While in search of inexpensive, consistent dividend growth stocks, Qualcomm found its way back on my radar after the stock price fell over 30% from its highs at the beginning of 2022. At first glance, the company possessed confounding valuation metrics when compared to itself, other chip stocks and its growth rates warranting an objective assessment of the company. In this article, I will attempt to deconstruct Qualcomm’s story to understand the market’s perception of the company and determine if there is an opportunity.
QUALCOMM BUSINESS OVERVIEW
Qualcomm is a global semiconductor company that designs, develops, and sells wireless telecommunications products and services which serve to form the foundational technologies for 3G, 4G, and 5G wireless connecting as well as high performing, low power processor technologies. The company derives its revenues from the sale of its integrated circuits (chips) primarily under the Snapdragon platform (which include processors and modems) as well as through the licensing of its intellectual property. Qualcomm is best known for its handset chipsets, but also possesses a diverse portfolio of intellectual property that appear to form the foundation for a reasonably strong moat for the company.
Qualcomm reports its revenue in two segments – Equipment and Services primarily comprised of its QCT (Qualcomm CDMA Technologies) business which includes 4 categories including handsets, RF front-end (RFFE), IoT and Automotive, and Licensing primarily comprised of its QTL (Qualcomm Technology Licensing) business which consists of licensing revenues principally from royalties for mobile handsets.
QUALCOMM’S STORY
Qualcomm has been the beneficiary of the growth in connected devices such as smart phone, tablets, and the like reported as ‘Handsets’. This has been particularly true over the past couple of years during which the company experienced an explosion of growth in the post pandemic world. Revenues have risen ~43% and ~32% in 2022 and 2021, respectively, as a result of higher prices and a favorable revenue-mix focused on higher tier 5G products.
Annual Revenue By Business Segment ($ in millions)
Further, over the past few years, Qualcomm has become a far more profitable business as EBT margins expanded dramatically to 34% from 17% in 2019. The result has been a company creating dramatic economic value for shareholders with returns on invested capital and returns on equity averaging 25% and nearly 84%, respectively, over the past 5 years; figures that are hard to ignore.
There are a few thoughts to deconstruct, particularly as it relates to Qualcomm’s revenue growth shown in the table above – both positive and negative.
Revenue growth appears to be a result of demand pulled forward
First, the growth rates seen over the past couple of years appear to be anomalies relative to the years prior to the pandemic. We can argue that, similar to other distortions in demand caused by the pandemic, demand may have been pulled forward for Qualcomm’s products. Qualcomm’s FY 2023 Q1 results showed a deceleration from the previous year as revenues and EPS fell 12% and 34%, respectively. The declines were led by slowing demand in the handset and licensing businesses resulting in an inventory build that is expected to impact earnings through the first half of ‘23. I think it is fair to assume that the next few quarters will be similarly difficult for Qualcomm as a result of difficult comps and the challenging economic environment. Management guided for Q2 sales of $9.1 billion, which would be down 19% year over year and 4% sequentially with handset and automotive flat while IoT is expected to be down. That said, I think it is also fair to assume that these challenges are cyclical as opposed to structural as Qualcomm works to rectify its inventory issue and the economic cycle shifts.
Revenue Concentration
The FY 2023 Q1 results were not all bad as Qualcomm did see revenue growth in the Automotive and IoT businesses, however, this growth was not enough to offset the losses in the handset business. This brings me to my second thought on Qualcomm which involves the concentration of Qualcomm’s revenue. While Qualcomm has begun to diversify its revenue mix, the handset business’s revenue still makes up the majority of Qualcomm’s revenue in 2022 accounting for nearly 66% of QCT revenue and the vast majority of QTL revenue.
**Compiled and tabulated by Arbalist Money using 2022 Annual Report data.
The concentration of Qualcomm’s revenue in its handset business is worth emphasizing because it forms two of the major risks of owning the company, share loss in the chips business to customers like Apple developing in house intellectual property, and regulatory threats to the licensing business.
For years Apple has threatened to reduce its reliance on Qualcomm similar to Apple replacing Intel’s processors for the Mac. In January 2023, Bloomberg reported that Apple plans to develop its own cellular modem chip which would replace parts from Qualcomm. Though delayed, Apple’s transition to its own chips may play out as soon as 2025. At an investor day in December 2022, Qualcomm’s CFO, Akash Palkhiwala, acknowledged the loss of Apple’s business stating that he was assuming “minimal contribution from Apple’s product revenues in fiscal ‘25”, and as recently as February 28, 2023, in a CNBC interview, Cristiano Renno Amon, President and Chief Executive Officer shared that he has no plans to provide modems to Apple in ‘24. Despite the timing, this will have a significant impact on Qualcomm’s earnings. Some analysts believe Apple makes up around 22% of Qualcomm’s sales. In management’s discussion of results in the 2022 annual report, management states, “In fiscal 2022, revenues from Apple and Samsung each comprised 10% or more of our consolidated revenues.” The true impact, whether total or partial, appears to be inevitable.
In terms of potential regulatory headwinds, Qualcomm has faced, settled, and at times successfully defended numerous regulatory cases. One of the noteworthy regulatory risks facing Qualcomm involves scrutiny in countries including the U.S., Taiwan, China, and South Korea among other regions regarding Qualcomm’s licensing business. The inquiries revolve around whether Qualcomm’s royalties should be based on the full price of a phone or on some lesser base such as specific components. The impact of such a ruling could have a dramatic impact on Qualcomm’s higher margin QTL business.
Diversification of Revenue Mix
Management has been proactive despite these threats to Qualcomm’s business particularly by diversifying the company’s revenue mix adding IoT and Automotive as lines of business.
The IoT business involves the utilization of Qualcomm’s technology to connect devices beyond smartphones which in part involves enabling the use case for 5G technology. On the FY23 Q1 conference call, Cristiano Renno Amon shared his optimism for IoT which he believes is poised to become Qualcomm’s largest addressable market spanning across three categories: consumer, edge networking and industrial. The idea is to capitalize on the digitization of everything which I will briefly elaborate on in the next section.
In Automotive, Qualcomm is developing the Snapdragon Digital Chassis which the CFO called a $30 billion opportunity for Qualcomm. Cristiano Renno Amon called the digital chassis “the industry’s preferred purpose-built platform to help drive this innovation for the next generation of vehicles.” At CES, management introduced the Snapdragon Ride Flex, comprised of 3 domains: connectivity, digital cockpit and advanced driver assistance systems (ADAS). While CFO, Akash Palkhiwala has acknowledged Mobileye and NVIDIA as leading incumbents in the ADAS space, Qualcomm acquired Veoneer, an ADAS pure play, specifically for the company’s ADAS and autonomous driving systems software unit, Arriver, in August 2021. The integration of this software and unification of the three domains may offer Qualcomm an advantage by reducing the amount of hardware and software necessary to perform these functions for OEMs. This has helped Qualcomm win business with companies like BMW.
The question remains, can growth in IoT and automotive offset near-term and potentially permanent losses in the handset business? This is the risk of owning Qualcomm.
Secular Tailwinds
The good news is that Qualcomm has a secular tailwind, the digitization of everything. Semiconductors companies are expected to grow at a CAGR of 12% through 2029 as a result of the proliferation of digitization. Qualcomm’s collection of intellectual property positions the company to be a beneficiary of this trend. At Qualcomm’s investor day, Palkhiwala identified four areas of growth for Qualcomm:
- Personal Computers. Qualcomm recently acquired Nuvia as Qualcomm looks to grow in the PC market. Nuvia offers Qualcomm CPUs and technology design team expertise in high performance processors that will be integrated into certain QCT products.
- Metaverse. Palkhiwala believes that Qualcomm can benefit from Metaverse growth by integrating Qualcomm’s offerings into VR and AR devices.
- 5g Broadband. Despite the near-term economic challenges and uncertainty in China, Palkhiwala believes Qualcomm will benefit from growth of 5G broadband specifically citing growth in emerging market homes.
- Industry Transformation. Palkhiwala provides an example involving the digitization inside of retail stores.
BONUS – Artificial Intelligence. Qualcomm has begun developing AI offerings that will have impacts across its products. The company introduced the Snapdragon 8 Gen 2 mobile platform which includes a 5G AI processor that powers the camera. This platform will be integrated into the Galaxy S23 family of Smartphones expanding Qualcomm’s partnership with Samsung. Qualcomm also unveiled the semiconductor industry’s first 5G modem-RF chip that can be used not only in smartphones, but mixed reality (AR and VR) headsets, 5G networks and other areas bringing faster connections to devices, while also allowing them to get better signal strength, data speed and coverage.
RETURNING CAPITAL TO SHAREHOLDERS AND FINANCIAL STRENGTH
Adding to the appeal of Qualcomm is a $2.93 annual dividend and a healthy share buyback program. The dividend currently yields 2.44% and has been increased each of the past 19 years. The company’s most recent dividend increase to $0.75 per quarter was a 10% increase. The 5 year CAGR is ~5% and a 10 year CAGR is 11%. The dividend has a historic free cash flow coverage ratio around 2x and the payout ratio sits around 25% offering the potential for continued dividend growth.
Through share buybacks, Qualcomm has reduced its diluted shares outstanding by 35% since 2013.
It appears that Qualcomm can afford returning capital to shareholders with a FCFE coverage ratio of 1.07 in 2022. This means that Qualcomm covers the dividend and share buybacks with free cash flow even after debt payments. While we did not see a deterioration in these metrics in Q1 FY ‘23, it is entirely possible to see an impact on the FCFE coverage ratio for Qualcomm in the near-term as a result of declining earnings impact on FCF. This may be partially offset by a reduction in capex as Qualcomm showed to start the year. A number below one would imply that other capital outside of free cash flow would be needed to fund the dividend, share buyback and repay debt; however, given the strength of Qualcomm’s balance sheet, these capital return programs should remain safe.
With that said, we have seen a significant reduction in cash not only attributable to aggressive share repurchases, but Qualcomm’s acquisitions which have primarily been cash purchases. Qualcomm currently has about $6 billion in cash and about $16 billion in total debt. It would not be surprising to see management slow the pace of share repurchases to build its cash position, or to favor additional acquisitions to reach their targets in growth areas.
VALUATION
Based on Qualcomm’s valuation, it appears that the market is focused on the negative aspects of Qualcomm’s story. As mentioned, Qualcomm is down over 30% from its peak at the beginning of 2022, perhaps rightfully so. Qualcomm’s management faces tough competition particularly in the areas Qualcomm hopes to grow, and very real risks to margins and earnings for reasons previously mentioned.
As a result, the company is trading around 13x analysts 2023 estimates of $9.40, well below its 5-year average of 16x and 10-year average of 18x. Further, the company’s 5-year average EV/EBITDA ratio is around 26x, now trading around 10x 2023 estimates. These metrics are also significant discounts to its peers. All of this is to say that it appears that the market is aware of and pricing in the risks to Qualcomm.
To quickly get a sense for a reasonable valuation for Qualcomm, let’s use Graham’s valuation formula.
In an effort to be more conservative, I am going to modify the formula to assume a company with no growth trades with a P/E of 7 instead of 8.5, and use a multiplier of 1x instead of 2x growth.
The consensus analyst earnings estimates for Qualcomm is 8% CAGR through 2027. This assumes a 25% decrease in earnings in 2023, growth in 2024, another decline in 2025 most likely as a result of Apple and then an acceleration of growth. The other inputs include Qualcomm’s TTM EPS of $10.38, and the 20 year corporate bond rate of 5%. When computed, the result is an intrinsic value of $136.74. Since the formula leaves room for error based on the inputs, we will ask for a 25% margin of safety which brings us to $102.56. I think we could make a strong case seriously considering Qualcomm at those levels.
CONCLUSION
Qualcomm’s management appears to have a solid strategy for moving the company forward as it faces some serious risks namely regulatory risks particularly related to its licensing business as well as execution and competitive risks to diversify its revenue mix and offset the loss of business from major customers like Apple. Even at these levels, those willing to bear these risks could consider buying Qualcomm given the already depressed valuation, strong portfolio of intellectual property, reasonable strategy, secular tailwinds and solid capital return history to shareholders. Those more risk averse may want to look for a greater margin of safety when factoring in the near-term economic headwinds and the considerable amount of uncertainty surrounding this name. However, at some price all companies become bargains. Given what we know, Qualcomm appears to deserve serious consideration below $100 per share. That price would offer a reasonable cushion for the uncertainties mentioned, and all things being equal, the stock would offer a nearly 3% dividend yield and trade at 11x 2023 estimates.
In the meantime, I will be closely watching how the handset business holds up given the risks as well as developments as they relate to the company’s efforts to diversify their revenue mix. Execution on this front will meaningfully offset much of the uncertainties discussed and increase the investable case for Qualcomm.
