I’ve owned Qualcomm (QCOM) for many years, and the company is at an excellent rate of return in my portfolio, currently yielding nearly 4% on my cost basis. However, since I invested in Qualcomm, the company has appreciated significantly and currently trades at what I would consider being a significant premium both to historical and future earnings potential.

In this article, I’ll show you why I consider it wise to wait for Qualcomm to become cheaper again prior to investing in the company.

The Branding Source: Qualcomm cleans up its logo

Qualcomm – What does the company do?

Qualcomm is an American company, researching, manufacturing, and holding IP, semis, software, and services related to wireless technology. Among its crown jewels are patents critical to standard mobile communication technologies, but the company produces semiconductor components and software for vehicles, smartwatches/watches, computers, Wi-Fi, smartphones, and other devices.

(Source: Qualcomm Investor Presentation)

The company doesn’t own much production capacity, and most of the company’s physical products are instead produced by others. The company has a 35-year history and began researching satellite communication systems for trucks. When 3G technology rose to the standard, which included Qualcomm’s patented CDMA patents, the company rose higher – and since that time, there’s been a long series of legal discussions about licensing pricing for the standard.

Qualcomm as the company stands today, is divided into three reportable segments. These are:

  • QCT – Qualcomm CDMA Technologies, which focus on the semiconductor business.
  • QTL – Qualcomm Technology Licensing, with a focus on the licensing of the company’s technologies and patents.
  • QSI – Qualcomm Strategic Initiatives, which focus on strategic investments.

In terms of size, we have the following current split between these segments.

(Source: Qualcomm)

As of 2019, there were about 6B 3G/4G connections around the globe, either CDMA or OFDMA-based, with connections projected to reach 7B by 2023, resulting in licensing income for Qualcomm. The company also expects that 5G devices will multimode support for 3G and 4G as well as W-Fi, meaning there will be licensing for most of these devices as well.

(Source: Qualcomm Investor Presentation, 2019)

The product family includes such platforms as the Qualcomm Snapdragon family of integrated circuits for a variety of computers, phones, and automotive platforms, with other platforms including Qualcomm Hexagon, Qualcomm Areno, and others. The company’s QCT portfolio also includes RF products designed to simplify 5G RF design. RFFE is responsible for converting near-zero frequency baseband signals to signals that can be transmitted or received over the air, a massive part of any 3G-5G technology. The company also sells products and software related to Wi-Fi, Bluetooth, NFC, GPS, and others. As mentioned, the company uses a fabless production model, not owning or operating any production foundries and therefore rely on third parties for assembly and even most of the testing.

(Source: Qualcomm Investor Presentation 2019)

Primary foundry suppliers for the company include Global Foundries, Samsung Electronics, Semiconductor Manufacturing International, Taiwan Semiconductor Manufacturing Company (TSMC), United Microelectronics, Advanced Semiconductor Engineering, Amkor Technology, Siliconware Precision Industries, and STATSChipPAC. Most of these manufacturers/foundries are located in the Asia-Pacific region, and the company, thus, has a lot of exposure here in the case of geopolitical instability (as one might argue we currently face to some degree).

So, while the company researches and develops crucial technologies and products, it produces almost none of its own hardware. This is of course not unique to Qualcomm, but it’s something to keep in mind when investing.

It’s likely that Qualcomm technologies will become more and more important as time passes. Key areas likely to become more important include things like automotive…

(Source: Qualcomm Investor Presentation)

… but also many, many more.

(Source: Qualcomm Investor Presentation)

The company expects the addressable market of $65B in 2019 to grow to over $100B in 2022, and keep growing from there. This offers tremendous growth opportunities for leading companies and suppliers, such as Qualcomm, as the world and its companies, and consumers will want the technologies that Qualcomm supplies.

Advantages with 5G over 4G are several for the company. First of all, and most important, company revenue per device will be increasing with 5G, and the technology will also mean more AI integration. 5G also offers more intersections for different technologies and sectors for starting to use the company’s services and products. As everything becomes more connected, companies like Qualcomm, which are part of providing this connectivity, are set to profit. For the company, most of their future plans are about or related to 5G technology.

(Source: Qualcomm Investor Presentation)

The company intends to leverage its technology advantage to ensure that future product lines also lean on the company’s technology. While my Broadcom (AVGO) position is significantly larger than my position in Qualcomm, the fact is that in terms of RFFE, the company holds a distinct market leadership position.

(Source: Qualcomm Investor Presentation)

That’s not mentioning that the company’s products also powers most of the smartphone cameras on the planet, with the next-best competitor being significantly lower than Qualcomm. This technology leadership combined with the company’s portfolio of patents covering more than 100 nations gives Qualcomm a market position equaled by very, very few.

(Source: Qualcomm Investor Presentation)

So, Qualcomm is a business that owns its money in part by developing and researching technology, but also by managing its massive portfolio of patents, earnings revenue from licensing, software, and other segments. Qualcomm is a market leader in several key segments, and this gives it an excellent platform for becoming the market leader in the future as well. Overall, it’s a company that’s been with us since wireless communication started to massively expand in the 1980s to 1990s, and has grown to become one of the most important technology companies in the world today.

Qualcomm – How has the company been doing?

Not everything has been a walk in the park, however. Qualcomm’s earnings history is full of examples of earnings volatility and instability. Qualcomm occupies the in part enviable in part not enviable position of having a portfolio containing some of the most crucial IPs for wireless communication via CDMA. These things have become industry standards, and the company has agreed to what is a “fair, reasonable and non-discriminatory terms” for its licenses, which come to about 5% or $30 per mobile device sold. This is around 5-10X the times usually charged by patent holders. Because of this, it has become a practice for competitors, clients and regulators to charge Qualcomm or try to drag them to court for unreasonable rates or unfair competition.

These court battles have been frequent, and all over the world. It impacts company earnings, and is very likely to continue to do so. The biggest recent two examples are battles with Apple (NASDAQ:AAPL), wherein the companies agreed to cease all litigation and signing a 6-year agreement (and Apple paid $4.5-$4.7B as a one-time payment), but Qualcomm was fined in the EU for $1.2B that is currently appealed. The company’s battle with the FTC was recently brought into the ninth circuit as well, which reversed a decision against Qualcomm.

(Source: Seeking Alpha)

With all of these battles, it should be no surprise that the company has experienced bouts of ups and downs over the past few years, which in part reflect these things. The recent climb is in part due to the FTC, new launches, and an application to be able to supply Huawei with chips.

The latest actual quarterly results that we have are 3Q20, which came in at the upper range of the company’s GAAP revenue forecasts at $4.9B quarterly revenues. QCT earnings and margins came in at the higher end of the range as well, and the company shipped 225M 5G global handsets for the quarter, within expectations.

The licensing segment came in well above, expectations, beating the upper range of the revenue expectations by over $50M, and beating the lower end of margin expectations by over 11% in terms of increase (62% QTL EBT margins). Comparing YoY EBITDA requires removing the Apple settlement ($4.7B), in which case YoY company EBITDA for 3Q20 is actually up by $100M on a comparative basis.

On a non-GAAP EPS basis, the company’s quarterly $0.86/share results were above the high end of the guidance. The strong results for the quarter were, in particular, due to strong results from QTL and no real drops in chipsets, despite COVID-19. The company also expects a large increase in royalty revenues for 4Q20, due to the beginning of earnings from the Huawei agreement.

COVID-19 impacts on Qualcomm have been marginal for the most part. The company hasn’t experienced any sort of detrimental supply chain issues as a result of the pandemic, nor has it impeded the pace of the company’s research. With 5G handsets starting to exceed other technology handset shipments, the company’s revenue is set to increase further here. The company also announced its new series 6 snapdragon mobile platform, specifically for 5G.

Looking over at company fundamentals, we find very little of worrying character. The company has an A-rating from S&P, and while debt/capital is elevated at 80% of LT debt, it’s also handleable for a company with the license portfolio and revenues that Qualcomm has. The company’s overall payout ratio is somewhat elevated following a strong tradition of dividend growth over the past 20 years and currently stands at 13% over the past 10 years (per year). The EPS payout ratio is actually set to fall from the current 72% LTM ratio, down to a 45% NTM payout ratio due to favorable new revenue streams from, among other things, Huawei.

Over the past few years, the company has also utilized the pressured share price to buy back a significant amount of common shares.

(Source: SimplySafeDividends)

And while overall debt/cap is high, overall Net debt/EBITDA is not, with a current NTM net debt/EBITDA ratio of 0.57X. The company has a strong moat internationally thanks to its thousands of crucial licenses, many of which are essentially a “must-have” for any company seeking to work in the industry.

Because of this, I view Qualcomm’s fundamentals as quite strong, all things considered, and its dividend is considered to be “safe.” The fact is, the company traded at extremely poor levels in large part due to the legal battles ongoing with the FTC and Apple. Given that one is resolved and the other looks positive, it’s no wonder that the outlook for Qualcomm is significantly improved.

Qualcomm – What’s the valuation?

Unfortunately, this is also the crux of the company’s current overall position in terms of its valuation. I’m surprised at the number of bullish/very bullish articles at this valuation, given the current forecast we’re seeing for the company. Take a look.

(Source: F.A.S.T Graphs)

Don’t get me wrong – Qualcomm is a great company, with amazing fundamentals and a great portfolio. It doesn’t take a genius to see that the company is trading outside of its typical valuation ranges here, and while certain things are settled at this time, and this could and should improve things, the question is if these current excellent trends should result in this positive outlook for the company.

Qualcomm doesn’t historically trade for a valuation that’s higher than 15X earnings. This is an oddity – why? Because the company’s portfolio, which after all includes some of the most important IP on the planet for wireless communication, should essentially give the company a type of immunity, or premium. But it hasn’t, historically. Now that things are looking up, some argue that we should give the company this sort of premium. Me, I’m not so sure.

Current expectations are for a 63% earnings growth in 2021, followed by more muted earnings growth, or flat development in the subsequent years. If we assume that the company suddenly justifies a 30X earnings multiple, then yes – this is a decent entry point. The company will likely be able to significantly grow earnings in ’21 and ’22. However, even if that occurs and you argue that the company trades at a 25-30X premium multiple, all you’ll get if earnings do expand to that tune, is an 18-25% annual return.

(Source: F.A.S.T graphs)

This is a great return. Few companies offer this – but it’s also entirely based on forecast assumptions which, with a 10% margin of error, have a 36% miss rate on a 2-year basis. That means that I view these as little more than somewhat indicative in terms of what might happen with earnings.

I view it as far more likely that the company will revert to either a historical premium or a higher premium than the historical one – let’s be generous and say 16-17X earnings, reflecting increased confidence in Qualcomm’s earning capacity.

(Source: F.A.S.T Graphs)

However, even such a premium which is, in all fairness, far more conservative than the high multiple some are giving Qualcomm here, would result in no more than low single-digit rates of return with only a 2.2% yield. To which, I pose the question: Where is the appeal at this valuation?

I prefer giving companies very conservative valuation targets which can either then meet my targets, or exceed them. It’s historically rare (though certainly not unheard of) that investments go below my short to medium-term targets. That doesn’t mean Qualcomm will fall, it just means that I don’t view the appeal at this valuation as all that good.

Let me put it this way.

Qualcomm has never, since 2006, traded at a weighted average 30X earnings multiple. Whenever you invested in the company at peak valuations – such as that time in 2006, you would until today, at 30X earnings, have made around 7.7% per year for 14 years. While this is in no way bad, it also includes the latest expansion. Only a month or two ago, that return would have been less than 4% per year.

The danger here, as it is for most companies, is investing at a too expensive valuation for the company. 30X weighted average in terms of earnings is certainly too expensive for Qualcomm, and it has me on the fence whether I should divest part of my holdings for the profit for reinvestment.

Qualcomm’s 4-year average EPS with current forecasts, including 2020, is $6.2625/share. I’m being generous here, including the company’s 64% forecasted 2021 EPS growth. That gives us a 16-17X earnings valuation range of $100-$106/share. This makes Qualcomm 10-15% overvalued at today’s valuation, even including those superb, forecasted earnings.

I’m unwilling to shift my stance and valuation further at this point. In full disclosure, my stance is lower than the analyst consensus overall here, most of whom give the company a far higher target. S&P Global targets put the company’s high at a $150/share target, with a low at $74/share, and a mean of $124.85/share (Source: S&P Global). However, it’s important to note that these targets have shifted nearly 50% in terms of their mean in less than one year. While some things have happened since then to change the outlook of the company, it’s my view that the market is being excessively exuberant on this company’s future.

Qualcomm – Bulls and Bears

black water buffalo on field during daytime

(Source: Unsplash)

Bullish stances on Qualcomm are based on a continuation of the company’s excellent performance, the resolving of many of the company’s previous issues, and new contracts with companies like Huawei. Some seem to believe that the company’s results, which usually come with a catch, are now set to soar for the next few years.

They also point to the assumption that a $6-$7 EPS may only be the beginning as this company realizes its full potential, and that the license deal with Huawei is only the first step in a future potential of boons which may indeed bring this company higher.

Overall, the positive view on Qualcomm here is based on a mix of the company’s growth potential with the company’s actual, current earnings potential with news including Huawei included. Because of this, Qualcomm bulls expect this company to soar further, and $110-$125/share is only the beginning.

brown panda on open field near river during daytime

(Source: Unsplash)

Me, I take a more bearish tact on things here, in the sense that I believe these positive expectations are somewhat exaggerated. I believe Qualcomm to be worth a 14-16X earnings multiple, perhaps even 17-18X if they can realize and keep to this sort of growth in the future and realize in full a $7-$8 annual EPS. To say however that the company is worth essentially a 20-25X 2023 earnings multiple, that is too far for my taste.

The risk that I see is investing in a company where earnings, even if positive, result in either a too low or even long-term flat/negative growth rate if things somehow don’t turn out as positive as people seem to believe. Given that I’m primarily an investor who invests in undervalued quality companies, this makes the company uninteresting for me at this price – and that is also what I base my more bearish thesis on. I don’t view Qualcomm as a bad company – it’s an excellent company, that’s why I own the stock. But at a 10-15% overvaluation to what I view as even an excessive amount of overvaluation to a 2021-2022 fair value, that’s where I draw a line.

Thesis

As I said, Qualcomm is a great company – and at the right price, I’ll be loading up more of this stock to capitalize on the growth we’re seeing, will be seeing and have seen here. Now, however, the stock is riding a bit too high, and some investors should be asking themselves whether now is a good time to take home some of the profits they made if they invested earlier. Myself, I invested when Qualcomm was cheap, and things were looking pretty bad in terms of lawsuits and legal battles. I invested based on the company’s fundamentals, and even without positive outcomes in these things, it’s my belief that these fundamentals would have seen the company through the times they’re currently facing.

As things stand now, however, we’re simply looking at an overvalued company, that’s growing more overvalued. Because of this, the company to me is a “HOLD,” and not worth buying at this time.

For the time being, I’m keeping my position, but if the company expands a lot further, say above $150, I may consider selling here and waiting for the company to drop back down.

Thank you for reading.

Stance

At a price target $100-$106/share, Qualcomm is 10-15% overvalued and deserving of a “HOLD.”

Disclosure: I am/we are long AVGO, QCOM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: While this article may sound like financial advice, please observe that the author is not a CFA or in any way licensed to give financial advice. It may be structured as such, but it is not financial advice. Investors are required and expected to do their own due diligence and research prior to any investment.

I own the European/Scandinavian tickers (not the ADRs) of all European/Scandinavian companies listed in my articles.

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