Asphyxiation is a condition in which the body doesn’t receive enough oxygen. A common side effect of asphyxiation is death. Before then, of course, there are hallucinations; we start seeing things that don’t exist. When the market is making new highs, valuations are high, and you get altitude sickness. It is typical to suffer from value asphyxiation: imagining value when it is not there. Mistakes in this environment predominantly come from the commission (not the omission) of buy decisions. That is why, before you commit your capital, you have to double-check your lucidity and think thrice.
And that is why, when we stumbled on Qualcomm, we could not believe what we saw. The San Diego–based chipmaker should double its earnings over the next four years. It has an impenetrable moat, great management, a cash-laden balance sheet, infinite incremental return on capital — and it is cheap, trading at a low-teens multiple. These things are not supposed to happen to a company with a market cap of more than $100 billion that is followed by several dozen analysts — unless the Street is concerned that the company is on its way to becoming obsolete — and especially not while the market is making new highs.
Qualcomm is a value in plain sight because it is misunderstood by investors, and for good reason: Two thirds of its revenue comes from the semiconductor segment. The company designs chips that go into cell phones and tablets. If you read sell-side reports on Qualcomm, most of the ink is spilled about its semiconductor business. This bias makes sense, because Qualcomm is covered mostly by semiconductor analysts, and that is what they know — semiconductors. They have an edge in that arena, and so that is what they write about. They can provide many insights about the intricacies of Qualcomm’s chip-set designs and how its chips are in hundreds of smartphone models, whereas Intel (its largest potential rival) has its chips in less than a handful. They will tell you how Qualcomm combines multiple functions into a single chip, and how that gives the company a competitive advantage. Analysts will generate dozens of pages on the semiconductor segment, which has been growing 20 percent to 30 percent a year.
Qualcomm’s licensing business gets the least amount of ink; after all, it accounts for only a third of revenue and is a very straightforward, unexciting business that lacks dramatic competitive dynamics — because Qualcomm is the only game in town. It collects about $7 (a 3 percent to 5 percent royalty, based on wholesale price) from almost every smartphone sold globally. Of course licensing, despite its lack of excitement, represents about three quarters of Qualcomm’s profit.
Let me explain Qualcomm’s licensing business through an analogy. There is a continent called Spectrum that for a long time had only one-lane (2G) roads, which were for the most part built before Qualcomm arrived on the scene. Qualcomm employs a lot of math geniuses, and its engineers figured out the most efficient way for cars to get from one place to another (they developed complex algorithms for the most efficient use of cellular frequencies) and thus helped to fit more vehicles onto newly built highways that were based on Qualcomm’s design. This aspect is very important, because as vehicles get smarter and safer and more and more people want to drive them, traffic jams can result, and so we need ever bigger and better highways (that is, greater bandwidth).
Qualcomm gives away its highway designs to construction firms — makers of hardware, the likes of Ericsson and Cisco — and highway owners — such as AT&T and Vodafone. Qualcomm is like a global tollbooth operator that charges manufacturers (like Nokia and Apple) a percentage of a phone’s wholesale price. The wireless industry outsources a big chunk of its R&D to Qualcomm to design the most efficient use of limited, high-demand spectrum. This dynamic creates a significant competitive advantage for Qualcomm, because it gets to spread its massive R&D costs across a huge number of phones.
Qualcomm makes almost no money on cell phones that work solely on 2G networks. 2G is fine for voice communications but doesn’t do a good job of carrying data. Smartphones require higher-speed networks to function, and this is where 3G and 4G (also known as LTE) come in. These networks were developed in large part based on Qualcomm’s intellectual property.
In 2012 there were 3.5 billion global cell phone subscribers. Only about 800 million of them were on 3G/4G networks; the rest are using dumb or feature phones on 2G networks. But 2G gets pushed ever closer to obsolescence with every $1 billion that mobile carriers spend on 3G/4G networks. And they are spending hundreds of billions of dollars.
If we assume that the number of global cell phone subscribers will grow 4 percent a year — a fairly realistic assumption, considering that the global population is more than 7 billion people and soon dogs will have phones — and that only 5 percent of subscribers a year will switch from 2G to 3G/4G, the number of smartphones on 3G/4G networks will be growing 21 percent a year by 2017. Despite that enormous growth rate, only half of users will be on 3G/4G networks by then, so Qualcomm’s growth is unlikely to decline much after 2017. However, the bulk of the smartphone growth is happening in developing countries where cell phones are relatively inexpensive and technology tends to get less expensive with time, and so Qualcomm’s licensing-revenue growth will fall below subscriber growth. The company is guiding for a 2 percent to 3 percent average selling price decline per year, but even if we say the decline is 5 percent a year, then licensing-revenue growth will still be in the teens.
It gets better. Wireless services will advance far beyond cell phones and tablets. They will be embedded in cars and in billions of machine-to-machine devices, from vending machines that accept credit cards and process them wirelessly, to meters that monitor your water consumption and send data to the utility company, to innumerable other uses that we haven’t even dreamed up yet. In addition, over the next few years you will be hearing a lot more about small cells: your personal cell tower, the size of a deck of cards. Small cells will help to solve the wireless bandwidth problem in populous areas. There will be hundreds of millions of them installed, and just as with machine-to-machine devices, Qualcomm will be receiving its rightful license fee.
Currently, Qualcomm doesn’t receive royalties from the phones that operate on China Mobile’s network. China Mobile is the largest operator in the world; it uses its proprietary 3G standard but is now transitioning to the global 4G standard. It is only a matter of time before Qualcomm starts collecting royalties from smartphones used on China Mobile’s network.
Qualcomm’s competitive advantage is very deep and derives not just from an enormous intellectual property portfolio but also from the fact that Qualcomm spends more money on wireless R&D — $4.7 billion over the past 12 months — than any other company in its space. A good chunk of the research dollars goes to develop new chips and invent new breakthrough technologies, but the rest is spent on improving wireless technology. Qualcomm is by far the best way to play on the global growth of smartphones.
By our estimates, Qualcomm will generate about $7 of annual free cash flow per share by 2017, and its debt-free balance sheet will balloon from $17 of net cash per share to about $40. Using a conservative multiple of 14 and giving some credit for cash, we believe that in four years Qualcomm could be a $130 stock. The company has a great management team that receives high scores for both running the business (building the moat) and capital allocation. Qualcomm’s management hasn’t made any dumb acquisitions and has bought back the company’s stock when it was cheap (a novel idea).
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