Description

Given the market over the last few years, investors seem to be overly extrapolating certain datapoints, initially macroeconomic datapoints in 2008 and more recently earnings estimates. Given how much information dissemination has improved with better communication, it's hard to have the same information edge in the market as several years ago, but nonetheless, investors still and will always succumb to avarice and fear, which presents us with opportunities when companies sell off on an over-extrapolation of datapoints. Such an opportunity is available in Qualcomm after the company's Q4 preannouncement. Qualcomm preannounced a drop in ASPs for its Qualcomm Technology Licensing Business (QTL) below its previous guidance and also lowered revenue guidance for 2010 by 3% while maintaining EPS guidance. However, the market substantially over-reacted resulting in a drop in the share price from $47 to $39, offering us an opportunity to own a company with a great IP portfolio correlated to wireless growth in both developed nations and emerging markets as well as a high return on capital business with minimal capex, substantial barriers to entry and a great management team. Fair value is easily $54/share or 45+% upside with very conservative assumptions.

Business Description:

I'll keep this brief since the company does a very good job of explaining their businesses in their filings.

QTL Division: Qualcomm Technology Licensing owns a patent portfolio tied to CDMA, WCDMA, TD-SCDMA and OFDMA (4G LTE and Wimax). QCOM gets paid based on number of handsets sold times handset ASP times a royalty revenue rate that varies by OEM but generally is in the range of 3-4%. This business is extremely high margin and accounts for 35% of total revenue but 70% of operating profits at an 85% operating margin. QCOM holds over 6100 patents surrounding these technologies.

QCT: Qualcomm CDMA Technologies sells integrated circuits and system software for wireless voice and data related devices as well as GPS products. The company has 100% market share in CDMA related chips and 40% in WCDMA. Given R&D related scale, the company has been a massive innovator over the last several years in their chipset business and has taken significant markets share. New chipsets for computers, e-reader screens and single chip solutions have continued to drive growth in the business. This business accounts for about 60% of revenue and 30% of operating profits at 25-30% operating margins.

QWI: The business includes government related services, content enablement services, enterprise services, mobile commerce services and has single digit operating margins and is about 5% of total revenue.

QSI: QSI houses QCOM's strategic venture related initiatives. The company has a history of extremely innovative technology and continues to develop new products and services. QSI is split out of pro-forma EPS as the company believes it is non-core to operations, though it is slightly loss generating, but an extremely small piece of the total business.

Why is the company misvalued:

As discussed above, the company preannounced earnings and brought down guidance for revenue by 3% while maintaining EPS guidance for the year. The guidance drop is related to a drop in ASPs in the company's QTL business. The company previously guided to $198 in ASPs but the quarter came in at $184. The lower ASP number is combined with the fact that in the last quarter, the company came in at $196 which was 4% better than the previous quarter's guidance of $189. Investors reacted negatively for multiple reasons. This was an absolute drop in ASPs as well as a miss of guidance. Moreover, while the company has pretty much always been wrong on ASP guidance (tough number to call perfectly) they've usually been within one standard deviation of the actual number, yet this time were about 2 SD's away. They attributed the difference to pricing pressure related to the macro environment in Western Europe and Japan. Since the preannouncement, the sellside has been jumping on the credibility bandwagon, decreeing that they should have preannounced in December when they likely knew the ASP numbers and also should not have gotten the ASP number so terribly wrong. However, we believe that they are being overly penalized for a quarter in which they met EPS guidance and in which they barely lowered revenue guidance for the year, resulting in a misvalued stock given the valuable IP, high ROCs, strong R&D base and management's history of good capital allocation decisions.

Why near term ASP declines shouldn't be as bad as the investment community seems to be pricing in.

The market seems to be pricing in perpetual declines in ASPs for the QTL business. I will go into greater detail in my valuation section, but I believe that while ASPs have and may continue to decline, there are numerous reasons as to why near term declines shouldn't be greater than what the company is predicting.

Mostly related to LG and Motorola, datacards and other new devices

The sellside has done some good work on aggregating datapoints related to 3G unit share and ASPs for the largest OEMs through the past year to conclude that the majority of the ASP drop was from two OEMs, LG and Motorola. Motorola has recently launched several new handsets which resulted in an ASP decline in CQ2 09. (Given the quarter lag, that resulted in ASP increases for QTL in CQ3 09, or FQ4 09. QCOM year ends in CQ3) Given the substantial increase in the previous quarter, MOT saw pricing normalize in CQ3 09, resulting in a drop in ASPs for QCOM in FQ1 2010. LG ASPs dropped because of general discounts in handsets, but has guided to rising ASPs going forward. Finally, as increasing new devices such as datacards and e-readers have sold, ASPs have declined on the whole given the larger volume of lower ASP devices. There's an ASP cap for many highly priced devices (i.e. QCOM won't received 3.75% of the ASP for a Cadillac with Onstar).

What OEMs are saying about pricing and volume

QCOM is guiding QTL ASPs to $181 for FY 2010. This guidance essentially calls for a slight increase in ASPs in the second half of the fiscal year, which corresponds with commentary from OEMs in their earnings calls and at Mobile World Congress last week.

-Nokia is expecting some ASP erosion in CQ1, which would be reflected in FQ3 for QCOM, but expects price erosion to be less than the market as a whole for 2010. NOK also expects 2010 unit growth of 10%. (This is across 2G and 3G-we're assuming 3G growth is greater given the shift of new phones into the 3G category).

-Samsung expects new smartphones to help 2010 ASPs and is assuming flat pricing.

-LG is shifting their focus to the smartphone sector and expects ASPs to rise 4-5% QoQ in Q1.

-Motorola also expects meaningfully higher YoY ASPs from new feature phones and smart phones. MOT guided a drop in Android units in Q1, but is confident in 2010 unit growth will be flat.

-RIM expects flat ASPs with solid international unit growth

-HTC is attempting to better market their brand name and thus will lower pricing to gain share, but expects pricing declines to be equal to the rest of the industry, resulting in substantial volume increases

Generally, while ASPs are not expected to grow significantly, guidance from the large OEMs shows us that there will not be any major pricing drops next quarter, which the market is currently not pricing into QCOM's stock. Moreover, the real value here is in volume growth in phone and other devices.

Volume will still drive growth in QTL

As more emerging markets adopt 3G, simpler form factor handsets with lower price points will cause the ASP to decline, but pretty obviously, volumes will increase with additional 3G adoption. Moreover, as additional devices such as notebooks, netbooks, e-book readers, iPads, OnStar systems...etc include 3G wireless chips (might become as ubiquitous as iPods with data capabilities-one step further than the iTouch with wifi) QCOM will benefit on an absolute basis from substantial increases in volumes. Bottom line here is that the street is overextrapolating ASP declines and isn't properly thinking through that even with declines in ASPs, there is a massive opportunity for QCOM in data as many sorts of devices adopt 3G capabilities and the company receives revenues from all of them. There are also 63 new smartphones that will be launched in 2010 by the top 10 OEMs which will drive substantial volume growth.

QCT Business:

QCOM has been a definite innovator in their chipset business. Given their substantial R&D spending and massive scale, they have been able to create better and higher quality chips at faster rates than their competitors. However, the market is certainly becoming more competitive and I'm conservatively estimating ASPs in the business decline, offset by unit growth through high quality and innovative new chips as well as new devices requiring complex chipsets (same logic as volume growth in QTL discussed above). Mediatek has primarily served the grey markets in China but is moving mainstream and attempting to lower pricing for greater marketshare. Snapdragon seems to be the best mobile applications platform chip from our work on the product vs. competitors. When compared to similar products by Intel, TI and nVidia, Snapdragon uses less power, supports higher resolution graphics and supports greater variations of connectivity than any of the others. While a small part of revenue, it speaks to QCOM's continual innovation across devices.

Long Run

The largest long term risk to Qualcomm discussed by bears is the sustainability of cash flows several years out as we see a shift from 3G to 4G. Will the company be able to sustain the QTL business without 3G royalty streams?

Devices with 3G Capabilities will be around for years:

While the carriers are beginning to discuss potential 4G builds several years down the road, 3G builds are far from finished. The VZ commercials which contrast VZ's 3G map to T's is a great example. As such, phones with LTE chipsets will still contain 3G chips for at least another 10 years-another 4 years to build out 3G networks fully and 6 years from there to fully build out LTE networks.

Patents related to 4G/OFDMA

QCOM has more OFDM/OFDMA related patents than any other company. They made a great acquisition very early on in Flarion which owned substantial 4G related IP. However, from checks, it seems as if the royalty rates are slightly lower in 4G than historically in CDMA/WCDMA (3.25% in 4G vs. 3.75%ish).

Free Options: QWI and QSI

We're not factoring in QSI and QWI in our valuation, but there could be future upside to the free options here.

Mediaflo:

Mediaflo is a mobile television platform that works through the carriers in which subscribers buy the add on service to watch television through their mobile phones. Qualcomm receives a subscription fee. While the business is currently very small, the value here is as form factors improve and smartphones become more ubiquitous, we could see greater adoption of the service. Moreover, the costs to a business like this are mostly upfront and fixed, so marginal costs to incremental subscribers are very low which could have meaningful impact in the future as the service takes off.

Mirasol:

Mirasol is a MEMS based color display that should help in the next step of innovation for e-book readers. The display is in color, has a fast refresh rate and low power consumption. It's still low contrast and allows for continuous reading without eye strain, but adds value through color and video functionality in e-book readers. The product should be ready in the autumn and while a small part revenue, it also speaks to continual innovation at QCOM and could be a meaningful contributor in the future.

Valuation Case:

The company has a $66bln market cap with $19bln in cash (29%) for a $47bln enterprise value.

FCF Yield:

The company guided to $10.4-11bln in revenue for FY2010. Beginning with the QTL business, the company guided to $181 ASP and 600-650mm units vs. 499mm units in FY2009. If we haircut ASPs to $175 and use the bottom end of guidance for units and a 3.75% royalty rate, we are at just under $4bln in revenue from QTL. Assuming $17 ASP in QTC (vs. $19.35 in 09) and 317mm units (same as 09, which is conservative given growth in higher end handsets), we are at just under $5.4bln in QTC revenue. Assuming $600mm in QWI ($640mm last year), we get to total revenue of $9.9bln, vs $10.4bln-11bln guidance. Assuming 25%, 85% and 3% PBT margins in QTC, QTL and QSI, respectively, (haircut to historical margins for potential increases in R&D for new chip designs) and a 22% tax rate (company guidance), we are at about $3.7bln in earnings. D&A is slightly higher than capex by about $50mmm, but assuming they are the same, this results in a 37% FCF margin (vs. 48% this past quarter) or an 8% FCF yield on enterprise value. Assuming they meet the high end of guidance, we see a FCF yield of 9% on our 37% FCF margins (conservative given high incremental yields in QTL business where our ASP numbers are below guidance).

Generally, given the high returns on invested capital, 3G growth, strong management team, IP protection and chipset innovation, I don't believe this is the sort of company that should trade at such a high FCF yield.

DCF:

Based on some fairly draconian assumptions in ASP declines in both QTC and QTL, I estimate fair value at $54 or 45% upside from here. In QCT, I assume 15% in volume growth between 2010 and 2013 as feature rich phones take share, with declines to 10% growth from 2013-2017 and 5% from 2017-2024. I also assume -7.5% annual pricing declines each year as increased competition reduces ASPs on chips. In QTL, I assume the same unit growth as QTC and -5% annual drops in ASPs. Based on a 3.5% terminal growth rate and 9% cost of capital, our fair value is $54. I believe those estimates are conservative since we assume the company has absolutely no pricing power in chipsets, while their designs are innovative and in QTL, we assume very little volume growth (in reality, with new devices and 3G adoption in emerging markets, growth should be much higher) and ASPs should stabilize in the future.

Put another way, based on all of our other assumptions, at $39/share, the market is currently pricing in -13% ASP drops in QTL for every year through 2024! I certainly do not believe phone prices will drop so significantly for so long.

Conclusion:

This is a great business with substantial barriers to entry and should see continued growth with 3G and 4G adoption worldwide. The company reported one quarter with a large ASP drop and the market is pricing in a much worse picture than reality and given how low ASP guidance is for the year, I believe that as they beat and raise next quarter, the market should restore value here. 

Catalyst

-Stabilization of ASPs in QTL next quarter

-Beat and raise by the company should restore confidence in management and positive sell side commentary

-Continued volume growth in 3G handsets