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Ken McGaha
Ken McGaha
Articles (67)  | Author's Website |

If I Could Buy Qualcomm, Shouldn't You Buy It First

August 02, 2014 | About:

Due to some of my life experience with private equity type transactions and the purchases and sales of closely held and family owned businesses, I sometimes like to apply that approach to large publicly traded companies just to help assess the market valuation compared to what the business would be worth to a private buyer.

The recent price reversal in shares of Qualcomm Incorporated (NASDAQ:QCOM) caused the business to appear on one of my value screens and I decided to see if the business would be a good acquisition for an individual. You might be surprised at what I found.

For those who might not be familiar with Qualcomm and its business. Qualcomm’s best known product is its code division multiple access (CDMA) which allows several transmitters to send information simultaneously over a single communication channel without interfering with each other. This allows multiple users to share a band of frequencies and increases the number of communications that can be conducted at the same time in a limited amount of bandwidth. Without this advancement in communications technology, our transition to a wireless existence would be severely restricted. If you use wireless communications devices, you probably own Qualcomm products or products where the manufacturer has paid a licensing fee to Qualcomm for using their technology. Once again, here is a business that provides a product or technology without which our society does not continue to function in the same manner as it does today.

The Creation Of A Buying Opportunity

Qualcomm is the unquestioned dominator in its field but even that position can have its own problems. China has recently become the world’s largest market for smart phones where Qualcomm’s technology excels and provides a crucial function. China has also decided to declare Qualcomm a monopoly; not such a good thing.

Qualcomm has also recently charged some Chinese manufacturers with shipping more products, for which they should be paying license fees to Qualcomm, than they are reporting to Qualcomm. They are also experiencing problems with some small tablet manufacturers not paying license fees and royalties. These short-term problems are all very solvable. However, as we see over and over again, some short-term and solvable issues have panicked investors and they headed for the door in droves. On their way out, they drove the share price down 10.24% from $81.97 to the current level of $72.55

What Is The Downside Risk?

The stock market is an emotionally driven creature and stocks can, at times, trade at just plain silly valuations both in terms of being overvalued and in terms of being undervalued. The market is also capable of maintaining crazy valuations for extended periods of time. But, in the end, value always wins out and prices will return to a level that reflects the true value of the business.

One way to determine if current valuations are out of line with the fair value is to ask myself if I would be interested in buy the whole business instead of just a few shares? In the case of Qualcomm, the answer is a resounding “yes”. I will not rehash the critical need for their products and technology; I will just go straight to the mathematics.

QCOM has a current market value of $121.6 billion, so I am currently a bit short of the cash required to buy the company. However, I could come up with a 10% down payment. No, I am not worth $12.16 billion; but, Qualcomm does have $18.153 billion in cash and short-term investments on their balance sheet as of June 30th. In addition, they have receivables of $2.084 billion and another $1.185 billion of inventory that could be liquidated. If I owned the business, I could take $12.16 billion in cash off the balance sheet and make my 10% down payment on the business. Of course, that would leave me with an additional $6 billion in cash that I could pay myself as a bonus for closing the deal.

In today’s zero interest rate world, companies like Microsoft (NASDAQ:MSFT) and Intel (NASDAQ:INTC) have been able to issue long-term bonds at 3% to 4% interest rates. Even if I had to pay 25% more interest, because I am not that smart, the total interest payments on the remaining $109.44 billion in bonds I would have to issue to finance the remaining 90% of the purchase price would only be $5.472 billion a year. Since QCOM had free cash flow of $7.73 billion for the year ended September 30, 2013, I could pay the interest on the bonds and still have $2.25 billion left over with which to provide myself a meager salary.

Now, we all know I am not going to be able to structure a deal to buy Qualcomm and take it private; but, QCOM could certainly eat itself by implementing an aggressive share buyback program using cash on hand and issuing debt. The numbers are what the numbers are and a deal of this type would make sense as far as what it would be worth to a private party. I don’t believe for one moment that a transaction like this will happen; running the numbers on it simply reveals just how compelling the value of this business is at the current price. This tells me there should be ample downside protection in terms of the value of the business. Anyone who tells you they know with certainty what the lowest price could be and gives you a number above zero will likely be wrong about other things as well. Price is set by emotion; value is established through analysis.

What Is The Real Fair Value And Upside Potential?

I always caution people about using earnings projections for establishing fair value because I know how easily per share earnings can be manipulated within accepted accounting rules. I do understand that most people use this metric so it is important to consider. Qualcomm is expected to earn $4.84/share for the fiscal year ending September 30, 2014. Based on the current share price of $72.55, the P/E is established at a very reasonable 15.05 times current year earnings. This estimate would produce an increase of 20.26% over 2013. Analysts are currently projecting the company to experience annual earnings growth of 14.6% for the next 5 years. It is reasonable to expect the share price to rise along with the rate of earnings growth when it is currently trading in line with that figure.

For my analysis work, in the tech sector, I like to use the average of the previous 5-year average annual returns on equity, assets and capital multiplied by the current year’s earnings to establish fair value. In the case of Qualcomm, that calculation results in:

[{(16.4 + 12.2 + 16.2)/3} X $4.82] X 1.25 or $89.97/share fair value. If you discount the share price by the $12.76/share of cash, receivables and inventory on hand, you can argue that the fair value is actually closer to $100/share. The stock price would have to rise 37.8% from where it is today to reach this level.

If we assume the share price increases at the same pace as the earnings, the stock should return about 15% annualized over the next five years. If the valuation closes the existing gap between current price and fair value while also increasing in proportion to earnings growth, the returns could become spectacular.

Final Thoughts And Actionable Conclusions

There are never any guarantees when it comes to investing and markets can and do assign ridiculous values to both good companies and bad ones at various times. While Qualcomm is certainly a compelling value at the current price in my view, that does not mean the price cannot or will not move lower. Successful investing is not about picking exact tops and bottoms in price, it is about recognizing and seizing upon compelling values when they are found and liquidating them once they are loved by all. Trying to pick exact tops and bottoms will cost you money on both ends over the long haul.

Now, for those who just like to pick up a compelling value and put it away for several years while the market corrects its mistake, just pick up a few shares of QCOM at the current market price, I think you will be quite pleased with your double-digit annual returns over the next 5 to 10 years.

Investors who just have to get a discount on everything they buy without regard to the actual value, can consider selling one $70 strike price September 20, 2014 expiration put option for each 100 shares of the stock they would like to buy and receive a premium of around $1.10/share or 1.57% over the 48-day life of the contract. If the shares stay above $70, the options will expire worthless and you will keep the premium collected for the sale and produce an annualized return of 11.9% on the $7,000 of capital that would have been required to purchase the shares covered by each contract sold.

Investors who like dividends but find most of them just a bit too meager could buy the shares in the market and, for each 100 shares purchased, sell one $75 strike price call option with a September 20, 2014 expiration date and collect a premium of about $0.85/share. This will produce an immediate return on invested capital of 1.13% over the 48-day life of the contract for an annualized return on allocated capital of 8.6%. However, this trade option is better than that. Qualcomm shares go ex-dividend for shareholders of record as of August 29th and that dividend will be $0.42/share increasing the return to $1.27/share (the sum of the option premium plus the dividend) or 1.75% for 48 days. This increases the annualized return to 13.3% on invested capital.

Should the share price rise above $75 by September 20th, the option seller will lose the shares to the buyer but will collect an additional $2.45 (75-72.55) in short-term capital gains. This result would increase the total profit to $3.72 or 5.12% on invested capital. This results in an annualized rate of return on investment of 38.96% over the next 48 days.

I just love finding undervalued businesses that provide products or services we do not want to try to live without. I also really like to have multiple choices for attractive ways to open a new position. Qualcomm scores high in all respects.

About the author:

Ken McGaha
Ken McGaha has been managing his own investment portfolios for over 25 years.

He is a full-time copywriter as well as a freelance contributor to several investment related websites.

Ken also prepares analysis pieces of individual stocks on a contract basis for other individual investors.

Visit Ken McGaha's Website

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