Description

 QUALCOMM Inc. (QCOM) Buy 

Summary:

QCOM is leveraging their leadership in wireless connectivity to rapidly diversifying its business outside of handsets into adjacent markets such as auto, IoT, computers, and AR/VR. Losing AAPL revenue (to in-house design) is largely de-risked given conservative QCOM assumptions (AAPL revenue going from 15% to LSD% by 2024). QCOM’s current valuation is attractive vs. other diversified semi companies.  They’re benefitting from the ongoing 5G upgrade cycle as well.  I believe QCOM’s multiple will re-rate higher as management delivers its 3-year financial targets, which are credible and doable. QCOM is also an undervalued metaverse play on the device side (the Snapdragon chip is in the Oculus Quest, and QCOM is working with MSFT), and has much upside if they break into computing.  

Qualcomm is the clear leader in cellular connectivity chips and IP (baseband, SoCs, etc.). 

The combination of continued rev/EPS growth, diversification of end markets (away from being handset focused into a diversified semi company with broad and nascent growth drivers), expanding margins and commitment to return capital to shareholders is the playbook that works very well in semis and should lead to higher multiples, less financial and stock volatility, and a broader investor base.  Earnings and revenue growth are inflecting much higher now starting last year after a rough few years.  Underlying growth (after backing out Apple going in-house) is HSD rev growth, and ~10% EPS growth. 

BTW, Apple has been working on its own modem since 2018, and it’s taking them 5-6 years to finally make a good enough one to use in its phone.  Intel tried to make one, they were bad, so they gave up and sold the biz to Apple. Clearly it’s very difficult to make a quality modem - there’s a lot of art in addition to the science.  Given the difficulty of making a good enough modem, it’s certainly possible that Apple could delay the launch and use Qualcomm’s modem for a longer period of time. 

As Qualcomm executes on this playbook, I think the multiple can go from 12.8x fiscal 9/2022 P/E to high teens (e.g. 16x).  I think the stock can go from $150 to $200+,  or 16x fiscal 2023 EPS of $12.90.  And there’s upside to earnings if their new end markets and categories take off or they gain more share. 

Many investors still think of a handset patent troll.  They have settled their main patent disputes over the last few years with the major handset OEMs (e.g. Apple, Huawei, Samsung) so there shouldn’t be any major surprises left for a long time.  Also, QCOM has repeatedly done an impressive job enforcing their patents and getting settlements (great IP lawyers), showing the importance of their patents and technology. 

The ongoing supply chain disruptions have been good for semis as that consistently keeps prices and margins high.  Demand is still greater than supply in all of QCOM’s products. 

QCOM also has a solid capital return policy, with a 1.8% div yield and a sizeable opportunistic stock buyback (which plays well in times like this)

The neon gas concern is generally overstated as well.  Semi companies all have plenty of alternate supply and inventory, and can use other gasses in place of neon.  

The balance sheet is also very clean and very low net leverage, giving them plenty of opportunities for accretive share buybacks or M&A.  $11.3bn cash, $15.7bn debt.  $172bn mkt cap,  $176bn EV, $18bn of EBITDA.  Rated A/A2

Investment Thesis:

-         Although global smartphone penetration rate is over 78%. QCOM will still benefit from the 4G to 5G transition over the next few years supported by strong handset revenue growth

o   5G will be a growth driver for several more years, total handset revenue is expected to grow from $33bn to $46bn, ~12% CAGR. 5G brings in several positive drivers including:

§  increasing complexity of modem and RF components drives content growth

§  ASP lift from consumers upgrading to more premium 5G devices (1.5x ASP multiplier)

§  mmWave adding ~$35 of content per device

§  better upgrade rates due to 5G differentiation vs. 4G

§  carrier device promotional activity in the US

o   Accelerating Android revenue expected to grow faster than its Serviceable Addressable Market (SAM), offset by potential AAPL share loss

§  Huawei’s HiSilicon remains out of the market and provides QCOM the opportunity to gain market share

-         QCOM is diversifying revenue outside of smartphones. They plan to grow the non-handset business from $5bn to $9bn by FY2024

o   Key drivers of growth included the migration to cloud, work from anywhere (WFA), 5G technologies, and digital transformation which require more connectivity and power efficient chips. The company announced new technologies and partnerships which shows the growing traction of the Snapdragon portfolio across business segments

§  Basically, billions of devices are becoming smarter and connected to the cloud. QCOM is the technology that powers the mobile connectivity (which is referred to as connected intelligent EDGE)  

§  Mobile is winning. QCOM’s mobile heritage and DNA puts the company in an incredible position to provide high-performance, low-power computing, on-device intelligence, and everything wireless across AI processing, connectivity, camera, graphics, hidden sensors, etc.

§  By 2025, 64% of data will be created outside of traditional data centers. More data at the edge requires more local processing and intelligence

o   As the connected intelligent edge gains scale, QCOM expects to grow its TAM by 7x within the next 10 years to ~$700bn, driven by cloud growth of 35% YoY and 64% of data being created outside of traditional data centers by 2025

o   QCOM will benefit from the development of the Metaverse

§  QCOM Snapdragon chip is in the Oculus Rift 2.  QCOM also announced the expansion of its collaboration with MSFT to drive the ecosystems, including developing custom AR chips to enable lightweight and power efficient AR glasses

·        MSFT and QCOM plan to integrate software from both companies on the platform, including Microsoft Mesh and Snapdragon Space

o   Automotive opportunity

§  At CES, CEO highlighted potential growth opportunities for connected cars and the Snapdragon Ride platform

§  QCOM estimates the design win pipeline across global automakers at $13bn and continues to build its multi-tier digital chassis platform with new wins across Tier 1s and OEMs like Volvo, BMW, Honda, Renault, and Alps Alpine

§  CEO highlighted the importance of C-V2X (cellular vehicle to everything) technology, which runs on 5.9GHz spectrum, and is critical to the company's immersive automotive portfolio for telematics, in-car connectivity, infotainment, and ADAS

o   QCOM is expanding the ecosystem for Windows on ARM

§  the mobile and PC markets are converging, with the adoption of 5G truly enabling for the first time a mobile experience that can compete with fiber.  Microsoft’s Suace Pro and Duo use the Snapdragon chip

·        COVID disruption has also accelerated the adoption of a hybrid workplace focused on mobility and transportability. QCOM sees the integration of the Snapdragon platform onto PC as the next logical step in this evolution

·        The ARM ecosystem has also matured from both a hardware and developer perspective, helped by Apple's internal silicon efforts demonstrating the capabilities of the ARM IP.

o   Apple demonstrated that ARM is fully capable of running a high-end notebook with superior battery life (based on the success of the M1-powered Macs)     

o   Recently unveiled Windows 11 has both 32-bit and 64-bit Arm compatible versions, supportive of the expansion of ARM as an additional option for OEMs beyond the historical x86 dominance in PC

§  QCOM noted that 200 enterprises are either testing or deploying Windows on Snapdragon laptops and 2-in-1 devices. This broad ecosystem includes MSFT, who continues to collaborate with QCOM on Windows on ARM, but also PC OEMs including Acer, ASUS, HP and Lenovo who are working with QCOM to develop PCs powered by Snapdragon

§  QCOM plans to begin sampling new PC oriented silicon (based on the Nuvia acquisition) later this year for 2023 designs

·        QCOM's $1.4bn March 2021 acquisition of Nuvia, a CPU and technology design company, will help drive market share gains in the PC market vs. x86

-         Attractive financial profile and compelling capital allocation framework

o   Management provided robust three-year guidance, with QCT (handsets and adjacent markets) expected to grow by a mid-teens revenue CAGR combined with +30% operating margin. With tailwinds from the metaverse and extended reality, IoT revenues are expected to accelerate from $5bn in FY21 to up to $9.0bn in FY24

o   Management expects the QTL revenue and margin profile (70% OM) to remain stable through FY2024, and highlighted that handset licenses comprise 90% of QTL revenues

o   Management plans to maintain a strong capital return program

§  Returned 90% of FCF to shareholders in the last two years

§  Committed to do anti-dilutive buybacks and grow dividends

Company Segments:

-         QCOM is a leading global provider of wireless sector semiconductors and licensed technology. The company operates two primary business segments: QCT and Qualcomm Technology Licensing (QTL).

o   QTL segment (20% of total revenues in fiscal 2021, with a 73.2% EBT margin)

§  grants licenses to use its IP portfolio, which includes various patent rights used in certain wireless products

§  Typical SEP (standard essential patent) agreement covers all three versions of cellular standards (3G, 4G and 5G) and last for 5-10 years

§  QCOM has signed with every major handset OEM and the first renewal is not until FY2024

o   QCT segment (80% of total revenues in fiscal 2021, with a 28.7% EBT margin)

§  This is QCOM’s primary semiconductor product business and develops integrated circuits and system software for use in voice and data communications, networking, and application processing

§  RFFE: expected to grow at least in line with its +12% SAM CAGR

§  IoT: expected to see a 17% SAM CAGR, $42bn to $67bn, on industrial, edge networking, and consumer applications, with revenues forecasted growing from $5.1bn today to $9bn in F'24E, or a ~21% CAGR

§  Auto:  is currently the smallest of QCOM’s growth verticals, presently at $1bn of FY21 revenue

·        However, management anticipates an acceleration in sales towards $3.5bn over the next 5-years (~+28% CAGR). Looking further out, the company sees growth towards ~ $8bn in 10-years time (+23% CAGR) benefiting from >10x silicon content across telematics, connectivity, and digital cockpit and ADAS applications.

·        QCOM's 5-year revenue forecast is ~70% covered by existing design wins with management highlighting continued momentum and a >2x design win pipeline expansion since 2019 Analyst Day

Valuation:

Despite run-up in the stock since Nov 2021, QCOM still underperformed SOX in the last 12 months. The stock is attractively valued vs. other more cyclically sensitive semis names  

-         I think QCOM’s valuation could trade up to high teens, similar to value semi ideas I’ve invested in the past (e.g. ON, NXPI) as they execute on their diversification strategy, gain new end markets and design wins outside of handsets, expand margins, and improve capital return. 

-  QCOM trades at only 12.8x Fiscal 9/2022 P/E right now,  in the ballpark with other cellular / comm focused peers like Qorvo, Skyworks.  And compute like Intel.  I think it’s better than those, and has a better roadmap and ability to grow outside their core focus

Valuation is close to the low end of its historical range over the last 10 years

10 year P/E 1 year forward 

Risks:

-         AAPL developing its own modems (very well known)

o   AAPL (15% revenue customer) is currently building its own team of chip designers to make modems. QCOM’s agreement with AAPL is a 6 year licensing agreement (effective starting 4/1/2019) with a two-year option to extend and a multi-year chipset supply agreement

o   QCOM’s analyst day financial targets take into account AAPL’s internal development efforts, with conservative assumption of 80% share today to 20% share at AAPL following the Sept 2023 iPhone launch and going into low-single-digit % of revenue for QCT in 2024. QCOM plans to offset AAPL revenue loss with Android and non-handset growth

• I think it’s a possibility that Apple could delay this launch given the difficulty of making a good modem, especially for high end/ premium phones.  Intel tried to make a good modem, and started by buying the wireless division of Infineon in 2011 for $1.4bn.  They were not successful and were highly ridiculed when Apple put them in the iphone 7 and 8.   Making a good wireless modem is actually highly complicated and requires a lot of art in addition to science.  There’s much complexity when dealing with all the frequencies, interference, signal quality, standards, performance requirements, etc. 

• Getting the Apple overhang out of the way in 2023 could arguably be a positive as well. That would allow headline numbers to look at lot better going forward and put it behind them.

Apple-designed chip journey to continue

Earlier this year, Ming-Chi Kuo suggested that we might see the first Apple-designed modem chip by 2023, but he was uncertain about the timing given the years-long timescale involved in what is a highly complex task.

Three factors contribute to that complexity. First, a radio chip has to meet a long list of different standards for mobile data (from 2G onwards), Wi-Fi, and Bluetooth, supporting both the latest versions and all the legacy ones. Second, power-management is exceedingly challenging, because radio transmissions are very demanding of battery life. Finally, Apple has to avoid infringing Qualcomm’s numerous patents in this area.

A Nikkei Asia report today echo’s Kuo’s expectations, and suggests that 2023 is indeed Apple’s target date.

Apple is forging a closer partnership with Taiwan Semiconductor Manufacturing Co. in hopes of reducing its reliance on Qualcomm, Nikkei Asia has learned, with plans to have the Taiwanese chip titan make 5G iPhone modems from 2023.

Apple plans to adopt TSMC’s 4-nanometer chip production technology to mass produce its first in-house 5G modem chip, four people familiar with the matter said, adding that the iPhone maker is developing its own radio frequency and millimeter wave components to complement the modem. Apple is also working on its own power management chip specifically for the modem, two people briefed on the matter said […]

For the new 5G iPhone modem, sources said, Apple is using TSMC’s 5-nm chip production to design and test-produce the chip. It will then use the even more-advanced 4-nm technology for mass production, the sources added. Commercialization will not come until 2023, people familiar with the matter said, in part because of the time needed for global carriers to verify and test the new modem chips.

-         Qualcomm does not have any major chip contract expirations in fiscal 2022 and 2023 with its handset OEM customers. However, beyond that, risks still exist that its handset OEM customers could in-source their application processors or thin modem chips or seek alternative sources

-         Lengthening of smartphone replacement cycles

o   Big upgrade cycle related to 5G is coming, which should mitigate mature handset market

Stock chart

1 year

5 year

Since 1992

Financials

Slides

Catalyst