by $1.50 in FY2018E. Pro forma EPS of ~$6.50 * 15x = $97.50 target
  • Blended multiple of 15x accounts for analog peers trading ~20x combined with Qualcomm's lower wireless multiple at ~12x.

Base Case ($77): Apple wins lawsuit, but NXP transactions is approved.

  • A $1.00 hit to pro-forma EPS reflecting a substantial loss of the Apple modem business as well as significantly lower royalties. Note: Some sell-side analysts model a total loss of the modem business at Apple and a 15% reduction in royalty revenues as a $0.50-$0.75 EPS hit. Being conservative we used $1.00 as the base case.
  • $6.50 in expected pro-forma EPS less $1.00 haircut, $5.50 * 14x = $77.00
  • Lower multiple reflects uncertainty on the licensing business.

Bear Case ($44): Apple wins lawsuit and NXP transaction does not clear regulatory hurdles.

  • Apple verdict hits Qualcomm standalone EPS by $1.00
  • 2017E EPS $4.65 -$1.00 =$3.65 * 13x (cash adj. 9.73x) = $47.50

Risks:

  • A slowing rate of replacement of smartphones and other devices.
  • A further deceleration in demand for smartphones.
  • A negative Apple verdict sets precedence for a new round of lawsuits.
  • Smartphone ASP's decline.
  • OEMs developing in-house chips.
  • NXP acquisition fails to meet regulatory hurdles.

Disclaimer: This report is intended for informational purposes only and you, the reader, should not make any financial, investment, or trading decisions based upon the author's commentary. Although the information set forth above has been obtained or derived from sources believed to be reliable, the author does not make any representation or warranty, express or implied, as to the information's accuracy or completeness, nor does the author recommend that the above information serve as the basis of any investment decision. Before investing in a security, readers should carefully consider their financial positions and risk tolerances to determine if such a stock selection is appropriate.

At any time, the author of this report may trade in or out of any securities that are mentioned in the report as long or short positions in his own personal portfolio or in client portfolios that he manages without disclosing this information. At the time this report was published, the author had a long position in QCOM either in his personal account or in accounts that he managed for others.

Disclosure: I am/we are 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.

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