Qualcomm (QCOM, Financial) was a top detractor during the first quarter. Shares retreated after President Trump issued an order to block any attempt by Broadcom to acquire Qualcomm shares or stage a proxy contest, per research from the Committee on Foreign Investment in the United States (CIFIUS). As best as we can tell, given the limited public disclosures, CFIUS speculated that any change in control from Qualcomm to Broadcom could pose a risk to the national security of the United States. Specifically, CFIUS claimed that Qualcomm’s research and development (R&D) efforts were critical to the U.S.’ leadership in the development of global wireless communications standards, and worried that any efforts by Broadcom to defund that R&D risked a “reduction in Qualcomm’s long-term technological competitiveness and 17 influence in standard setting [which] would significantly impact U.S. national security,” especially vis a vis China.5
While we’re not surprised that this deal was terminated, we are surprised that it was terminated in this manner. First, as we have frustratingly witnessed, regulators the worldover – including our own U.S. FTC – have pressured Qualcomm’s business model, and therefore R&D, for years, either through fiat and/or lawsuit. Second, Apple (one of Qualcomm’s largest customers) has indemnified and compelled its Chinese contract manufacturers to withhold several billion dollars in very high margin payments to Qualcomm over the past 15 or so months with little or no pushback from U.S. regulators. In addition, Huawei – a quasi-Chinese SOE – has mimicked Apple’s behavior and withheld – what we estimate to be – several hundred million in high margin revenue dollars over the same timeframe – again, no regulators seem to have a problem with this. So, it makes us wonder why CFIUS and U.S. POTUS decided that Broadcom’s proposed ~$80 per share offer for Qualcomm represents the most intolerable potential risk to the national security of the United States, when clearly Qualcomm has already been pressured by the actual activities of governments, including the U.S. In fact, we’d argue that the actions (and inactions) of regulators, particularly during the past 15 months, are what precipitated Broadcom’s attempt at unlocking growth and value at Qualcomm.
Despite this detour, we will continue to be patient with our Qualcomm ownership, as we think many investors have become overly negative. For example, it is consensus to assume close to zero revenues from Apple and Huawei over the next year, and maybe longer. However, Apple (and we suspect Huawei) is accruing expenses for a potential settlement with Qualcomm. While that might be an accounting necessity, we think it’s also indicative of a real probability. Second, Qualcomm has set several hundred commercial precedents with handset OEMs, most recently with Samsung – the largest handset OEM by units – and offered similar licensing terms to Apple. So we are highly skeptical Apple is being treated unfairly, despite its claims. Once these commercial arrangements are settled, we expect Qualcomm’s longer-term organic growth to be driven by the global shift to 5G standards, where Qualcomm has dominant technological positioning. Further, we think there continues to be a high probability that the Company’s acquisition of NXP Semiconductor will get approved in the coming months, which could lead to sizable earnings per share accretion.
From David Rolfe (Trades, Portfolio)'s Wedgewood Partners first quarter 2018 shareholder letter.
