Description

Company Overview

Qualcomm Inc. (QCOM) is a global leader in the development and supply of advanced semiconductor and wireless technology solutions primarily for the mobile, automotive, and Internet of Things (IoT) end markets.  Founded in 1985 by seven former Linkabit employees, Qualcomm’s R&D led to the development of the CDMA communication protocols which became the backbone for the 2G & 3G wireless communications and is still the foundation of 4G and 5G networks.  By the mid-2000s, Qualcomm harnessed its mobile expertise and introduced its Snapdragon SoC (system-on-a-chip) platform which integrates CPUs, GPUs, modems, and memory into a mobile chipset.  Over the next seventeen years, Qualcomm’s SoC played a significant role in fueling the growth of smartphones, tablets, and other mobile and wearable devices by improving the chipset’s speed, processing power, and lowering battery consumption.

With its revenues highly correlated to the smartphone market, Qualcomm has been diversifying its portfolio by leveraging its research and intellectual property (IP) into adjacent industries like automotive and the IoT.  Admittedly, Qualcomm was very early to the game, especially in automotive, as the 4G standard did not have the bandwidth, speed, or latency needed to support a digital car and its high-tech features.  With the rollout of 5G over the last 4+ years, the automotive industry finally has the infrastructure needed to build the digital car of the future.  Approximately 80% of active smartphones have 5G connectivity, that number is substantially lower for the automotive industry as 5G is mostly available only on premium car models.  In the US, it is estimated that by 2025, one in four cars on the road will have 5G connectivity and it will take until 2030 to reach 60% penetration.  With automobiles slowly evolving into a software-defined vehicle, automotive manufacturers (OEMs) are beginning to design their cars around connectivity, infotainment, and assisted driving and safety, all of which requires a higher level of SoC chipset.

The IoT market promises to be massive with expectations of 125 billion connections by 2030.  Since 2020, this highly fragmented market has been growing around 23.5% per year and is made up of personal, commercial, and industrial devices.  Currently, the majority of these devices are sensors used to monitor and transmit limited amounts of data.  Over time, many of these devices will follow the path of the wearables market and be able to not only transmit a wide range of data in real time but also perform edge computing.  Qualcomm forecasts that when mobile is combined with a mature automotive and IoT industry, the addressable market will exceed $700 billion.

Industry

The global semiconductor and wireless telecommunication industries are characterized by rapidly changing technologies, a large number of competitors vying for market share, and varying levels of regulation that differ from country to country.  Even though Qualcomm focuses on niche segments within each industry, they still face stiff competition from a number of key companies.  

Years of competition and consolidation have distilled the cellular connectivity market down from over seven companies to just Qualcomm and MediaTek.  So far, Qualcomm has been able to maintain a strong competitive edge in the high-end premium market for cellular modems, with MediaTek gaining market share over the years in the low to medium-market segments.  Together, they represent nearly 100% of the cellular connectivity being used in smartphones, tablets, automobiles, and the Internet of Things.  

In the semiconductor space, Qualcomm competes with a number of companies, each of whom designs their own unique SoC which integrates CPUs, GPUs, memory, and cellular/Wi-Fi modems into a compact computing solution.  In the smartphone and tablet market, Qualcomm faces off directly with MediaTek, Apple, UNISOC, Samsung, and Huawei.  Except for MediaTek, all these competitors also manufacture their own smartphones and tablets, which adds another layer of complexity to an already competitive landscape.  In comparison to the smartphone market, the automotive sector is just on the cusp of transitioning into a digital platform.  As such, the market continues to be both nascent and fragmented as semiconductor designers are gravitating to one of the car’s key platforms:  Connectivity, Infotainment, Car-to-Cloud, and ADAS/AD navigation.  When it comes to IoT, the market, its manufacturers, and suppliers are even more fragmented catering to a vast market that is quickly expanding.  The majority of IoT devices are purely sensors but with the expansion of 5G and falling costs of SoCs, today’s IoT devices have the ability to perform edge computing as well as communicate with the cloud with very low latency.

To produce a successful SoC for the mobile, automotive, or IoT markets, a manufacturer needs to design a fast and powerful chip that has cutting-edge performance, low power consumption, and can be delivered at an effective price.  Qualcomm’s success also depends on its ability to stay ahead of its competition by consistently anticipating the manufacturer’s future needs.  That is why competing in the smartphone market directly against companies like Samsung, UNISOC, & Huawei adds a level of complexity, as those companies are already planning for future features that are relatively unknown to Qualcomm.

Investment Thesis

With its global leadership in wireless connectivity, portfolio of cutting-edge intellectual property, and high-quality brand, Qualcomm is well-positioned to benefit from the growing addressable markets in mobile, automotive, and IoT.  For a long-term investor willing to weather the economic headwinds, regulatory and legal challenges, and competition from new technologies and competitors, Qualcomm and its management team provide a meaningful investment opportunity.

Smartphone Segment

Qualcomm is synonymous with the mobile market.  Its success is a direct result of the growth and evolution of cellular technology, and the growth and evolution of cellular technology is a direct result of Qualcomm’s years of R&D and IP.  The company has been able to harness its cellular expertise, intellectual property, and strong relationships with smartphone manufacturers to become a dominant provider of mobile SoC solutions.  Even when competing directly with key smartphone manufacturers like Samsung, Xiaomi, and Vivo, who also design their own SoC for their smartphones, Qualcomm continues to win new deals for their high-end smartphone models.  Handset manufacturers are finding it challenging to match the Snapdragon’s speed, processing power, and low power consumption.  Qualcomm has benefitted greatly as the smartphone market in developed countries grew at a 27% compounded annual growth rate from 2008 through 2018.  Since that time, unit sales have slowed and even declined by over 10% in the past year.  With nearly 80% of the developed market owning a smartphone, future smartphone growth should fall to the mid-teens level with refresh cycles helping to provide a periodic tailwind.

In its most recent quarterly earnings report (Q2 FY ’23), Qualcomm’s handset revenues had declined by 17%.  China’s lackluster economic recovery has been a contributing factor and the expectation of a recovery in the second half of 2023 is becoming more remote.  Handset manufacturers continue to draw down their inventory as the uncertain economic backdrop and lack of an engaged upgrade cycle pressures smartphone sales.  Huawei’s loss of market share due to ongoing sanctions has also played a role in Qualcomm’s recent revenue downturn.  Some of Huawei’s lost sales were picked up by Qualcomm customers Oppo, Vivo, and Xiaomi.  However, the majority of Huawei’s sales went to Apple which designs its own SoC for its own smartphones.  Losing customers to Apple is very concerning for Qualcomm because its ecosystem can be very sticky, and they would be less likely to return to the Android OS.  Apple is a meaningful customer of Qualcomm’s cellular modem chips.  It is well documented that Apple is in the process of designing its own cellular modem for future iPhone models.  Qualcomm has already indicated that future revenues will be negatively impacted if they were to lose Apple as a customer.  Guidance for Q3 FY ’23 was soft with operating margins falling as well.

The new growth in smartphone sales is expected to come from emerging countries like India, Indonesia, Vietnam, and the Philippines.  In a 2020 report, Pew Research found that due to years of under-investment in fixed broadband or fiber infrastructure, over 70% of internet users in 11 emerging markets were becoming Mobile-First users – first access to the internet is via a smartphone.  With a combination of more affordable mobile devices and cellular plans and increased mobile commerce and communication, growth in emerging market smartphone sales is expected to continue to rise into the mid-20s for the foreseeable future.  However, it is important to realize that roughly 15% of smartphone sales in emerging markets are from refurbished phones.  That number is actually growing as the demand for smartphones with premium features is rising.  The increase in refurbished smartphones could be another headwind for Qualcomm as Apple’s phones represent over 50% of the global refurbished market and, as mentioned above, Apple’s ecosystem can be very sticky, leading to future Apple iPhone sales.

Automotive Segment

Today’s automobile manufacturers (OEMs) face a growing challenge from their customer base: quicken the pace of digital integration within their current and future vehicle platforms.  For years, cars were seen as the “ultimate mobile device” but lacked the technology to achieve that standing.  Auto manufacturers have historically resisted technological change and for good reason, it costs money.  A car model will usually go through a six-to-eight-year lifecycle (design to final production) with upgrades usually taking place after the third year of production.  The length of the production cycle is necessary to recoup the billions of dollars spent designing the car, testing its safety, inventorying its parts, and tooling and operating the assembly line.  Assuming the manufacturer gets everything right, they will be able to turn a profit.  If not, the best they can hope for is to break even.  Over the years, OEMs have tried to accelerate their car’s technology platform by outsourcing the car’s innovations to their suppliers.  At the end of the day, auto manufacturing is still an analog industry trying to compete in a digital world.  That is all about to change.

Telsa has singlehandedly forced the world’s car manufacturers to embrace the automobiles’ digital renaissance.  The EV manufacturer has shown, firsthand, that the car of the future will be a software-defined vehicle that can be customized and updated just like a smartphone.  In order to accomplish this feat, car OEMs will need to transition to a software and semiconductor-focused company, which is currently outside their area of expertise.  This is a problem that Qualcomm can help solve.  By leveraging its years of expertise in designing durable, high-end handset SoCs, Qualcomm has created the Snapdragon Digital Chassis – a comprehensive digital solution that integrates Connectivity, the Digital Cockpit, Car-to-Cloud communications, and Advanced driver-assistance systems (ADAS)/Automated Driving systems (AD) into one platform.  The key benefit of Qualcomm’s digital chassis is that all the car’s different components and high-tech features will be able to seamlessly communicate with one another by using the same chipset and operating system.

Qualcomm has already received a number of OEM design wins that currently add up to a pipeline of $30 billion of future revenue along with a number of active design proposals still in consideration.  In 2022, Qualcomm generated $1.4bn from automotive sales, mostly from the digital cockpit & connectivity.  By 2026, the company expects to start ramping up its ADAS solution with automotive sales expected to increase to over $4 billion and expanding to over $9 billion by 2031 as more models incorporate the Snapdragon Digital Chassis.  The automotive industry will never have the parabolic growth or refresh cycles that the smartphone market has, but it can be a very sticky business especially when your product is designed into a car’s major components.  As long as Qualcomm’s Snapdragon works as promised, it is very likely to be the foundation of future models and new design wins.

Depending on the vehicle model and what features are included, Qualcomm’s semiconductor content per vehicle ranges from $200 to over $3,000.  There are a number of benefits that OEMs gain by using Qualcomm’s Snapdragon: 1) All the platforms of the Snapdragon Digital Chassis are built using the same operating system making communication and integration seamless.  2) Speed and rate of innovation and future capabilities are increased when having to design for just one SoC platform vs. designing for a number of different SoC vendors.  3) There is less concern that future software updates will sever the communication between the different platforms.  4) The Snapdragon Digital Chassis and all the subsequent car features, especially the digital cockpit, can be customized to reflect the look and feel of the OEM’s brand.

Over the past seven years, brand loyalty in the car industry has declined from over 60% loyalty to a car brand to less than 49%.  There are a number of factors that have contributed to the decline: 1) Drivers are gravitating toward high-tech features that are not standardized across OEMs.  2) Online car buying shopping is narrowing the field based primarily on price, and, 3) Car manufacturers are isolated from their customers, relying on dealers to act as brand ambassadors.  At the moment, the Car-to-Cloud platform is a much-overlooked component of the Digital Chassis but promises to be a key feature that will allow car manufacturers to connect directly with the car and its driver.  The platform will allow OEMs to monitor the car in real-time and make the necessary software adjustments via over-the-air updates just like a smartphone.  Car-to-Cloud will also give manufacturers the ability to sell directly to the driver with pay-as-you-use hardware services, and subscription services, and will allow an OEM to have their own app store similar to Google and Apple.  This customer service will come directly from the manufacturer and is expected to heighten brand loyalty.  Given the improved customer experience, when the time comes for a driver to trade in their vehicle, they are more likely to stay with their current brand.  The other benefit is that transitioning to a new car will be similar to activating a new smartphone, log in and your user customizations and apps will automatically upload.  When this happens automobiles will have finally joined the digital age.

IoT Segment

The Internet of Things refers to connected devices that send and receive data.  They include wearable products like watches and health trackers, consumer devices like doorbell cameras and programable thermostats, and industrial monitors for logistic & supply chain optimization and predictive maintenance and repair.  With the growth of 5G connectivity, IoT devices have gone from remote sensors to programmable devices that perform edge computing and communicate with the cloud.  The global IoT market is expected to continue to grow in the mid to upper 20s for the foreseeable future with wearable and consumer products leading the way.  Qualcomm defines its IoT segment as any connected device that is not a smartphone, tablet, or automobile and has identified 3 large serviceable opportunities. 

The largest serviceable opportunity is the PC market.  For the past 15+ years, the PC market has been in steady decline with 2022 global sales recovering to 280 million units.  Demand for PCs, especially in emerging markets, has been negatively impacted by the growth and computing power of mobile devices like smartphones and tablets.  With a refresh cycle of 3-4 years, the best the PC market can hope for is mid-single-digit growth going forward.  However, within the PC market, notebooks have been taking market share, increasing from less than 70% to over 75% of total global PC sales in recent years.  As more notebooks are integrating 5G communications to support mobile video conferencing and cloud computing, notebooks are acting more like a mobile device and the need to balance processing power with energy consumption is becoming even more critical.  Qualcomm’s recent purchase of Nuvia was specifically aimed at combining Qualcomm’s mobile expertise with Nuvia’s ARM-based chip design to create an SoC for the notebook market that would challenge both Intel and AMD for market share.  The results appear promising as Qualcomm is partnering with Microsoft to transition Windows 11 into an ARM-based mobile architecture.

Another area of potential growth within IoT may be in the field of augmented, virtual, and mixed realities.  Just like with automotive, Qualcomm was early to the game having dedicated over 10 years of research to an industry that sold just 10 million units globally in 2022.  However, Apple’s recent debut of its Vision Pro headset may be a clear indication that technology has evolved to make AR/VR/XR a new computing platform, which in turn may spark continued interest in the format.  Qualcomm’s Snapdragon chipset can be found in most of the manufacturers’ headsets including Samsung, Meta, and ByteDance.  It is too early to tell if AR/VR/XR will be able to compete with PC’s and smartphones but if it does grow Qualcomm stands to benefit.

The Last area of serviceable opportunity that Qualcomm identified is from the deployment of 5G in emerging markets.  Most emerging markets did not have the capital to build out their broadband infrastructure by laying cable or fiber, creating Mobile-First markets.  With the global expansion of 5G, many emerging markets are now using 5G to provide fixed wireless access (FWA) within the home.  FWA would require a home modem that connects to the internet via a 5G connection and then broadcasts the signal via WiFi to the rest of the household.  It is estimated that nearly 40% of global households lack a broadband internet connection.  FWA will allow families to share an internet connection, helping reduce the cost per subscriber, while providing an opportunity to integrate the use of notebooks instead of just mobile devices.  This opportunity is finding traction in countries like India, Indonesia, and Vietnam where home broadband is non-existent.  Over the next few years, Qualcomm expects that FWA will be deployed to over 100 million households worldwide.

Valuation 

Qualcomm is at a key turning point in the company’s journey.  The parabolic expansion experienced in the smartphone market from 2008 through 2018 has slowed significantly with future growth expected in the high-single digits to low teens.  The slower than expected economic recovery in China, Huawei’s loss of market share being absorbed by Apple, economic uncertainty leading to handset OEMs drawing down their chip inventory, and a delayed upgrade cycle have all led to the current revenue and margin softness in smartphones.  The good news is that over the past 17 years, Qualcomm has expanded its footprint beyond the mobile market by developing SoCs for the automotive and IoT industries, achieving meaningful market share in the segments that it serves.  The bad news is these industries do not produce the revenue of a smartphone market.  It will likely take until 2025, early 2026, for Qualcomm’s earnings to recover to the $12.50 EPS level generated in 2022 (this assumes the loss of Apple revenue in 2024).  Over that time, the growth in automotive and IoT will help reduce dependency on Qualcomm’s handset sales, as revenue will get diluted from 58% of total revenue to 52%.  Going forward, Qualcomm’s revenue will be less cyclical and more balanced between mobile, automotive, and IoT, leading to continued and accretive margin expansion and EPS growth.  

When applying a 15x multiple to late 2025/early 2026 EPS of $12.50, investors can expect shares of Qualcomm to gravitate to $187.50/share.  For a patient investor, the future recovery and upgrade cycle of the mobile market and the continued expansion of automotive and IoT markets will be the fuel that powers Qualcomm’s EPS beyond $14/share in the years that follow.  In the meantime, investors can expect that Qualcomm’s management will be focused on reducing expenses and maintaining its capital allocation program of dividend payments and share repurchases.

After its Q2 FY earnings release and soft guidance in early May, Qualcomm’s stock experienced an understandable decline below $105/share before AI mania took hold and drove the stock back above $123/share.  For a long-term investor, buying shares at the current levels still provides for a meaningful return over the next 3-4 years, especially as growth in automotive and IoT continues to play a larger role in Qualcomm’s fortunes.

Risks

Besides the concerning economic outlook overhanging the global economy, there are a number of associated headwinds that Qualcomm and the segments it serves are facing:

• On-going regulatory concerns facing Qualcomm in global markets.

• Legal challenges to its IP, patents, and royalties.

• Cyclicality of the Smartphone market.

• Intense competition within the end markets that Qualcomm serves, especially from dominant players like MediaTek.

• The ongoing trend of manufacturers designing their own SoC in-house.

• China's recovery is further delayed or does not amount to a full recovery.

• Loss of Apple’s revenues (which is expected).

• Refurbished smartphones satisfy a larger portion of emerging market handset growth.

Catalyst

• Global economic outlook more constructive
• Recovery in smartphone demand leads to OEM inventory replenish
• Increased Automotive design wins
• Quicker adoption within the IoT market leads to revenue strength and improved margins