QCOM: The Sun Comes After the Rain

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SEE LAST PAGE OF THIS REPORT Paul Sagawa / Artur Pylak

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March 30, 2015

QCOM: The Sun Comes After the Rain

Sentiment on QCOM has come a full circle back to the skepticism that plagued the stock at the time of our last detailed look in May 2013, falling to “Death Watch” quadrant of our valuation framework, signifying weak projected cash flow growth over the next 5 years AND pessimism for the likely value of the stock thereafter. We believe that near term growth will accelerate as the company moves past 3 issues: 1- enforcing recently negotiated royalty terms with Chinese manufacturers; 2- delivering 64-bit Kryo processors; and 3- adjusting to the strong dollar. Longer term, we believe investor fears are overplayed. TAM has significantly more runway based on IoT connectivity, ongoing shift to 3G/4G/5G, and growing component complexity for devices. QCOM’s IPR position for 4G/5G is very strong and royalty claims were strengthened by China deal. QCT design advantages will sustain device share dominance and capture more value per device. We see the skepticism as opportunity, and after a bumpy, transitional FY15, expect QCOM to return to strong growth and profitability.

  • QCOM expectations are weak in both short and long terms. Current consensus estimates project a 3-yr cash flow CAGR of just 2.3%, well below the company’s trailing 5-yr trajectory and the 11.2% median projection for all large cap TMT companies. For the longer term, QCOM’s valuation implies that the terminal value, after the next 5 years of projected cash flows have been subtracted, is just 49% of EV, again, well below the median for our universe of TMT large caps. The collapse in sentiment corresponds to an abrupt deceleration in 2014 revenues caused by a disruption in Chinese sales related to a government investigation and delays in delivering QCT’s proprietary 64-bit chip architecture
  • Major headwinds will subside. 1) QCOM recently reached agreement with Chinese regulators on standard royalty terms for device makers in that country. Prior to the agreement, the company was having significant difficulty collecting from Chinese manufacturers, a situation that may take a few more month to completely resolve. 2) With ARM’s shift from 32 to 64 bit architecture, QCOM was forced to temporarily implement ARM’s turnkey Cortex processor design, putting it at parity with rivals on time-to-market, footprint, and power draw. QCT will have a 64 bit version of its proprietary Krait processor implemented in its new Snapdragon SoC designs in 2H15, restoring its performance advantages.
  • QCOM’s TAM has plenty of runway. There are an estimated 4.5B mobile device users in the world, of which about 2B operate on 3G/4G networks, and 1.75B of these devices are smartphones. By 2019, Ericsson projects that there will be 9B device subscriptions (N.B. many users will have multiple devices), with nearly 7.5B on 3G/4G networks and 5.6B smartphones. Most of this expansion will come at sub $100 device price points, although we still expect low single digit growth from the high end segment. Given that QCOM only collects royalties and sells chipsets for 3G/4G devices, largely at the high end, this implies significant further growth in its addressable market, even with sharply declining ASPs.
  • QCOMs IPR position will remain strong and profitable. QCOM has 12.5% of the seminal patents in 4G LTE and a portfolio of over 50K wireless patents, many of which are not “essential” but are the state of the art for any implementation. Furthermore, QCOM’s R&D spending is overwhelmingly devoted to pushing the performance of wirelessly connected mobile devices, making its spending leadership vs. rivals with broader priorities more impressive. IPR law depends heavily on precedent to determine value, and QCOM’s longstanding and industry wide licensing program has long established the economic worth of its patents. The recent agreement with Chinese regulators recognizes this in agreeing to the company’s standard royalty terms for exports, with a 35% discount for domestic sales.
  • QCT’s design, scale and skills are superior. QCOM has long been dominant in leading edge modem design. This advantage is most applicable at the high end of the chipset market, where it has had a 24-month lead in integrating the most recent LTE standards releases to its Snapdragon chipsets. Add to this its superior Kryo processor design, complementary capabilities (RF, MEMS, packaging, etc.) and significant economies of scale. The Kryo-based 64 bit SoCs due in 2HCY15 will extend QCOM’s die size, integration, power draw, cost and time to market advantages vs. its merchant rivals, while introducing the innovative Zeroth deep learning technology. These strengths are also a factor in lower end solutions, driving share gains vs. MediaTek in China – business that is additive to QCOM’s dominant share of the non-Apple high end. As global volumes of low-end 3G/4G smartphones continue to multiply, we expect QCOM to gain share and profitability with time and scale.
  • QCOM can expand its share of BOM and address emerging opportunities. QCOM is beginning to address more functionality within mobile devices. It has already launched a successful RF product with unusually broad support for different frequency bands, and could, in the future, begin integrating that technology into its turnkey solutions. We see sensors – increasingly implemented in smartphones, but also necessary for many other connected devices – as a substantial opportunity. We also expect QCOM to play aggressively in integrated connectivity solutions for the emerging wearables, connected vehicle and “Internet of Things” (IoT) markets. We also believe that QCOM can lever its skills into future markets, such as ARM-based server CPUs, as they emerge.
  • Negative sentiment is a big opportunity in QCOM. QCOM has been a notable laggard amongst the stocks in our large cap model portfolio, down about 10.5% YoY in a strong tech market. This negative sentiment may turn up in coming quarters due to several factors. First, improved royalty collections, completion of the transition to 64 bit chipsets, and more stable currency should return the company to robust top and bottom line growth. Second, initiatives to take device market share, expand the share of BOM addressed, and build new businesses in adjacent emerging markets should show progress, altering the narrative toward future growth. Finally, moves to raise its dividend and increase share buybacks will reward income investors, rein in share count, and placate would-be activists. We believe QCOM is likely to beat FY15 2.8% sales growth consensus, and to significantly top expectations for 4.7% growth in FY16 with further impact to the bottom line.

The SSR TMT Heatmap

Wireless Will Win, Who Wins Wireless?

Investors are worried about QCOM. The company that “invented” 3G wireless and went on to establish both an ingenious IPR licensing business and a dominant high end smartphone chipset unit, faces significant transitions in the mobile device market contributed to an abrupt slowdown in 2014 sales. 3G is giving way to 4G, where the primacy of QCOM’s intellectual property is less obvious. China, the world’s biggest mobile device market, just slapped QCOM with a $975M fine and established set IPR royalties for its domestic brands with 35% discounts on products sold at home. Rival chipmakers, previously unable to match QCOM’s integrated LTE chipsets, are now in the game with their own single chip solutions while QCOM appeared to have fumbled with its first generation 64-bit processors. The high-end smartphone market, QCOM’s bread and butter, shows signs of impending saturation. Why then are we bullish?

After the Chinese agreement, QCOM’s QTL IPR licensing business has better visibility than it has had in years. The agreement sets a country-wide royalty regime consistent with the existing contracts with China’s biggest device manufacturers, who are rapidly consolidating share, simplifying negotiations and collections from all licensees in the country without sacrificing long-term revenues. The deal recognizes QCOM’s leading contributions to 4G IPR, with both standards essential and “best practice” implementation patents, supporting the ongoing QTL licensing program across the industry. As the universe of wirelessly connected devices continues to expand, and as QCOM friendly 3G/4G technology inevitably displaces those 2G devices that are still more than 60% of the world’s installed base, there will be plenty of royalties to collect. We note that QCOM’s extraordinary commitment to R&D places it in strong position to continue its leadership in 5G and in generations beyond.

QCOM’s QCT chipset business is coming through a transition. Historically, QCOM’s Snapdragon chipsets have employed a proprietary processor design that gave them performance, power draw, footprint and cost advantages over other merchant solutions. However, with the recent shift to 64-bit processing, QCT was unable to complete its proprietary solution on time and thus, was forced to use the same Cortex reference design from ARM used by its rivals. While the end product was still considered strong, SoC solutions with the new proprietary Kyro processor core and the innovative Zeroth deep learning system architecture are due by year end and are expected to be much, much stronger, enabling exciting new functionality. At the same time, high end devices will begin to require support for LTE Advanced and its carrier aggregation feature, an area where QCOM has a substantial head start vs. its competition. We note that QCOM has also begun to use its scale and design advantages to take share in the fast growing low end smartphone segment, driving significant potential growth.

Beyond those traditional business drivers, we are excited about opportunities for QCOM to extend its business in new directions. QCT has added innovative RF chips to its portfolio, and appears likely to offer a range of sensors and display components in the future, allowing it to address a bigger piece of the mobile device BOM. There are also new markets beyond smartphones. QCT is making progress in tablets, is well positioned for wearables, and is working on new products for automobiles, health care devices, and cloud data centers. It is hard to imagine a future world where wireless communications and low-power/high-performance processing solutions are not significantly more important than they are today. That future world will be a fertile field for QCOM.

Exh 1: QCOM Share Price, Last 5 Years

Haters Gonna Hate

After doubling its share price in a nice five year run from mid-2009 until last year, Qualcomm has been beaten up in a 12 month slide from highs above $80 to its current trading range around $70 (Exhibit 1). This sharp shift in trajectory ties to a simultaneous deceleration in revenue – after posting topline growth of 39%, 28% and 30% in fiscal years 2011, 2012, and 2013, respectively, sales growth slowed to just 7% in FY14 (Exhibit 2). With that backdrop, analysts slashed their forward expectations – consensus expects just 2.8% sales growth for FY15 (ending in September) and a paltry reacceleration to 4.7% in 2016. This in the face of official guidance for sustainable future sales growth of 8-10% with further leverage to the bottom line. In fact, 5-year consensus estimates forecast 8.3% free cash flow growth for Qualcomm, a slap in the face to that guidance given the easy compare of FY14’s historically low margins. Worse yet, once the present value of those 5-yr cash flows are subtracted, the implied 5th year terminal value represents less than 50% of Qualcomm’s enterprise value. To put it in perspective, the median large cap tech stock sees more than 75% of its EV coming from its implied terminal value and only 4 of the 187 stocks we analyzed had terminal value expectations lower than Qualcomm (Exhibit 3). Investors not only believe Qualcomm will have a tough 5 years, they are pricing in dire circumstances thereafter.

Exh 2: QCOM Trailing 12 Month Revenues, Last 5 Years

Exh 3: SSR’s TMT Valuation Framework CHART – “Death Watch”

The China Syndrome

This is either a warning or an opportunity, and we are strongly inclined to see the latter. The recent weak results accrue from two major headwinds. First, and foremost, Qualcomm only recently negotiated a settlement to a multi-year investigation of its IPR licensing practices by the Chinese antitrust regulator. Not only did this investigation inflame skeptical investors, who began to fear a systematic dismantling of the company’s wildly profitable patent royalty program, but it also emboldened Chinese device manufactures, who began to underreport sales and hold back royalty payments. Historically, roughly 90% of the 3G/4G devices sold worldwide have paid Qualcomm royalties, a percentage that dropped to 86% in 2014 based on the Chinese situation (Exhibit 4). It may have also stymied QCT’s efforts to take share in the low end chipset segment, as smaller brands turned to competitive chips while avoiding efforts to collect royalties.

Exh 4: Estimated versus Reported 3G/4G Shipments, 2013-2014

The agreement with Chinese authorities is largely benign, particularly relative to investor fears (Exhibit 5). Yes, Qualcomm has to pay a $975M fine to the Chinese government as a penalty for its “anticompetitive” behavior, but for a company with nearly $18B in cash and short term investments and a $115B market cap, this is not serious damage. More importantly, the regulators set terms for royalty payments for all Chinese brands – 5% for devices that include 3G capability and 3.5% for devices that are 4G only, with a 35% discount for products sold within China. These terms are apparently similar to deals already negotiated with larger Chinese manufacturers and consistent with the royalty rates likely embedded in the QTL’s current revenue stream.

Exh 5: QCOM/NDRC Resolution Summary

The immediate effect of the deal is that Qualcomm can begin to collect those royalty payments that had been misreported or withheld, with progress likely to show in results, starting in 4QFY15 and playing out through 2016. Having royalty rates pre-negotiated with the Chinese government should also make it easier to chase down scofflaws, who have been avoiding payment altogether. These companies will face regulatory pressure to comply with the terms of the deal, with many likely to fail as scale advantages inevitably drive consolidation toward the bigger Chinese brands. This concentration will be a further boon to Qualcomm’s collection efforts, as the big brands, all with export ambitions, have been consistently compliant with the terms of the their IPR licenses.

The 64 Bit Question

Qualcomm has steadily gained share in high-end smartphone chipsets, increasingly dominating the non-iPhone market with its Snapdragon system-on-a-chip (SoC) products (Exhibit 6). The driving factors behind its leadership were its significant time-to-market and performance advantages in designing the modem element in the SoC to support the newest releases of 3G and 4G standards, and in the performance, power draw and footprint of its proprietary Krait versions of the ARM processor core. However, with the most recent generation of chipsets, these advantages were eroded (Exhibit 7). Modem standards are updated every two years, and in the second year of this particular iteration, Qualcomm’s rivals showed up with 3G/4G modems integrated into their SoC’s. Not only this, but with ARM executing a generational shift from 32 bit processing architecture to 64 bit processing, Qualcomm was not yet ready with its proprietary Kryo implementation of the standard and had to bring the Snapdragon 810 to market with the same Cortex ARM reference design used by everyone else. BAM Qualcomm’s biggest advantages were gone, and for the first time in years, rival merchant chipmakers saw an opening. In January, Samsung announced that its new flagship Galaxy S6 would use its own proprietary Exynos SoC – previous versions had used Snapdragon wherever 4G was necessary. Rumors suggested that Apple, which has long used Qualcomm modems to pair with its own proprietary processors, might be ready to have a go at its own integrated SoC.

Exh 6: Smartphone App Processor Market Share, 2010 – 2014

Exh 7: Performance Benchmarks of Major SoC Designs, February 2015

All of this has been overplayed. Outside of Samsung, which has been trying to use its own processor architectures for years, none of the other major device makers have defected from Snapdragon for their high end devices. The new 64 bit Kyros chips will begin to sample in the second half of the year for inclusion in devices to ship in 1Q16 – and initial reports are extremely positive. The new SoCs will also be the only game in town for integrated modems supporting the new LTE Advanced standard release with its network performance expanding carrier aggregation technology. The new Snapdragons are also expected to launch with Qualcomm’s Zeroth cognitive computing software to enable deep learning applications. This technology can be programmed let applications learn – a capability critical to potentially invaluable functionality such as facial recognition, voice and handwriting input, setting adjustments based on context, etc. It also plays a role in helping the SoC learn how to allocate processing resources most efficiently to provide superior performance and power efficiency for the particular usage patterns of each user. We expect the new Snapdragons to be extremely popular with OEMs, with a strong potential of winning back that Samsung business.

Exh 8: Smartphone App Processor Market Share, 1Q 2013 – 4Q 2014

We also note that Qualcomm’s reported smartphone processor market share will show a clear dip beginning with the December quarter on the back of Apple’s phenomenal iPhone 6 sales – note that iPhones use Apple’s proprietary processor, Qualcomm supplies only the modem, a much smaller share of the bill of materials than a full SoC sale (Exhibit 8). We believe strongly that Apple’s current sales strength is, in part, driven by pulling user upgrades forward. As we reach the anniversary of the iPhone 6 introduction, we expect that impact to fall sharply, and for Qualcomm’s SoC market share to cosmetically rise as a result. While it will not result in an actual increase of sales, the optics of rising share may stand to help Qualcomm with more casual investors.

Exh 9: Mobile Phone and Smartphone Penetration, 2014

Where we are Going, We Don’t Need Wires

There is a perception that the global smartphone market is reaching maturity. 25 countries, including China, the US, Canada and most of Western Europe, top 50% penetration, with about 1.75 billion smartphones in use around the world. Even with 10% unit growth in 2014, most of it came at the lowest price points, driving average selling prices down and marking the most expensive tier as nearing saturation (Exhibit 9). Given Qualcomm’s historical strength at selling its chipsets to those high end brands, does this not portend serious problems for the company moving forward? We think not.

There are currently about 4.5B mobile devices in the world. Just 40% of these devices operate on the 3G and 4G standards subject to Qualcomm’s intellectual property and addressable by Qualcomm’s semiconductor business (Exhibit 10-11). Over time, because of the substantially greater efficiency of the more modern standards, all 2G networks will give way to 3G/4G bringing the whole of the mobile market into Qualcomm’s purview. By 2019, Ericsson projects that the total number of mobile subscriptions will double to around 9B (N.B. many users will have more than one), with 7.5B operating on 3G/4G, and 5.6B of these being smartphones. Given obsolescence and replacement, we project that as many as 9B 3G/4G devices will be sold over the next 5 years and that the large majority of these will be smartphones.

Exh 10: Mobile Subscriptions by Device Type, 2012-2020

Exh 11: Mobile Subscriptions by Technology, 2012-2020

Prices will fall. We project high-end smartphone unit growth will be in the low single digits over the next 5 years, particularly given the artificially high 2014 volumes associated with early upgrades to the iPhone 6. Low end models will grow at a robust 12-14%, with average prices for the segment edging ever lower as viable sub $50 products begin to drive demand. Collectively, this points to overall ASP’s dipping at a 4-5% CAGR, yielding market sales growth of 4-5% annually through 2019 (Exhibit 12).

Exh 12: SSR Smartphone Forecast, 2014-2019

Pay Me Now, or Pay Me Later

Qualcomm aims to collect a royalty on every device sold with 3G and/or 4G connectivity embedded in it. Its claim to those royalties is well established over more than 20 years of legal challenges and negotiations with hundreds of device makers, almost every one of whom has bowed to the inevitable and signed a contract which obligates them to report their sales and pay royalties to Qualcomm. Most of these agreements offer blanket access to all of Qualcomm’s intellectual property, both patents that are “essential” to the 3G and 4G wireless standards and those that are “non-essential” but helpful in implementing standard compliant products. That distinction is important, as “essential” patents are required to be made available at “fair, reasonable and non-discriminatory” (FRAND) rates, while “non-essential” IPR can be licensed for any rate that the market will bear. While Qualcomm is the leader in patents that have been reported to the ETSI standards body as essential, it is the many thousands of non-essential patents that allow it to sustain its 3-5% royalties on mobile device sales (Exhibit 13).

The just concluded negotiations with the Chinese government illustrate the strength of Qualcomm’s claims, confirming 5% royalties for multimode devices and a 3.5% rate for single mode 4G before forcing a 35% discount for sales of Chinese branded devices in China. In practice, these terms are similar to the agreements that Qualcomm had already reached with the biggest Chinese device vendors (Exhibit 14). They should also greatly ease the difficulty in actually collecting royalties in China. Historically, Qualcomm has only been able to collect royalties on about 90% of all 3G and 4G devices shipped, with underreporting from some Chinese licensees and defiance from other Chinese manufacturers the primary problem. This was exacerbated during the lengthy and public investigation by the Chinese regulatory authorities, with collections falling back to 86% during 2014.

Exh 13: QTL Revenue as a Percent of Total Reported Device Sales, 1Q05 – 1Q15

Exh 14: Announced LTE Royalty Rates

Exh 15: QTL Revenue Model, 2014-2019

Exh 16: QTL Division Revenues and Margin, 1Q 05 – 1Q 15

With the agreement in hand and the cooperation of the Chinese government, Qualcomm can now pressure its licensees to live to the terms of their agreement and reconcile their underreported sales and unpaid royalties. It can also take scofflaws to task, with the support of Chinese courts that must recognize its IP rights and with pre-negotiated terms in hand. Moreover, we believe that natural economies of scale will drive considerable consolidation in the still highly fragmented Chinese domestic market, with share concentrating in the hands of the large, internationally ambitious and license compliant large brands. All of this stands to take Qualcomm’s collection percentage much higher going forward, a serious boon to the revenue prospects for the extraordinarily lucrative QTL business unit (Exhibit 15). We project QTL’s revenues from smartphone patent licensing to grow at a relatively robust 7.5-8% CAGR through 2019 (Exhibit 16).

It’s a G Thang

Qualcomm’s primacy in 3G, with its CDMA technical underpinnings, is well documented in the annals of wireless history. With the rise of 4G, with its shift from CDMA to OFDMA, many analysts project a significant decline in QTL’s royalty rates. The reality has not been quite so dire for Qualcomm. First, the overlapping nature of network deployment requires multi-mode devices for many, many years after the introduction of new network standards. Nearly 15 years after the introduction of 3G, 60% of the devices currently in use worldwide are still 2G only and the vast majority of 3G devices still support 2G standards as a fall back. The same will be true for 4G, which provides coverage to only a tiny fraction of the world’s landmass – expect multimode devices to be predominant for many, many years.

Exh 17: 4G LTE Patent Distribution of Top Companies

Second, Qualcomm’s patent position for 4G is very strong. Qualcomm has the highest percentage share of the patents essential to the 4G LTE standard, with particular strength in those patents necessary for device makers (Exhibit 17). It also has thousands of other patents related to the workings of mobile devices in general and 4G devices specifically that are of enormous value to its licensees. Once again, the recently negotiated deal with Chinese regulators explicitly establishes the value of Qualcomm’s intellectual property to 4G single mode devices.

Third, Qualcomm is the employer of choice for talented wireless engineers and invests far more in R&D than any of its would-be rivals (Exhibit 18). The strength of that effort is evident not just in the quantity of patents, of which Qualcomm currently has more than 13,000, but in their quality. Of the 710 Qualcomm patents identified as essential to 4G by iRunway in a 2012 study, more than 11% were considered “seminal” – defined as ranking in the top 5% of all 4G patents judged on 22 parameters reflecting strength and importance. Altogether, Qualcomm was rated as holding 12.5% of all seminal patents pertaining to 4G. Qualcomm’s research advantage in 5G related technologies may prove to be even greater than it had been in 4G, when Nokia, Motorola, Nortel, Blackberry and others were still aggressive R&D rivals.

Exh 18: Annual R&D Spend of QCOM and Comparable Companies, 2005-2014

Chips and Dips

Qualcomm’s QCT business has been on a tear (Exhibit 19-20). A decade ago, Qualcomm was the leader in 3G modem chips, but only entered the processor business in 2009 with its first Snapdragon chipsets based on the industry standard ARM instruction set. Prior to that point, mobile device CPUs had been dominated by TI, Infineon, Freescale, NXP and others, but with the rise of the iPhone and Android-driven touchscreen smartphones, the Snapdragon line with its integrated baseband modem began to gain traction. Within 5 years from introduction, Snapdragon had gained a dominant position amongst high end smartphones, present in the flagship models from every major global brand, save for Apple, including Samsung, which selected the Snapdragon 800 over its own Exynos processors for 4G enabled versions. Apple, which developed its own ARM processors to support the iPhone line, continues to buy Qualcomm modems to pair with its proprietary CPU and graphics processor solution.

Exh 19: QCT Division Revenues and Margin, 1Q 05 – 1Q 15

Exh 20: MSM Shipments and QCT Revenue per Chip, 1Q 05 – 1Q 15

Qualcomm’s integrated System-on-a-chip, which combines CPU, baseband modem and graphics processing onto a single die, is exceptional. Until the most recent versions, Qualcomm had relied on Krait processing cores, its own proprietary implementation of the ARM standard. Competitive merchant chips relied on the Cortex turnkey implementation provided by ARM. Krait was designed to minimize the processor footprint and its power requirements, offering greater performance and enabling more functionality to be integrated to the SoC. Combined with clear leadership in modem design, Snapdragon SoCs came to market more quickly, offered superior performance, drew less power and took less real estate on a device motherboard. Quickly, Qualcomm began to take market share. Today, Qualcomm has more than half of the global market for smartphone SoCs (Exhibit 21).

Exh 21: Smartphone App Processor Market Share, 2010 – 2014

The transition to 64 bit processor architecture was a rare slip up for Qualcomm, which had mapped out an ambitious generational shift to a new processor design that it named Kyro. While Kyro will arrive in 2HCY15, with what is expected to be even greater advantage in its performance, power draw, and footprint, the current version of Snapdragon contains the same ARM designed Cortex reference design used by every other merchant SoC solution, although optimized for performance by Qualcomm. With this moment of vulnerability, Samsung implemented its own Exynos SoC in its new Galaxy S6 flagship model amidst rumors that the Snapdragon had overheated in its tests. While these rumors have been refuted several times over by credible sources and while the Snapdragon 810 still outperforms its rivals on almost every benchmark, Qualcomm’s aura of invincibility had been pierced for investors.

We are comfortable that the coming Snapdragon 820 will reestablish Qualcomm’s technical dominance. On top of the expected performance superiority of the Kyro processor, the 820 will also introduce Qualcomm’s Zeroth cognitive computing platform, a software engine to facilitate machine learning. With Zeroth, devices running Qualcomm’s chipset can use learning applications for many intriguing functions – for example, step function improvements in handwriting, voice and facial recognition, applications that launch on context or automatically adapt for revealed user preferences, or efficient assignment of system resources based on historical use patterns.

You Take the High Road, and I’ll Take the Low Road

Qualcomm critics have pointed to the success of Asian chipset competitors MediaTek and Spreadstrum as evidence of impending doom. Having established success with 2G chipsets for the feature phones that once dominated the low end mobile device market, these companies have moved up the food chain to supply low end 3G smartphone chips, and, according to the narrative, will soon successfully move up to challenge Qualcomm’s higher end products as the Chinese manufacturers press their cost advantages in global markets. Of course, there is another way to look at this.

As the 2G chipset players were moving up into the smartphone space, Qualcomm was simultaneously moving down to offer products at cheaper price points, offering turnkey solutions for low-end smartphones that could be brought to market quickly with room for margins. Evidence suggests that this move has been highly successful. Longtime MediaTek customer Xiaomi made a highly visible shift to Qualcomm chipsets for a number of its new models, and the other leading Chinese brands, such as Huawei, Lenovo, and ZTE are solid Qualcomm customers. These brands have begun advertising “Snapdragon inside” to Chinese consumers as a signal of product quality as they continue to consolidate market share in the domestic market. Given Qualcomm’s substantial scale advantages, and its world-leading modem and processor technology, we believe that the opportunity for the company to take substantial profitable share at the low end, at the expense of its Asian merchant rivals, is far greater than the risk that those same rivals will take business from Snapdragon at the high end.

Currently, Snapdragon SoCs are found in roughly 52% of all smartphones sold, a tick down as a result of the astounding success of Apple’s iPhone 6 and 6 Plus and Samsung’s decision on the popular S6. We believe that this percentage will move back up beginning in 2016, and continue on a positive trajectory going forward as Qualcomm captures more market share amongst low end device makers (Exhibit 22).

Exh 22: QCT Revenue Model, 2014-2019

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Please Sir, Can I Have Some More

Qualcomm’s strength in wireless technology and in semiconductor design gives it a large number of potential directions in which to pursue new opportunities. One intriguing possibility is in co-opting other functionality within the components of a mobile device, bundling it with their SoC or even integrating the functionality right onto the core processor solution. This approach has certainly played out in the modem, where the 2011 acquisition of Atheros gave Qualcomm leading WiFi technology which has been absorbed into their baseband products.

In early 2014, Qualcomm began shipping its first RF radio products. RF is a profitable enclave within mobile devices – typically a handful of components led by the power amplifier and some filters – that has been dominated by an oligopoly of four companies: Murata, Qorvos, Skyworks and Avago. Entry to the RF market has been difficult, as these parts have required specialty manufacturing processes and materials, such as Gallium Arsenide and advanced ceramics. However, the advance of Silicon semiconductor processes has brought the market to the point where RF components may be implemented in ordinary CMOS. This has two main implications. First, as chip makers grow more experienced in implementing power amplifiers and related parts in silicon, and as the processes get more advanced, the performance of these parts will begin to rival GaAs RF at a drastically lower cost. Second, once RF is implemented in silicon CMOS, it can be integrated with other mobile device parts onto single chip solutions (Exhibit 23).

Exh 23: Major Semiconductor Categories present in a Typical Smart Portable Device

This is where Qualcomm comes in. Its silicon RF360 products were launched to great fanfare, with promised support for an unusually wide range of frequencies. In practice, the first generation parts proved a bit disappointing. Most of the initial sales were not for power amplifiers, but for lower cost parts like the “envelope tracker” and “antenna tuner”. Still, Qualcomm managed to sell these parts to 40 OEMs and the company reports that 30% of the products containing its dominant modem products also contain at least one element of its RF solution. This is, subjectively, pretty good progress into a market that has been dominated by a few suppliers for a long time. Given Qualcomm’s commitment to the project, its resources and the long term potential of RF integrated SoCs, we are very confident that the company’s push into RF will prove very successful in the long run, adding a new chunk of value to its increasingly turnkey solutions.

We don’t expect it to stop with RF. Sensors are a substantial growth area – not just in smartphones and tablets, but in wearables, automobiles, medical devices, connected home components, and many other applications (Exhibit 24). Qualcomm, through acquisition and development has considerable skills in the MEMS technologies underlying many of these sensor opportunities. One example is the recently announced ultrasonic fingerprint sensor to be integrated into the newest high end Snapdragons chipsets. Ultrasonic technology uses high frequency sonar to take a 3D image of a finger, able to look past dirt and grease, able to work through device casing materials like metal, glass, or plastic, and able to offer exceptional image detail. This solution is superior the capacitive technology in competitive products, likely resulting in faster processing, in far fewer unsuccessful scans and in far less vulnerability to fraud.

Exh 24: Physical / MEMs Sensor Applications

There are a range of other sensor opportunities – e.g. biometric readings, movement/orientation, etc. – which we believe will see substantial growth in coming years (Exhibit 2526). (see http://www.sector-sovereign.com/2014/10/october-21-2014-sensors-whats-in-your-smartphone/). These opportunities are addressable for Qualcomm, which has the added advantage of being able integrate the most popular of them into turnkey packages for device makers. It may also be that Qualcomm can get paid for its Zeroth cognitive computing software. With added functionality, QCT may be able to demand greater price premiums for its Snapdragon chips and to solidify its market share leadership.

Exh 25: SSR’s Taxonomy of Sensors

Exh 26: Global Sensor Revenue, 2013-18

New Directions

To date, Qualcomm has been a smartphone story, enjoying the flow of royalties and building a dominant chipset franchise. However, Qualcomm’s expertise in wireless communications technology, low power system design, and efficient processing are clearly applicable to the range of new connected devices on the radar screen. Qualcomm has made considerable progress in the tablet market, previously a stronghold for rival Nvidia. Because most tablets do not integrate 4G connectivity and because motherboard real estate is far less of a design concern, two of Snapdragon’s biggest advantages have been negated but the processing performance and power draw characteristics have won the day for QTL in flagship products like the Samsung Galaxy Tab 4 and the Amazon Fire HDX tablets and the Levono Yoga Pro 10 HDX convertible. We believe that the upcoming introduction of the Snapdragon 820 and a growing trend toward integrated connectivity could lead to dominance in the tablet market similar to the company’s position in smartphones.

Hype for the Apple Watch has the “wearables” category on the radar screen, and while we are more conservative than most on the likely volumes to be generated by smartwatches, these sensor packed devices are an interesting potential sideline for QTL. Juniper Research estimates the 2019 market for such devices at over $50B, which would suggest a better than $25B opportunity for semiconductor suppliers, of which Qualcomm could address a majority. Even if the market were considerably smaller than that, it would be a significant expansion opportunity for QCT.

Exh 27: QCOM’s Addressable Adjacent Markets

Likewise, the market for other connected devices, otherwise known as “the internet of things”, is a substantial opportunity for Qualcomm. As machines in the home and across communities are connected, radios and modems will be needed to connect them. These will necessarily be low cost components, but the potential for volume is immense. Automotive is another area where the company could leverage its expertise in communications and computing. Infotainment and driverless control are expected to drive substantial growth in the semiconductor TAM in the automobile, and importantly, bring that TAM into technical areas where Qualcomm is advantaged. Many of these markets could also bring significant IPR royalty revenues as well (Exhibit 27).

Qualcomm also points to the architectural shift of wireless network operators toward “small cells”. In this architecture, on the roadmap for every major equipment maker and network, big, expensive “macro” cells are replaced by many small, inexpensive “small cells”, each with limited range and requiring that traffic hauled to a central data center for processing. These small cells will require radio, modem and processing functionality with performance and power efficiency requirements akin to high end smartphones. Qualcomm is extraordinarily well positioned to power these devices and sees a total addressable market of roughly 700M units by 2018.

Processor chips for enterprise servers is a $12B market dominated by Intel. We believe that enterprise IT is in the early days of a generational sea change away from internally operated data centers toward cloud-based public data centers run by the likes of Amazon, Google and Microsoft. These sophisticated operators have moved relentlessly to improve the performance and efficiency of their data centers, a focus that has led them to consider alternative server CPU architectures for the future. The ARM architecture employed by Qualcomm has considerable appeal – it is high performance, low power and manufactured in the massive quantities needed to drive economies of scale. Qualcomm has announced an initiative to develop processors for this market, and we believe that the potential is significant.

Over the next 5 years, we believe that chip sales and license fees from these and other new market initiatives will grow to be as much as 10% of Qualcomm’s revenues, topping $4B by 2019 and adding 200bp or more to the company’s overall sales growth rate. This is the difference between 7.5% average growth and 9.5%, all of it propagated from realistic opportunities (Exhibit 28).

Exh 28: QCOM Adjacencies / New Business Revenue, 2014-2019

The Potential Reward FAR Outweighs the Risk

Qualcomm currently trades at a 14.2x P/E, just 9.0x if you net out the $31.6B in cash and securities on the balance sheet. This is far below the 19.5x P/E of the S&P500, and a considerable comeuppance for a company that has delivered an average 20.7% annual EPS growth over the past 5 years. Consensus expectations for FY15 EPS of $5.01 on sales of $27.3B are well inside of the company’s guidance ranges, although it has a long history of extremely conservative guidance. Expectations for FY16 for sales growth of 4.7% and EPS growth of 8% are sharply below management’s guidance for future sales growth of 8-10% with faster growth in earnings.

We think Qualcomm is very likely to beat these projections, if not for the current quarter, then for the second half of FY15 and thereafter. Chinese royalty payments, underreported and withheld during the government inquiry, will jump on back payments before settling into a more certain long term growth trajectory. Shipments of the new architecture Snapdragons will begin by year end. By 2016, we expect some of Qualcomm’s moves to adjacent markets – additional chips in smartphones, share gain in tablets, a growing position in wearables and the “internet of things”, automotive, etc. – to begin to pay off.

Moreover, Qualcomm has announced a major step up in its efforts to return cash to shareholders (Exhibit 29). Management has raised its quarterly dividend to an annualized rate of $1.92/share, a 2.8% yield at current prices. It also authorized $15B in share repurchases, with the intent to repurchase $10B within the next 12 months, replacing a pre-existing program that had only $2.1B in authorized repurchases remaining. Qualcomm is committing to return a minimum of 75% of its future free cash flow to investors via dividends and share repurchases. This program is aggressive relative to Qualcomm’s peers and should both assuage potential shareholder activists while attracting income and value investors.

If Qualcomm can both beat expectations and attract new classes of investors, its dismal multiple has a LONG way to expand. We have included Qualcomm in our 15 stock model portfolio and called it out as one of our top 5 picks for 2015. Look for it to begin to break out this summer.

Exh 29: Top 10 Tech Companies with Authorized Stock Buyback Programs

Exh 30: QCOM Simple Revenue Model, 2014-2019

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