Qualcomm QCOM
July 20, 2018 - 12:44pm EST by
giantfan
2018 2019
Price: 58.89 EPS 3.24 5.25
Shares Out. (in M): 1,483 P/E 18.7 11.2
Market Cap (in $M): 87,311 P/FCF 0 0
Net Debt (in $M): -16,600 EBIT 0 0
TEV ($): 70,799 TEV/EBIT 0 0

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Description

 

Qualcomm (QCOM)

Long QCOM

(Please see Disclaimer below)

 

Pitch:

        QCOM operates a growing and sustainable business model and leads in wireless data innovation.

        Stock is very cheap and no one even remotely believes management's FY19 guidance.

        Investors are paying 'nothing' for optionality tied to license dispute resolutions with Apple (AAPL) & Huawei.

        Target price is $73.50 (+25%).  

 

Business Overview: Please see Value1929's 2/18/17 write-up for background.

 

MAJOR TOPICS:

NXP Semiconductors (NXPI)

      Deal originally announced more than 18 months ago!  Held up largely due to regulatory issues in China.  We will probably know next by Wednesday 7/25 if the deal will be consummated or scuttled.  QCOM management has made it clear they are finally willing to walk away if the Chinese don't approve the deal.

      China's regulator MOFCOM has stymied the deal citing worries over consolidation and patent licensing practices. 

      The deal has gotten intertwined with ZTE, a Chinese telecom networking provider, which violated US sanctions against North Korea and Iran.  Trump killed ZTE by stopping all US technology sales to the company.  ZTE has paid $1.4B in fines and brought on a new Board and Exec team to lift the kill order.  In return, MOFCOM was expected to bless the deal.  The Trump trade war has possibly gotten in the way. 

      If deal falls through QCOM has pledged to recapitalize the balance sheet and repurchase $20B-$30B worth of stock (as much as 35% of the market cap) which would be $1.50 accretive.  We win no matter what happens. 

Apple (AAPL) and Huawei:

        AAPL is QCOM's largest customer – mostly royalties which are paid by AAPL's ODM partners (Foxconn, Wistron, Pegatron, Compal) who are reimbursed by AAPL.  AAPL does not have a direct license with QCOM.

        AAPL stopped paying royalties to its ODM partners in FY 3Q17 citing a litany of complaints.  AAPL and QCOM are currently engaged in numerous lawsuits globally. 

        Ultimately, longs are betting that QCOM and AAPL settle their many disputes on the courthouse steps later this calendar year.  The most important suit is in Germany where QCOM and AAPL executives, including AAPL CEO Tim Cook, are likely to testify publicly.  There are also many cases in US District Court, at the International Trade Commission (ITC) and in China. 

        I estimate the bid-ask on royalty discounts to the current payment structure are 33%-60%.  AAPL will receive a discount off of their current implied royalty payment – but as long as that discount is not 100% and these lawsuits are settled in a reasonably timely manner then the overhang will be lifted and the stock will go up considerably.

        AAPL also owes QCOM billions in unpaid royalties which are currently accruing.  The figure could be as high as $6B.

 

        Huawei is the third largest smartphone manufacturer in the world.  It is both a customer and competitor of QCOM.  Huawei was likely the third largest customer of QCOM's QTL segment paying ~$700m annually in royalties. 

        Huawei stopped paying QCOM all royalties FY 3Q17.  QCOM has not named Huawei explicitly but everyone knows the truth. 

        Huawei did this on the back of AAPL, hoping that pressure on QCOM's earnings and stock price would bring QCOM to the negotiating table. 

        Huawei is probably not disputing the validity of the patents or the need to pay royalties.  Rather, they want a discount given the imminent rollout of 5G which include significant IP from Huawei.  Huawei has been a big contributor of patents to the 5G consortium administered by 3GPP and likely believes that they deserve a reduced royalty rate from QCOM given the obvious need to cross license.

        Resolution likely occurs either when a) Chinese/US tensions trade die down or b) after AAPL resolves its patent dispute.  

 

Samsung:

        Samsung is the world's biggest smartphone manufacturer and QCOM's second biggest customer. 

        Samsung signed a 5-year cross license agreement with QCOM January 2018 which validates all of QCOM's patents and their patent licensing regime while giving Samsung a step down in royalty rate. Samsung, like all licensees, now gains access to all of QCOM's 5G patents for one lower royalty rate. 

        QCOM signed this deal to pressure AAPL: it validated QCOM's patents and licensing practices.  QCOM can now argue in court that AAPL is way out of line with their peers given that they currently pay nothing for QCOM's patents. 

        The step down in royalty rate is already baked into guidance.  I estimate Samsung's royalty rate went from 1.5% to 1.0%.  

 

QCOM Stock is a Cheap Option:

      The table below demonstrates that Street Expectations imply a 52% Haircut for the ENTIRE QTL business.  for 2019 Pretax Income Imply that the Entire QTL Business gets a ~52% Haircut.  This INCLUDES the non-AAPL/Huawei business.  In my estimation, this is an absolute worst case scenario where AAPL, Huawei and EVERYONE else get a 52% cut across the board. 

      This is extremely aggressive given we know Samsung probably took a 33% cut. 

      Additionally, QCOM's new 5G FRAND Royalty rate card which was published in November 2017 explicitly offers up an at worst 40% cut. 

 

FY19

 

Revenue

   

QCT

        17,786

MS Estimate

Apple

           1,536

$3.2B in sales before cut

Huawei

              384

$800m in sales before cut

Everyone Else

           1,920

Mgmt guided new run rate is about $1.0-$1.1B per Q now

QTL - Total

           3,840

 

QWI

                  -  

 

Total Revenue

        21,626

 
     

Pretax Income

   

QCT

           3,039

MS Estimate

Apple

           1,075

70% Margin

Huawei

              269

70% Margin

Everyone Else

           1,344

70% Margin

QTL - Total

           2,688

70% Margin

QWI

            (200)

 

Total Pretax Income

           5,527

 With Implied Patent Rate Haircut (below)

     

Pretax Income

           5,532

Implied by Guidance (Street is at $5.9B)

     

Tax Rate

15.0%

MS Estimate

     

Net Income

           4,703

 

     

Shares Outstanding

           1,494

MS Estimate

     

Core EPS

 $          3.15

Implied from Guidance

     
     

Implied Patent Rate Haircut

 

52%

   

 

Management's  FY19 Guidance:

      No one believes management's FY19 guidance of $6.75-$7.50; Bloomberg consensus is $3.50. 

      Amazingly, $3.50 is not far above what management implies for 'Core EPS' in 2019.  Core EPS excludes the Cost Reduction Program ($0.60), NXPI or Buyback Accretion ($1.50) and Licensing Resolutions ($1.88 at the Midpoint of Management's Expectations).

      Two of these three buckets are easily within management's control and will become evident in the next 3-6 months.  The third is 'free' as previously discussed. 

   

FY19

 
   

Non-GAAP EPS

 
 

Core EPS

 $                    3.15

 

Add:

     
 

Cost Reduction Program

 $                    0.60

$1 Billion in SG&A/R&D at 15% Tax Rate

       
 

NXPI Accretion

 $                    1.50

Or a Buyback

       
 

Licensing Resolutions

 $                    1.88

Range Given: $1.50-$2.25

Total:

     
 

Management EPS Midpoint

 $                    7.13

Range Given: $6.75-$7.50

       
       
       
 

License Dispute

   
 

($ in millions)

FY19

 
 

Revenues & Pre-Tax Income

 

100% Margin

 

Apple

                     2,600

$3.2B estimated from MS

 

Huawei

                         650

Residual

 

Total Revenue/Pre-Tax Income

                     3,250

Range Given: $2.5-$4.0B

       
 

EPS

   
 

Apple

 $                    1.57

Taxed at 15%, 1.49B shares

 

Huawei

 $                    0.31

Residual

 

Total EPS

 $                    1.88

Range Given: $1.50-$2.25

       
       
 

Also:

   
 

Catch-Up Royalties

                     6,000

Range Given: $5-$7B

 

After-Tax Cash

                     5,100

 

 

Per Share

 $                    3.41

6% of QCOM Share Price

 

 

 

Price Target:

      QCOM is inexpensive; it trades at 8.5x the low end of management's FY19 EPS guidance.  The median EPS multiple over the past 5 years is 14.0x.  The company's 4.3% dividend yield is the highest in the entire semiconductor industry. 

      The balance sheet is unlevered: $40B of cash and $23B of debt. 

      My price target is $73.50 and would represent a 14x forward EPS  multiple on management's FY19 'core' EPS plus the benefits of the Cost Reduction Program and NXPI Accretion/Buyback.  This of course excludes any benefit from resolutions with Apple/Huawei. 

 

Risks:

      AAPL does not settle and drags out the litigation.  A non-resolution remains an overhang on the stock for years. 

      Smartphone penetration in the developed world is approaching 100%.  Growth is slowing.  Without increased innovation the average user's replacement cycle will elongate. 

      More competition: Intel now owns >50% of iPhone modem designs.  Samsung is putting more Exynos APUs in their own phones.  Mediatek and Huawei are taking share in China smartphones. 

      Regulatory Risks: QCOM has been the subject of numerous regulatory investigations around the world related to its licensing practices: China, Korea, Taiwan, EU, US.  More could come. 

 

DISCLAIMER: The author is long QCOM.  This is not a recommendation to buy or sell any investment.  Additionally, this document should not be relied upon to make an investment decision as the numbers and figures presented are solely the author’s estimates.  Investors should contact the company directly and read QCOM public filings to form their own opinions and make their own investment decisions.  The author may transact in the securities of QCOM without notice.  

 

 

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

  • NXPI deal resolution.  Or massive $20-$30B Buyback.  Imminent.
  • AAPL dispute resolution.  2H18
  • Huawei dispute resolution.  2H18
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