Qualcomm: Large R&D Cuts Could Be Disastrous

Summary

• Qualcomm has spent about $37.9 billion on research and development over the past 10 years.
• Significantly slashing its R&D spending may boost its profitability over the short-term period, but it could hamper its sales growth over the longer run.
• I believe that significant R&D cuts aren't in the best interest of Qualcomm's shareholders.

Shares of Qualcomm (NASDAQ: QCOM) have stayed distressed over the past few months. The chipmaker has been mired in legal controversies of late and the absence of any new products that would make up for its ongoing revenue slump has created an overhang on its shares. Fellow contributor Bram de Haas hypothesized in his recent article that Qualcomm could make up for its shrinking profits by slashing its R&D budget. While I appreciate Mr. Bram’s work, I disagree with his conclusion. I strongly believe that drastic cuts in R&D spend could potentially do more harm than good, for both Qualcomm and its shareholders.

Maintaining Lead

Let me start by saying that Qualcomm holds more than 26,600 patents as of now and owns a lot of mission-critical wireless IP that hundreds of OEMs have grown to use. The majority of its vast patent portfolio wasn’t built over a period of one or two years but rather over the past decade. In addition to having a top-notch management and a quality think tank, it’s Qualcomm’s audacious R&D investments of $37.9 billion, spent over the past ten years, that have made the chipmaker an indispensable name in the wireless networking field.

(Source: Company Filings, Compiled by Author)

If we took away a major chunk of its R&D spend that happened over the past few years, Qualcomm probably wouldn’t have been in the leading position (such as baseband and mobile application processor segments) that it currently enjoys. For starters, it wouldn’t have amassed its vast patent portfolio. Just to have a better understanding of its prowess in the field, Qualcomm commanded 50% of the mobile baseband market last year while its closest competitor, MediaTek, didn’t even have half of that. Slowing down on R&D spending would simply allow its rivals to close in on Qualcomm’s technological lead.

Besides that, Qualcomm is pursuing ventures in key growth areas such as ARM-based servers, 5G wireless standards and deep learning amongst other disruptive fields. Amongst them, 5G is singlehandedly projected to represent a business opportunity of $582 billion by 2026 and $3.5 trillion by 2035. Of course, these numbers are just estimates and actual figures could vary by a significant margin, but the point that I’m making here is that key investments in 5G alone could easily drive Qualcomm’s growth for the next decade.

Speaking of 5G, there are several large companies that are pouring billions to capture a piece of this lucrative market as well. If Qualcomm slashes its R&D budget at this point in time, to boost its short-term profitability, it could potentially lose its leadership in the wireless mobility segment. Loss of leadership would eventually result in the loss of pricing power. You cannot hope to lead a market estimated to be worth trillions, and potentially outclass competition, by cutting down on your investments. It’s a very bad idea.

More to the point, we could see some large-scale mergers or acquisitions in the wireless networking domain (Nokia and MediaTek?) to counter Qualcomm’s proven expertise in the field, should the latter become complacent with its research work and IP accumulation. Similarly, shrinking its ARM-based server related investments would simply mean handing out this potential market to Cavium, AMD and AppliedMicro. The point that I’m trying to make is that the chipmaker stands to lose a significant chunk of business and business opportunities if it reduced its R&D spend by 30-40%-plus just to improve its short-term profitability.

Some Empirical Evidence

It’s understandable if you’re still not convinced with the thesis. After all, we just discussed only Qualcomm’s case so far. Hence, in order to widen our scope of understanding, let’s take a look at the chart below.

(Source: Business Insider)

Goldman Sachs conducted a research some time ago, basically to determine the correlation between R&D spending and sales growth – the results were rather interesting. The chart attached above illustrates how companies that increased their R&D spend between 2004 and 2012 tended to grow faster than others. The saying, “It takes money to make money” perfectly applies here.

Let’s build a bit more on this study with some more data points. Another study – chart attached below – highlights the correlation between valuation multiples and growth rates. If Qualcomm’s forward growth rates deteriorate two or three years down the line, perhaps as a result of sharp R&D spending cuts, then analysts and market participants would tend to rerate the chipmaker with lower valuation multiples. This would be another negative for Qualcomm and its shareholders.

(Source: Intercom)

With that said, we must remember that Qualcomm’s management isn’t here to make a quick buck over the next two years, but rather has a long-term vision for the company that spans well beyond the next 10 years. Until the chipmaker is financially constrained to fund its research spend, it doesn’t make much sense for it to significantly slash its R&D budget. After all, research spending and sales growth tend to be correlated.

Investors takeaway

Granted that all R&D spend is not money well spent, but you can’t go easy in the cutthroat semiconductor and wireless networking industries and expect to retain your market share over the years to come. Drastically reduced R&D spend might boost Qualcomm’s profitability over a period of two or three years, perhaps without showing any sort of effect on its licensing royalties over the period, but lower R&D could also result in weak product pipelines that might not be the best revenue generators. Therefore, I’m of the opinion that significant R&D cuts wouldn’t be in the best interest for long-term Qualcomm shareholders.

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Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.