Don't Get Fooled By Qualcomm

Summary

• Qualcomm investors had a rough time since last year. The stock has collapsed from a peak of $68 whilst the Semiconductor index (SOX) appreciated over 40%.
• Moreover, Qualcomm investors had to cope with a barrage of worrisome news. A dispute with Apple resulted in a licensee withholding royalty payments until further notice.
• On top of all this, doubts about the shareholder support and regulatory approvals for the NXP takeover become more vocal.
• Meanwhile Apple has its investors wonder how the tensions will impact new product development and future margins on the the back of different ‘more fair’ cost structures.
• What to make of this tense situation? What would the intelligent investor do? Sell and come back when the murky waters are clear again, sit it out and cash on dividends or even buy the dip?

As a Qualcomm (NASDAQ:QCOM) investor myself, I have been struggling to get my head around all big events, new product introductions and the latest earnings report. Has QCOM now become a ‘don’t touch with a ten-foot pole stock’? Big Tech competitors Intel (INTC) and Samsung (OTCPK:SSNLF) joined Apple in its strong-arm play to crack QCOM’s pricing structure of its licensing division (QTL). On top of all this, a licensee stopped paying royalties last quarter, and doubts about the likelihood of the NXP (NASDAQ:NASDAQ:NXPI) takeover became more vocal. What would the intelligent investor do?

Let me be clear, I don’t claim to know how these very complex events will turn out, both timing and outcome are highly uncertain. What I will try to do is to evaluate the facts and impact from a value investor’s perspective, with an investment horizon of 5+ years.

Litigations

For this article I will assume readers already have a certain background on QCOM and the running lawsuits. If not, you can read up on it in my QCOM article written in April here and various articles here on SA about the latest developments. On a very high level, what is happening now is that Apple is making its contract manufacturers withhold payments for QCOM intellectual property (IP). This dispute attracted the attention of other clients and competitors, amongst others Intel and Samsung who seized the momentum to join the fight. Their main claim is that QCOM uses its dominant position in the mobile processor industry to squeeze others out and force customers to accept unfair terms.

Without QCOM IP smartphones would be nowhere near the fast, communicative, and data heavy devices they are nowadays. The QCOM IP is at the core of what makes a smartphone and directly enables Apple to charge high end prices for its iPhones. QCOM significantly contributes to the value of the product sold. QCOM can do without Apple’s business, but Apple cannot do without the iPhone business. Hence, I believe QCOM has a very strong case to be entitled to a percentage of revenue. Not to forget that Apple (or actually its contract manufacturers) and all other clients signed these agreements in the first place. Nothing really changed to that and I would be surprised to see courts rule against the innovator (QCOM).

Why is Apple pushing it this far if QCOM has such a strong case? It doesn't happen often that companies of this size push suppliers to stop royalty payments completely.

My take on this, is that Apple has a lot to win, especially now more and more 5G trials are started and (5G) IP license contracts will be negotiated soon which will impact the royalties for many years to come. Apple is not merely pursuing a discount on the license fees, it is trying to restructure the whole pricing structure. How big this is, can be illustrated with the iPhone 7. Under current contracts, QCOM is paid a fee over the total value of the device (up to 3-5%) for the IP as opposed to a percentage of the value of the component sales that are based on the IP (e.g., the $20 value of Intel’s 4G LTE chips using QCOM IP). Apple has the balance sheet and incentives to pursue its goal and sees momentum in Antitrust litigation around the world (e.g., the recent Korean Fair Trade Commission ruling).

As always I am very happy to hear your ideas on this situation in the comments!

What is the magnitude of the claims?

The short term value of the withheld royalties is easily around $4B per year, which goes straight through P/L and impacts the QCOM earnings heavily, my guess is about $1.5 per share. In Q2, QCOM adjusted QTL revenues by $1B for the reported but unpaid royalty payments. In Q3, these royalties were not even reported nor paid, plus it is now expected that this situation will continue until there is a resolution. Therefore, no revenues were adjusted, but for the quarter total license income dropped $866M.

It is a big hit to the profitability of QCOM and the long-term impact can be huge as well but it will not threaten the financial health of the company and not even the dividend program or the NXP takeover bid. The outcome is unpredictable, but QCOM is willing to fight back and takes the time to defend its pricing structure fiercely. Even if the percentage will be over the component instead of the entire device, QCOM has a strong position to negotiate high percentages and will keep making a solid income on each smartphone/connected wireless device sold. In the meanwhile, even if the licensee does no longer report and pay any royalties, the licensee is still using the IP. Hence, a huge off-balance future claim on the missed royalty payments is building up.

In Q1, EPS for FY18 were expected at $4.66, analysts now expect $3.37 on average, which is essentially the Q3 EPS of $0.83 annualized (0.83 x 4 = 3.36). Thus, the forward P/E (fwd P/E) multiple should be huge, as the forward EPS does not assume the royalty payments to continue shortly, nor any substantial upside from the NXP transaction or future claims. We’ll come to that in the valuation paragraph.

Please, note that QCOM is practically always engaged in litigation over the amounts of royalty payments, patent infringements and the fairness of its pricing structure (Antitrust litigation). This is inherent to the IP business, and can cause huge one-off P/L and cash flow items (like this quarter, QCOM paid out the Q1 and Q2 fines to BlackBerry (BBRY) and the KFTC for $940M and $927M, respectively.

Q3 earnings update

The latest earnings update showed three key things. Headlines were very much focused on the forward guidance, that now fully excludes revenues from AAPL contract manufacturers as well as from a licensee that stopped reporting and paying royalties last quarter. This has a huge impact on forward earnings (QTL QoQ earnings dropped -/- 42% and margins contracted).

But what didn’t get too much attention is that the underlying business performed very well. The semiconductor business (QCT) surprised with strong results on the back of strong sales of the new market leading Snapdragon processors and the introduction of gigabit LTE modems. Sales increased 5.2% whilst margins increased due to a more favorable sales mix (EBT% now guided 17-19% for Q4 as opposed to 16.7% last year). In the meanwhile the non-Apple related QTL business performed conform expectations. SG&A increased 6% though, on the back of increased 5G investments and the high legal costs.

The long term prospects did not lower, and the dividends are still safe even with EPS down to $0.83 per share and the dividend payout level now at 69%. QCOM’s balance sheet is still very strong (<1x Net Debt / EBITDA) and the non-Apple business is growing.

NXP acquisition

Last and certainly not least, QCOM management reiterated that the NXP regulatory process is ‘on a pretty good track’ in the earnings call. The transaction is still expected to close by the end of 2017. Regulatory clearance is acquired in four jurisdictions including the U.S. and Taiwan, those that are left are the EU, China, Japan, South Korea and Philippines. Likelihood of regulatory approval is good, as the semiconductor space is a competitive industry. The NXP acquisition is a cornerstone of my investment thesis and I believe that despite the EU regulatory approvals process advancing to Phase II (more due diligence required), the likelihood of the NXP deal is increasing.

In case you are worried about the lack of interest for the shares and how QCOM keeps extending its offer for the shares, this is a very normal process because there's no benefit to tendering now vs. later. Therefore, most shareholders will wait until all regulatory approvals are acquired.

Obviously nothing was mentioned about the price of the acquisition and NXP shareholders who are pushing to get a better price. It’s clear that QCOM can pay more and that the NXP current trading shows that a higher price is justified. Incentives are just too big for this deal to fail on price. Besides, shareholders already approved of the transaction and hefty termination fees are agreed for both sides.

Reading between the lines I have become more comfortable with the transaction, management again made a couple of relatively strong statements. This can be seen as a play to manage regulators and NXP shareholders, but if management would know more they would be very hesitant to be so outspoken. Both Steve Mollenkopf and Don Rosenberg (general counsel and corporate secretary) used confirming language. Rosenberg: “we're very optimistic about our ability to continue to demonstrate the complementary nature of this acquisition with four regulatory approvals already we think - we're on a pretty good track there” and on regulatory progress: ”I said we're cooperating with them and haven't seen any issues at the moment”. Steve added to this discussion” it's on track. And I think building momentum and looking forward to that happening” after stating that the NXP and Qualcomm merger is positively received by the customers from a integrated roadmap perspective.

Also actions confirm that QCOM is expecting the deal to close. Integration planning is happening on both sides and QCOM issued $11.0B of unsecured debt in May to pre-fund the acquisition. QCOM offered $110 per share when NXPI was trading slightly above 80$ per share in 2016 for a total consideration of $38B. If the deal was announced today, QCOM would most likely have to pay substantially more as the semiconductor sector has increased over the same period by about 40%.

Valuations

This brings me to the most crucial point of the analysis, how to value the stock and how to deal with the uncertainty about the outcome of the key events?

I try to invest in undervalued or fairly valued companies of high quality with healthy earnings growth. My rule of thumb for expected total return is:

Total Return = Dividend Yield + Expected Earnings Growth +/- P/E Multiple Expansion/Contraction

Total Return in this formula should at least be above 10%. More if the business risks are higher, less if the quality of the company is undisputed. This is a little bit like the Chowder Rule.

QCOM forward dividend yield is at 4.3%, excluding the share buyback program. I expect the long term earnings growth to be 5-8% considering (i) the market leading IP portfolio and dominant competitive position, (ii) the strong long term growth track record (compounding revenue growth of 12% per year over the last decade), and (iii) positioning for opportunities in IoT, Automotive, 5G and the increasing number of connected devices and data we use. This does not include the NXP growth perspectives (analysts expect 15.9% EPS growth p.a. for the next 5 years).

The trailing P/E of 20.4 (fwd P/E 15.8), excluding the disputed royalties, is slightly above the 10-year median of 19.0 and far below the Morningstar calculated industry average (24.1x). If we would adjust for the royalties (assume the Q1 forecast of 4.66 EPS), the fwd P/E is 11.4. Adding NXP excluding synergies would add another $1.22 EPS ($1.55 with synergies), assuming no additional shares are issued, which could push the FY2018 EPS to $5.8. A case can be made that QCOM investors are looking at a solid margin of safety and should not worry about multiple contraction over the next five years.

This leads me to the conclusion that QCOM is a very attractive investment for the value investor with a mid to long term investment perspective. QCOM shareholders can expect earnings growth on top of a very solid base yield of over 5% p.a. (dividends + share buybacks) whilst the stock is valued at or below par even excluding the upside from a positive resolution of the disputed royalties and a successful NXP takeover. At the current valuation, shareholders do not need to have many things to go in the right direction to expect a total return above 10% p.a.

With these strong fundamental prospects I am very happy to take this window of opportunity add to my QCOM position. I am actually sizing up until my maximum single position size (equal to my Berkshire Hathaway (BRK.A) (BRK.B) and Disney (DIS) positions). Investing in QCOM means that profits will be flowing directly into your account for every smartphone sold. Very likely this will soon also be the case for every new car sold. I very much like that prospect.

Peer analysis

Back to the math and wonderful figures on cash flows, margins and multiples. It’s always good to know how an investment is compared to its peers. To me this all comes down to the valuation of the cash flow, which is best expressed as a combination between EV/EBITDA and cash conversion. A high EV/EBITDA is justified with a high cash conversion and growth perspectives. E.g., in the table below, it can be seen that a highly profitable company like Taiwan Semiconductors (TSM) with a net margin of 33.2% is trading at 8.4x EV/EBITDA whilst Texas Instruments (TXN) is trading at 12.9x EV/EBITDA with a net margin of 28%. Growth prospects are essential to determine the valuation, but so is the cash conversion, in this case the cash flow of TXN stock is valued a lot more attractively than the capital intensive TSM business. Keep an eye on this, otherwise you’ll end up paying a lot for operational profits that just do not convert into cash available for shareholders.

What can be learned? Compared to its peers QCOM is valued at a discount, even when we’re excluding the disputed royalties. A lot of metrics look very sound, including margins, valuation, debt levels, dividend yield, whilst the upside is not even included. Long-term ROIC is over 12% which indicates the profitability of the company and insider ownership with $135M committed is decent.

QCOM is a very cash generative company, normalized for the unpaid QTL revenues the cash conversion is around 70%. This strong cash flow has allowed QCOM to continue its increasing dividend streak since 2003 at an astonishing rate of 17.2% per annum over the last decade. On March 7^th, QCOM announced another 7.5% dividend increase, which will raise the annualized dividend pay-out to $2.28 per share.

Conclusion

Don’t let Qualcomm fool you, the waters are murky but underneath is a very strong current in the right direction. The company has been pressured hard on its pricing structure which had its impact top line, but management shows resilience by (i) fighting back hard in courts, (ii) making the right strategic choices in expanding its focus to IoT and automotive with M&A capabilities and (iii) a continuous stream of innovative high end products and accelerated investments in 5G technology.

QCOM is not only printing a lot of cash with its huge and impressive IP portfolio, it is also a solid play on 5G and driverless cars. Keep a sharp eye out for any adverse signals about the long term outcome of the legal disputes and the NXP acquisition, but at this valuation the margin of safety is comfortable and I will add to my position.

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.