QCOM: Finally at the Inflection Point

sagawa
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QCOM suffered mightily over the past 2 years, as a Chinese anti-trust case emboldened manufacturers there to refuse demands for royalty payments and turn to alternative chip suppliers. This was compounded by the company botching the transition to 64bit smartphone CPUs, opening the door for chipset share loss, notably at Samsung. After its fall from grace, QCOM took steps to reverse the negative course: 1. It cut a deal with China for reasonable standard royalties; 2. It released its proprietary and superior 64bit CPU design; 3. It contracted to build its 2017 SoC on Samsung’s world best 10nm LPP process; and 4. It announced layoffs for 15% of its workforce. These steps have begun to pay off with the big 3QFY16 beat. Chinese OEMs have begun to pay at standard rates, perhaps after forgiveness for a part of their back royalty obligations. QCOM has regained chip market share, and is poised to take more next year with its 10nm SoC. QCOM chip customers in China are also taking market share, perhaps at the expense of AAPL. We believe that these drivers, along with the ongoing QCOM friendly shift of the more than 2.5B 2G GSM mobile subs to 3G and 4G networks, will continue to drive sales and profit growth ahead of estimates going forward. Given this, we believe that the 13x forward P/E multiple (against pessimistic estimates) could rerate to something much closer to the 17.5% market multiple, yielding 30%+ upside from current levels.

  • QCOM shares are off 25%+ over 2 years. In July 2014, QCOM shares peaked at more than $80 before beginning a precipitous fall to less than $45 in January of this year. This drop was catalyzed by two major factors – an anti-trust investigation launched by the Chinese government, and the failure to complete a proprietary 64bit CPU design in time for the 2015 model year. QCOM was unable to collect royalties from many Chinese OEMs and it lost chipset market share, yielding sharp quarterly disappointments from declining sales and profits. The narrative on QCOM shifted to skepticism for the sustainability of its royalty stream and for the competitiveness of its chip designs.
  • Deal with Chinese regulators recognizes value of QCOM IPR. In February 2015, QCOM agreed on terms for patent licensing on phones to be sold in China by Chinese OEMs. The terms essentially preserve QCOM’s current rates for 3G/4G multimode phones, while offering a 30% discount on 4G single mode phones. Since China is the only major market where single mode will be a significant market, this sets strong precedent for negotiations outside of China, while still locking in reasonable rates in country. The framework also breaks the logjam in licensing negotiations with indigenous manufacturers who had been withholding royalty payments in the interim. QCOM has announced the signing of dozens of new licensing agreements over the past year.
  • New Kyro CPU is the industry performance leader. QCOM’s proprietary 64bit processor, dubbed Kyro, debuted with the Snapdragon 820 SoC delivered at the beginning of the year. Benchmarks show the 820 with a 70% performance increase vs. 2015’s 810, leapfrogging the latest offerings from Samsung and AAPL, companies that had seen advantage in the prior generation. With the new part, QCOM has won back market share lost in 2015 – of note, Samsung selected the 820 for its flagship Galaxy S7 after booting QCOM for the previous Galaxy S6.
  • Snapdragon 823 poised to raise the bar again. QCOM’s next SoC iteration, believed to be the 823, is rumored to be arriving before year end, perhaps powering Samsung’s coming Galaxy Note 6. This part is being built on Samsung’s brand new 10nm LPP fabrication process, a move that has significant positive implications for its size, performance and power efficiency. Rumors suggest that the quad-core 823 will operate at 2.2GHz, an 18% increase in clock speed that is one of several levers that should boost performance. Time to market has always been an advantage for QCOM and the 823 seems to push this even farther, coming 2-3 months earlier than previous cycles, if the rumors true. Moreover, we expect Kyro to migrate further down in QCOM’s product line, pressuring rising competitors like MediaTek and Spreadstrum.
  • Job cuts helping the bottom line. In July 2015, QCOM announced a 15% force reduction, cutting 4,700 jobs and $1.4B in annual expenses. In 3QFY16, R&D spending was down 310bp or $139M, helping to raise operating margins to 26.3%, recovering more than half the ground lost since 2014. These cuts will have more traction in coming quarters, as improving royalty collections simultaneously raise gross margins.
  • QCOM much better positioned than most think. The skeptical narrative around QCOM overestimates a deterioration in the company’s royalty rates while underestimating its potential to grow its chip business. QCOM holds 12.5% of the seminal patents in 4G, the highest share of any company, and it continues to lead in the development of the upcoming 5G standard. With the structure of its licensing contracts and the importance of precedent in global patent settlements, we expect rates to be relatively resilient. Furthermore, despite a mature premium smartphone market, the shift from 2G to 3G/4G in the developing world is a huge opportunity for both royalties and chipset sales. QCOM is also moving to address more value within wireless devices, and is well positioned against future growth opportunities, like IoT, automotive, and hyperscale data centers. We expect earnings growth over the next few years to average 10% or more annually.
  • Estimates and multiple are too low. With cost cutting layered against growth in both royalty collections and chip sales, and an accelerated share buyback program, we see consensus expectations for 11% EPS growth in FY17 to $4.69 as too low by 15% or more. In that context, QCOM’s forward multiple, 13x the pessimistic consensus, is just 11x our more optimistic view. With a 15.5x multiple against FY17 earnings of $5.25, QCOM would be worth more than $80 and with a 17.5x market multiple, more than $90.
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