Buy Qualcomm Despite China Chaos
After the bell on Wednesday, Qualcomm (NASDAQ:QCOM) reported its third quarter earnings, and Wall Street was pretty unimpressed with the results, knocking shares down 4%. QCOM shares had been gaining some momentum ahead of this report with shares hitting a new 52-week high during the regular session. After this release, the momentum has likely come to an end, and in the immediate term, I would not be surprised to see shares trade all the back down to $75. As an investor in QCOM, this report was deeply disappointing; however, I believe the long term story is still intact as the world is increasingly mobile and reliant on smartphones. As the premier patent holder and chip marker, Qualcomm will profit from this trend. With its outsized cash balance, the stock is also very attractive value. On a drop below $77, I will probably add to my position and suggest you buy some as well.
In the third quarter, Qualcomm earned $1.44 on revenue of $6.81 billion, which compares favorably to consensus of $1.22 on sales of $6.52 billion (financial and operating data available here). Backing out a gain of $0.12 thanks to a favorable legal decision, earnings were $1.32, still better than estimates. EPS was up 40% year over year and 10% sequentially while revenue was up 9%. At face value, these numbers seem pretty solid, but some of the internals of the report were a bit weak. More importantly, Qualcomm's guidance was very disappointing, as was its commentary on China.
First though, let's examine the third quarter more closely. MSM chip shipments came in a solid 225 million, which was up 31% year over year. This growth is a sign of how robust the smartphone market remains; however, chip revenue jumped a relatively meager 17%. This obviously implies that average selling prices were significantly lower year over year. China has been fighting Qualcomm to cut prices, arguing it has violated antitrust laws, which could be a reason for this decline. Additionally, some players like Intel (NASDAQ:INTC) are trying to build a presence, particularly towards the lower end of the market, which could be forcing QCOM to cut prices to maintain share. Average selling price data will be important to track in coming quarters to ensure QCOM is maintaining its near monopoly on the market.
Qualcomm also generates revenue by licensing its patents as it owns much of the intellectual property that 4G networks run on. Over the longer run, this business tend to correlate a bit with smart phone sales as the higher the number of the users, the larger the license fees. In fact, license revenue was surprisingly weak, down 3% year over year to $1.8 billion. This business has high margins (an 86% before tax margin this quarter), so profits fell by 5% compared to last year. I expect much of this decline can be attributed to China's efforts to get a better deal from Qualcomm (more below).
Finally, Qualcomm is the leading mobile chip company because it has out innovated the competition thanks to continued spending on R&D. While lower R&D boosts current income, it can devastate future results, which is why I always focus on it. Fortunately, Qualcomm maintains a robust R&D budget and is not cutting it simply to goose current results. R&D spending was up 11% year over year and is 18% of revenues (the same percentage as last year). With its large R&D budget, Qualcomm continues to invest in the business to ensure it maintains a technical edge over the competition.
Now while these numbers were generally good, guidance was relatively disappointing. In the past, Qualcomm has said Q4 should be the strongest quarter thanks to China's 4G LTE roll-out, but it appears the company was a bit too optimistic. It now expects to earn $1.20-$1.35 while the street was looking for $1.39. Its revenue mid-point of $6.95 billion compared to consensus of $7.15 billion. It also expects chip shipments to increase by less than 10% sequentially, which is disappointing considering the China upgrade and inventory stocking ahead of the Holiday Season. Simply put, this guidance was a miss and translates to full year estimates of $5.21-$5.36, which would be up 16-19% year over year. If we back out the $0.12 gain, QCOM's midpoint is $5.16 while I was hoping for closer to $5.20.
Finally, China is trying to win concessions from QCOM for lower fees, accusing it of antitrust activities. This probe is seen primarily as a negotiating ploy, and China has apparently escalated the situation. Qualcomm is accusing Chinese customers of not reporting all of the sales of licensed products to avoid paying Qualcomm. If true, this is a serious allegation and could significantly slow revenue growth in one of the world's largest and fastest markets. Qualcomm expects calendar 2014 device sales to be 1.3 billion while sales reported to Qualcomm will be in the 1.04 to 1.13 billion range. By my estimates, this problem with Chinese reporting could be cutting EPS by $0.25-35 over a 12 month period. Qualcomm needs to find a solution soon.
While the situation in China appears to be bordering chaos, it should also be noted Qualcomm has a ton of cash, $32.7 billion to be exact. This is up $600 million sequentially despite the repurchase of $1.35 billion in stock. Qualcomm anticipates repurchasing another $1 billion this quarter. These buybacks will help to accelerate earnings growth, and QCOM also offers a solid 2.1% dividend yield. Its cash hoard currently stands at $19.50 per share. Even with the problems in China, Qualcomm is a solid growth story thanks to secular tailwinds. The potential for more mobile devices, like watches, will only accelerate growth further, so I believe shares should be trading at least 14x earnings on an ex-cash basis or $92. At current prices, Qualcomm has over 15% of upside. China will be a drag, but Qualcomm is very inexpensive. I would be a buyer, not a seller, on weakness after this report
Stuart Don Levy
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