We Bought Qualcomm When It Was Cheap - Revisiting A Very Successful Investment
Summary
- As I write this analysis, Qualcomm is down more than 10 percent from its previous high.
- After the rally in recent months, the short-term and medium-term potential seems limited.
- In addition, investors should not forget the uncertainties and risks that still hover over Qualcomm.
- Overall and weighing the future, the stock still offers a good entry opportunity for long-term investors. In the short term, however, the potential could be limited.
Introduction
When I published the first bullish Qualcomm (NASDAQ:QCOM) analysis here on Seeking Alpha in June 2019, the company was in a heap of trouble. Never-ending feuds with competition authorities led to massive fines. The failed acquisition of NXP Semiconductors for $44 billion and Broadcom's (AVGO) attempt to take over Qualcomm for $117 billion also unsettled many investors. Investors felt like they were on a roller coaster, so volatile was the stock. And while the end of many of those uncertainties was foreseeable, I expected Qualcomm to be a great investment given its excellent future prospects. And even despite the recent price correction of more than 10 percent, Qualcomm has massively outperformed the S&P 500 since then.
Source: Qualcomm outperformed the broader market
I believe Qualcomm still offers a good entry opportunity for long-term investors. In the short term, however, the potential could be limited.
The investment thesis was spot on and management delivered
Having been untouchable in the previous broadband cellular network generations 3G and 4G, Qualcomm now also wants to dominate the future markets around the introduction of 5G. The key indicator is the QCT segment, in which Qualcomm bundles hardware for the transfer of data streams and related services. Here, the company divides the business into further four revenue streams, which can be differentiated according to applications, or industry sectors: Handsets, RF Front-End, Automotive, and IoT (internet of things).
My investment thesis was tied to the management's promise that 5G and the increasing networking of technical devices will massively expand the application areas of the respective products. As 5G enables stable and fast data transmissions, its introduction is expected to further strengthen the further interconnection of man and machine and give rise to promising markets such as autonomous driving and IoT.
Now that the rollout of 5G is progressing, it is also becoming visible that management is delivering on its promises. For example, Qualcomm ended fiscal 2020 with 12 percent non-GAAP revenue growth and nearly 20 percent earnings per share growth, despite COVID-19.
A big contributor to profits was the QTL segment, which includes Qualcomm's licensing business. Traditionally, this is Qualcomm's most profitable business. For although it contributed only 25 percent of the total revenue of $21 billion in 2020, at $5 billion, it was responsible for more than 60 percent of earnings before taxes (EBT). The signs are good that the licensing business will remain Qualcomm's cash cow. This is supported by the fact that Qualcomm, together with Huawei, holds the most 5G-related patents.
Equally encouraging are the latest quarterly (1Q 2020) figures for the QCT's individual revenue streams, all of which showed impressive growth and illustrate the potential of these markets:
Source: Qualcomm investor relations, 1Q results
Weighing the future: A tempting mix of risks and promises
If we look at the status quo, we see a lot of light for the coming years, but also some shadow.
Promising future
For 2021, Qualcomm intends to stick to its growth course. While management is not releasing a full-year forecast, analysts expect revenue to increase from $23.531 billion (GAAP) in 2020 to $30.980 billion in the current fiscal year. Furthermore, the growth trend is expected to continue over the next few years, bringing revenue to $34.2 billion by 2024.
Qualcomm's revenue and margins, source: www.DividendStocks.Cash
Cash flow and earnings will also benefit from this growth momentum. EPS is expected to rise from $4.52 in 2020 to $7.21 in 2022, and free cash flow from $3.84 to $8.38 over the same period.
Qualcomm's earnings, cash-flows, and dividends, source: www.DividendStocks.Cash
Are there still risks?
Qualcomm's business model is still not free of risks despite its recent strong performance. For instance, Apple's efforts to develop its own mobile modem continue to hover over the company like a Damocles sword. Qualcomm is said to earn up to 20 percent of its revenue from Apple as a customer. Accordingly, it is important that Qualcomm maintain its lead and continue to diversify its revenue sources.
Shareholders should also keep an eye on Nvidia's planned acquisition of British chip designer ARM. ARM develops CPUs based on a different architecture than Intel or AMD and licenses the design to Qualcomm and Apple, among others. Qualcomm has filed a complaint against the $40 billion deal. The reason is the fear that the takeover could create a new giant in the future markets of autonomous driving and AI, which would make access to the necessary licenses more difficult. We will have to wait for the decision of the respective competition authorities.
With Qualcomm's prominent position in important future markets, the focus of the competition authorities will also continue to be directed at the company. It is questionable to what extent Qualcomm will be able to continue to squeeze its licensing business as it has in the past.
Another shortcoming for cash flow-orientated investors is the dividend yield, which has fallen to below 2 percent in the course of the share price development. In addition, the dividend is at the lower end of the various long-term corridors, showing that there have definitely been more favorable moments for an investment in Qualcomm.
Dividend history for Qualcomm, source: www.DividendStocks.Cash
How do I see the risks?
Let's now see how we weigh the individual risks. It is uncertain whether ARM or Nvidia (NVDA) will really refuse to grant licenses to Qualcomm since this is a highly profitable business model after all. Nevertheless, Qualcomm is likely to swallow a pill that it has distributed to other companies in the past itself.
Accordingly, Qualcomm is trying to loosen its dependencies. It has already put money on the table with its recent acquisition of startup Nuvia for $1.4 billion. Nuvia, whose founding members have worked for Google (GOOG) (GOOGL), Apple (AAPL), ARM, Broadcom, and AMD (AMD), among others, is supposed to combat the dependency on ARM CPUs with its own design. Additionally, the acquisition could give Qualcomm a foothold in the growing server market, where Nuvia claims significant outperformance, with its Phoenix chip, compared to other chip vendors.
Source: Nuvia webpage
As far as the competition authorities' scrutiny of Qualcomm's business practices is concerned, I also had my doubts for some time as to whether Qualcomm would be able to maintain its rather aggressive pricing strategy for royalties due to the antitrust disputes with the various competition authorities. My guess was that Qualcomm management would opt for a more defensive pricing policy in anticipatory obedience. Fittingly, EBT margins fell from 80 percent in 2017 to just 64 percent in 2019, but then full-year 2020 reversed the trend as margins rose to 68 percent. The first quarter of 2021 even exceeded this margin by 9 percentage points at 77 percent and was also significantly higher than the EBT margin of 72 percent from the first quarter of 2020.
Source: Qualcomm investor relations, 1Q results
Looking at the low initial dividend yield, this is indeed unfortunate for investors who have been on the sidelines in recent years. Nevertheless, in view of the low payout ratio of less than half of earnings and cash flow, the payout is easily secured. Thanks to the expected positive profit and cash flow development, shareholders can look forward to increases in the coming years. From my point of view, increases in the high single-digit range are realistic without pushing the payout ratio too much. The yield on cost could therefore exceed 3 percent again in a few years.
Assessing the fair value for Qualcomm
Every investor must be aware that past returns reduce future potential. Accordingly, we also see that Qualcomm's fundamental valuation has turned unfavorable in light of the share price rally. Based on the average adjusted P/E ratio of the last ten years of 17.5, the share is overvalued. Despite the recent correction, there is a downside potential of more than 16 percent. Even when considering the cash flow based on a multiple of 17.5, the share has hardly any further upside potential.
Source: Dynamic Share price valuation by www.DividendStocks.Cash, based on a reference period of 10 years and a historical adjusted P/E ratio and P/C ratio of 17.5
Let's look a little closer here, though. The above is based on average prices over the last 10 years. Qualcomm, however, has been a difficult company with many problems all these years. The Apple and antitrust disputes came with risks that naturally played a role when it comes down to a proper valuation of the stock. Due to the many uncertainties, the market may have considered a certain discount on the share price to be justified in recent years. However, it may be doubted whether such a discount is still appropriate today. While not all risks have vanished into thin air, a multiple of 17.5 seems very conservative to me for a company with such a strong market position and good future prospects.
In addition, there is the possibility that Qualcomm may have entered a longer-lasting growth cycle that lasts well beyond the next few years, which is not yet reflected in the forecasts for the period beyond 2023. Shareholders who share such a view should value Qualcomm stock at higher multiples, such as an adjusted P/E of 25 and a P/C ratio of 20, which would then yield an upside potential of at least 30 percent through 2024, equivalent to an annual performance of 8 percent.
Source: Dynamic Share price valuation by www.DividendStocks.Cash, based on a reference period of 10 years and a historical adjusted P/E ratio of 25 and P/C ratio of 20
Conclusion: Qualcomm will be a superior investment, if...
Thanks to the recent price correction, Qualcomm shares are now valued somewhat more attractively again. But that still doesn't make them cheap in historical terms. I, therefore, doubt that investors will see a performance similar to the recent one within a few months. This is because the market now seems to have priced in much of the medium-term potential. However, if the operating business builds on the operating successes of recent quarters, the stock offers a good entry opportunity for long-term oriented shareholders after the recent correction.
Qualcomm is part of my broadly diversified retirement portfolio.
This article was written by
Analyst’s Disclosure: I am/we are long QCOM, AVGO. 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.
Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.
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