The Case for Qualcomm That Value Investors Don't Want You to Know

I love to find businesses that we can’t live without but are currently out of favor with the market. As long as the business is out of favor due to investor sentiment or a problem with the business that can be fixed over time, I tend to get excited about the long-term opportunity.

If I find a problem that has produced a permanent impairment to the business, I steer clear. There are always existing or soon-to-come opportunities to great businesses at undervalued prices, and I would rather hold cash than lose it because I was not patient enough or underestimated the risk involved in an investment.

There is no question that Qualcomm’s (QCOM, Financial) products are indispensable to our way of life. They are the global leader in mobile chipsets and they get a royalty for every cell phone sold in the world that contains their chipsets.

About the business

Qualcomm develops, designs and manufactures chipsets used in digital communications products (primarily smartphones) around the world. The company operates through three segments.

Qualcomm CDMA Technologies (QCT) develops and supplies integrated circuits and system software based on code division multiple access, orthogonal frequency division multiple access, and other technologies for use in voice and data communications, networking, application processing, multimedia, and global positioning system products. These are the product lines for which the business is most commonly known to consumers. It is also not uncommon for this to be the primary knowledge of the business held by casual investors.

Qualcomm Technology Licensing (QTL) grants licenses or provides rights to use portions of its intellectual property portfolio. These licenses and rights include various patent rights useful in the manufacture and sale of certain wireless products comprising products implementing CDMA2000, WCDMA, CDMA TDD, and/or LTE standards. They will also include their derivatives. This is the segment of the business that is responsible for Qualcomm’s products or licenses to its technology being used in so many of the world’s mobile devices.

Qualcomm Strategic Initiatives (QSI) is the investment arm of Qualcomm. It invests in early-stage companies in various industries, including digital media, e-commerce, healthcare, and wearable devices for supporting the design and introduction of new products and services for voice and data communications. It also holds the rights to the company’s wireless spectrum.

Why is the stock cheap now?

As we saw with Microsoft (MSFT, Financial) in years past, Qualcomm has to some extent become a victim of its own success. Its products are unquestionably the industry’s best. It also dominates the market and aggressively protects and enforces its patent rights.

The company has also long struggled with Chinese businesses failing to fully pay for their use of the company’s intellectual property and China’s failure to provide acceptable legal remedies against the local violators.

In recent years, the Chinese government and local manufacturers have accused Qualcomm of monopolistic and predatory practices. Since the rule of law in China tends to be whatever they decide it is that day, the cloud of uncertainty hanging over the company for the last two and a half years has decimated the stock price, while the market waited to find out the results of the “investigation” taking place in China.

Surprisingly, the Chinese legal system ruled in favor of the local manufacturers and deemed Qualcomm guilty of overcharging due to their technological monopoly in the industry. They have issued a fine against Qualcomm and ordered it to lower its licensing fees.

The new concern this presented to investors regarding Qualcomm’s global business is whether other countries would follow suit. They have. After all, what self-respecting government on earth would pass up the opportunity to take money from a private sector business when they have the power to do so?

The chart below shows the pain that has been inflicted on shareholders over the last three years.

Now that the governments of the world have aligned against Qualcomm, a settlement will be reached. Qualcomm wants to survive and if they don’t, there will be no cash for these governments to collect. It will be in everyone’s best interest to settle this matter in a way that gives everyone some of what they want.

Make no mistake, the governments involved just want a payoff, and Qualcomm just wants to put this mess behind them. Qualcomm will pay a large but manageable fine and agree to play nicer in the future. Meanwhile, investors who have been holding the stock since May 2014 have experienced a loss of about 44.6% of their invested capital.

While this charade has severely punished existing shareholders, as it comes to its inevitable conclusion of a settlement, those courageous souls who enter into long positions in the stock today will be the ones who ultimately benefit the most from the almost certain outcome as the stock price recovers and begins to reflect the true value of this dominant business.

How is the business currently valued?

Qualcomm is currently projected to earn $4.10 per share in the fiscal year ending September 2016 by the 30 analysts covering the stock. Based on Friday’s closing price of $44.56, if the company meets this expectation, it is currently trading at a price to earnings multiple of 10.86 times the current year’s earnings. This is really cheap for a business that is so dominant in its industry.

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The company is also projected to earn $4.77 per share in fiscal 2017. This would bring the valuation in at only 9.34 times forward earnings. Again, this is a very low valuation when compared to the current estimated forward P/E of 15 times earnings for the S&P 500.

If this dominant business were to simply be priced in-line with the broad market, it would be trading at $61.50 per share, or 38% above its current price level.

What are the future prospects for the business?

All of my regular readers know that I am a big proponent of the Internet of Things (IoT) and the massive changes it will bring to our lives as it becomes a reality. Since the IoT will consist of the wireless connectivity of all of the devices we have in our lives, who other than the world’s leading provider of advanced chipsets that run these wireless devices will benefit the most?

That’s right, barring some major unforeseen event, Qualcomm’s technology and equipment will front and center in these sweeping changes, and the company will profit handsomely.

Despite the short-term negatives that will eventually be resolved, it would be difficult for Qualcomm’s future to be much brighter. They might be forced to take a bit less per item, but they are going to deliver so many more items it will not matter in the long-term.

The analysts currently covering the stock are projecting earnings to grow at an annual pace of 12% over the next five years.

If we apply a conservative price to earnings growth multiple of 1 to the $4.10 per share the company is expected to earn this year, we would have an estimated current fair value of $49.20 or 10.4% above the current price.

However, if we apply that same valuation methodology to the estimated earnings of $4.77 per share projected for fiscal 2017, we would derive an estimated fair value of $57.24 or 28.4% above the current price.

How strong is Qualcomm?

I never seriously consider any investment without a review of its balance sheet. I used to have a director of finance who would always respond with: “What do you want them to be?” anytime I would ask what earnings were going to be for a given month. He was only half joking. There are a lot of ways to “massage” earnings to reach a desired number. Balance sheets can be manipulated but not nearly as easily as earnings, and these days the manipulation of balances sheets can get you thrown in jail.

My system for reviewing balance sheets is pretty straightforward. I look at liquid, short-term assets (cash, receivables and inventory) and compare it to the total liabilities of the business. A company that can liquidate its short-term liquid assets and pay off all of its liabilities is generally a pretty safe business in terms of being able to survive just about anything.

Qualcomm’s balance sheet fits the bill in this regard. At the end of December, the company was holding $19.067 billion of highly liquid assets. Against these assets, the total liabilities of the business are only $19.996 billion. So, while Qualcomm could not completely eliminate all of its liabilities with current liquid assets, it could come close. This is not a business that is at risk by any stretch of the imagination.

Assets

All numbers in millions of U.S. dollars

Dividends are the most overlooked aspect of profitable investing

Between 1930 and 2014, 40% of the total return of the S&P 500 came from dividend payments.

Almost all stocks have periods of over performance and under performance based on price alone. However, business that consistently pay dividends and relentlessly increase those payments eventually outperform in terms of total return.

Qualcomm started paying a dividend in 2003 and has paid it consistently quarter after quarter since. In March 2013 its first dividend was 5 cents per share. When it pays its next dividend on March 13, 2016 (February 29, 2016 ex-dividend), it will be 48 cents per share. This represents an annualized increase of 19% in the dividend payment for the last 13 years. The stock currently yields a very healthy 4.31% against the current share price.

Qualcomm has consistently raised the dividend amount every four quarters since its inception and, if that trend holds, shareholders will be rewarded with another increase for the June quarter.

Final thoughts and actionable conclusions

Qualcomm has some serious issues facing it at the moment. However, it will be in the best interest of all the parties involved in these issues to settle them without doing permanent damage to the business. One thing we can be sure of when it comes to politicians, they will always protect their own interests first. These problems will be resolved and Qualcomm will continue to dominate the market for mobile chipsets and become a dominant player in the IoT as well.

The question is: Are we now at a bottom in the stock? I don’t know. What I do know is that the business is currently priced cheap and has a very solid balance sheet and future. From this point, the stock could begin to move higher or it could move lower. It is anyone’s guess. We will all know when we look back.

I do not mind owning the stock at today’s price and can withstand any future downside based on my assessment of the current fair value. I have never felt the need to try and pick bottoms or tops in stock prices. I just try to pick great values. I also like the thought of collecting a 4.31% (and rising) yield on my capital, while I wait for the market to assign a more reasonable value to this world-class business. As a value investor, I much prefer for the stock to stay cheap forever as it allows me to build a larger position for less costs.

I did, however, find an interesting opportunity when researching Qualcomm for opening a new position. Sell the March 18, 2016 $40 put option for about 70 cents per share for an immediate return on capital at risk of 1.75% over the next 33 days, which results in a 19.25% annualized return on allocated capital, while waiting to buy the stock at a 10.2% discount to its current market price.

Sometimes patience pays…and pays very well whether you end up holding the stock or not. Each contract will obligate you to potentially buy 100 shares of Qualcomm stock at $40.00 per share so you capital requirement is $4,000 per put option you sell.

This approach might cause you not to end up owning the shares at all, but if you don’t you will have been paid quite well for waiting. If you do, you will buy them for a 10% discount to today’s price and have been well-paid for waiting to get the discount.