By Jonathan Weber
Qualcomm (NASDAQ:QCOM) stock has been relatively weak until recently, as two failed transactions - the takeover attempt by Broadcom (AVGO) and the unsuccessful acquisition attempt of NXP Semiconductors (NXPI), as well as the legal battle with Apple, Inc. (AAPL) - provided a lot of uncertainty regarding Qualcomm's future.
Fortunately, the outlook for Qualcomm improved significantly due to the recent agreement with Apple. Not only has Qualcomm's share price soared since the announcement, its dividend yield has plunged, making the stock relatively unattractive for new investment. Prior to the settlement with Apple, Qualcomm stock had been yielding above 4%, making it one of the highest-yielding large cap tech stocks. You can see our entire list of over 300 dividend-paying technology stocks here.
The swift and sudden jump in Qualcomm's share price means that the additional profits that Qualcomm will generate, thanks to the agreement with Apple, are now fully reflected in Qualcomm's share price. Qualcomm is a bit expensive right here, and we believe there are more attractively priced technology stocks available.
Qualcomm, originally named Quality Communications, is a technology company that was founded in 1985, by Dr. Irwin Jacobs. The San Diego, California-based company is one of the leading companies in the development and selling of integrated circuits that are used in communications equipment. Qualcomm has another major source of revenues, which is the royalty streams that it receives from a multitude of companies in return for allowing these companies to use Qualcomm's patents regarding 3G/4G-compatible devices. Qualcomm derives a large portion of its revenue and earnings through license fees, thanks to its very strong patent portfolio.
Qualcomm operates fabless, which means that it does not manufacture the integrated circuits that it designs and sells itself. Production is outsourced to other companies, so-called Foundries, which engage in the manufacturing of the products that Qualcomm has designed. This business model has several pros and cons: One contra is that Qualcomm does not take all of the value creation itself, as the respective Foundry takes some of the revenues that are generated by the sale of Qualcomm's products. Another negative is that Qualcomm is dependent on Foundries, which means that things like production issues at its partners that are not under the control of Qualcomm can negatively impact its products.
Operating fabless has some pros as well, though: Qualcomm can operate a very lean business, as it does not have to concern itself with production, which allows for a very slim organization. Qualcomm has only 35,000 employees, which is about one-third of Intel's (NASDAQ:INTC) employee count, for example. The fabless business model also means that Qualcomm does not have to build and maintain large production sites, which means that capital expenditures are very low for the company. This, in turn, means that almost all of Qualcomm's operating cash flows can be turned into free cash flows, which allows for above-average shareholder returns. According to its most recent 10-K filing, Qualcomm has managed to turn 86% of its operating cash flows into free cash flows during the last three years, on average, as average capital expenditures were equal to only 14% of the company's operating cash flows.
There are two major events for Qualcomm that happened throughout the last month: The announcement of its agreement with Apple, and its second quarter (fiscal 2019) earnings announcement.
After a legal battle that lasted for more than two years, Qualcomm and Apple announced that they have come to an agreement in mid-April. This agreement includes a one-time payment from Apple to Qualcomm, it has since been revealed that this will impact Qualcomm's third-quarter earnings results by $4.7 billion. The more important part of the agreement is that Apple will pay royalty fees to Qualcomm over the next six years. There is an additional option to extend this agreement by another 2 years.
These royalty payments by Apple will positively impact Qualcomm's profits to a large degree, according to the company's management:
Source: Qualcomm presentation
Qualcomm expects that the agreement with Apple will positively impact its earnings per share by $2.00 annually, which provides a sizable boost to the company's bottom line relative to the earnings per share of ~$3.50 that Qualcomm has earned during fiscal 2018.
It is thus not a big surprise that Qualcomm's share price has reacted very positively to the announcement. Its share price has risen from a level of $57 to roughly $89, which represents an increase of ~56% in Qualcomm's share price in just a few weeks.
Another recent significant item was Qualcomm's earnings release for its fiscal second quarter. On May 1, the company has announced that it had generated revenues of $4.9 billion during the second quarter, which was down $5.8 billion from the previous year's quarter but was still enough to beat the analyst consensus estimate.
Qualcomm's earnings per share totaled $0.77 for the quarter, which was easily ahead of the analyst consensus estimate of $0.71, but was down slightly from the $0.80 that Qualcomm has earned during the previous year's second quarter, despite the fact that Qualcomm's share count has declined substantially during that time frame. Its second quarter earnings release included guidance numbers for the current, i.e. third, quarter of fiscal 2019. Qualcomm expects to generate revenues of $4.7 billion to $5.5 billion during Q3, when the payment by Apple is backed out. Backing out this payment makes sense, as this one-time item is not reflective of Qualcomm's underlying, or operational performance.
Qualcomm also expects to see a 6% increase in its operating expenses, and the company forecasts to generate earnings per share in a range of $0.70 to $0.80 during the third quarter. Overall, Qualcomm's results for the second quarter and its guidance numbers for Q3 were not bad, but not overly strong either.
Qualcomm is heavily dependent on the performance of the global smartphone markets with both of its segments, as both the sale of integrated circuits as well as royalty fee revenues depend on how many smartphones are sold around the globe.
Source: Qualcomm presentation
Qualcomm expects that global shipments of 3G/4G/5G devices will rise slightly during the current year, with the majority of those devices being smartphones. Others include some types of tablets and other tech products.
Due to the importance of these technologies for businesses as well as for consumers, it is unlikely that global shipments will decline at any point in the foreseeable future, as demand will be driven by customers buying new devices to replace older existing devices, while there are also some customers who buy their first smartphone or other mobile device. The second factor is especially prominent in developing and emerging markets, where consumers are getting more affluent and can increase their spending on discretionary consumer goods. As long as the number of mobile device sales continues to grow, Qualcomm should be able to generate an increasing stream of royalty fees from the producers of these devices.
With its integrated circuit business, Qualcomm is more dependent on the decisions of smartphone producers regarding which chips and parts they want in their smartphones and other products. If producers decide against Qualcomm's chips, such as the Snapdragon series, Qualcomm does not benefit from rising smartphone and tech product sales around the globe. The growth outlook is thus less clear for this segment, although it seems likely that Qualcomm will be able to generate at least some growth going forward.
Qualcomm's Balance Sheet And Shareholder Returns
Due to the fact that Qualcomm is able to convert a large portion of its operating cash flows to free cash flows, Qualcomm has a history of returning large amounts of cash to the company's owners.
Source: Qualcomm presentation
In fact, Qualcomm has returned more than $87 billion to its owners over the last 16 years, which is equal to more than 80% of the company's current market capitalization, and equal to more than 120% of Qualcomm's market capitalization before the jump in Qualcomm's share price, following the announcement of the agreement with Apple.
Qualcomm has been returning cash to its owners via dividends and share repurchases in the past. Stock buybacks have been very irregular; there were years when Qualcomm made no or almost no stock repurchases, while the company has spent a massive $23 billion on buybacks during 2018.
Its dividend payments have been a lot more consistent, as Qualcomm has been raising its dividend regularly for the last decade, with dividend increases being announced annually. At the current level of $0.62 per share per quarter, Qualcomm's dividend yields 2.9% right now.
Data by YCharts
Even though a dividend yield of 2.9% is not low - it is, in fact, roughly one and a half times as much as investors can get from the broader S&P 500 average - this still is the lowest yield Qualcomm's shares have offered during the last three years. Right now, thus, might not be the best time to buy Qualcomm's shares, as investors get a relatively low starter yield right here.
Qualcomm's share repurchases have totaled roughly $55 billion throughout the last decade, which has led to a substantial decline in the company's share count:
Data by YCharts
This is a positive for Qualcomm's earnings per share growth, and investors can expect further reductions in the company's share count in coming years, which will positively impact Qualcomm's earnings per share growth rate in the future.
According to Qualcomm's most recent 10-Q filing, the company had a $10.1 billion cash position at the end of the second quarter, while short and long-term debt totaled $16.4 billion at the end of Q2. This gives Qualcomm a net debt position of $6.3 billion, which means that Qualcomm has a quite clean balance sheet: Its net debt position is equal to roughly 5 quarters of operating cash flows, which does not equate to a high leverage ratio at all.
Valuation And Total Return Outlook
Qualcomm's shares are trading for $86 right now, while earnings per share are forecasted to come in at $3.91, according to the consensus analyst estimate.
Data by YCharts
It is possible that not all analysts have updated their models to reflect the settlement with Apple yet, which is why actual net profits could come in substantially higher than that. Even if Qualcomm would earn $5.30, though, which is the current consensus estimate for fiscal 2020, Qualcomm's shares would still be trading for 16.2 times net earnings right now.
Compared to the long-term median earnings multiple of 15.5, shares are thus looking a bit expensive, even when we make a positive assumption that Qualcomm will hit the $5.30 in earnings per share one year earlier than the analyst community expects. Multiple contraction, therefore, seems a lot more likely than multiple expansion from the current level, we believe.
When we factor in a mid-single digit earnings per share growth rate for Qualcomm (from the higher level of $5.30) and Qualcomm's dividend that yields 2.9% right here and adjust for some multiple contraction headwinds, it is likely that Qualcomm will only produce a mid-single-digit annual return going forward. Qualcomm thus is not looking like a bad investment, and if an investor already has a position, holding onto it won't hurt, we believe. We also believe that Qualcomm is not the best place for new money to be invested into right now, though, as Qualcomm will only produce annual total returns of ~6% from the current level.
The agreement with Apple has been very beneficial for Qualcomm, but after shares have risen by over 50%, we don't believe that they are overly attractive right here. Existing investors that have a position in Qualcomm should continue to benefit from future earnings growth and steady dividend increases, but Qualcomm does look more like a hold than a buy right here.
Disclosure: I am/we are long AAPL. 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.