Qualcomm Inc (QCOM)

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Has Qualcomm's Time Come: Part II

Yesterday, Dave Mock looked at the underlying value in Qualcomm's high-quality earnings and cash position. Today, he looks at company operations and explains why he thinks Qualcomm has a bright future.

In the first part of my analysis of Qualcomm (Nasdaq: QCOM), I suggested that Qualcomm's stock price may appear more expensive than it really is. In this article, we'll take a more qualitative look at what's fueling Qualcomm's current growth cycle. While we want to cover all the positive aspects of the business, we'll also be prudent in acknowledging potential risks to various areas of the company's business.

Let's look at what's behind Qualcomm's recent earnings that has been fueling the stock lately -- four trends that I see as likely to continue through 2004.

Trend #1: Qualcomm's income is largely driven from wireless handset sales, which are booming.

Bill Mann's July 2003 article on Qualcomm stated concerns about the excesses built into the telecom sector as a whole. Overzealous bids for 3G licenses at the height of the late 1990s euphoria put many operators deep in the red. Additionally, with severe overcapacity built up in the networking sector, resumption in healthy spending levels was certainly a ways off.

But Qualcomm's more significant revenue exposure is to handset inventory levels, with network equipment making up only a fraction of the company's income. Trends in handset sales are driven more directly by consumer sentiments. So while the market for routers, switches, and even cellular base station equipment may be depressed for years, handset demand moves to a different beat -- one that is much faster paced.

I'd even suggest that the telecom malaise may have indirectly benefited handset sales. For carriers, recouping sunk costs is of utmost importance. If an operator builds a network, they pay for it whether anyone uses it or not. There's much more incentive to get customers signed up and paying for services; you can't dig yourself out of a hole without a shovel. So there's a strong incentive for debt-laden operators to sell handsets.

Recent reports in the sector show a significant recovery in handset sales, with solid growth expected to continue. Research firm Gartner Inc. reported a nearly 21% increase in worldwide handset sales to 520 million in 2003. They see 2004 sales increasing to a whopping 580 million units driven by new features such as integrated cameras. Each CDMA handset sold brings royalty to Qualcomm, and many units include the company's chipsets as well, bringing further revenue.

Of course, a contraction in overall handset sales will hurt Qualcomm's business. But we're early into a new cycle of expansion in this area, where demand is outstripping supply, so the concern is more in the long term.

Trend #2: The majority of Qualcomm's business comes from Asia, an area of high replacement cycles.

Qualcomm's most recent fiscal year had a whopping 43% of revenue derived from South Korea and another 15% from Japan. The percentage of revenue from international customers is growing each year as well, topping 78% in fiscal 2003. The evolution of mobile services in Asian nations has continued to propel Qualcomm's revenue higher as consumers in these markets tend to be early adopters of new technology and premium services.

The Asian markets in particular have short handset turnover rates -- the number of months wireless users own a handset before upgrading. In Korea and Japan, 18 months is the norm, compared to 24 to 36 months in other regions such as the U.S. and Europe. Each of those new handsets brings royalty to Qualcomm. Additionally, upgrades tend to move toward higher-priced handsets, which benefits Qualcomm further since its royalty is based upon the average selling price (ASP) of a mobile device.

The downside of this situation is the heavy -- and growing -- dependence on a few customers and the concentrated risk. Samsung, Motorola (NYSE: MOT), LG, and Kyocera (NYSE: KYO) make up the majority of Qualcomm's revenue. Samsung has quietly been developing CDMA chipsets for its own use, and Kyocera's obligation to source a majority of its CDMA equipment needs with Qualcomm expires at the end of 2004. There's no indication that any of these customers are eager to jump off Qualcomm's list, but new sources of competition may still pressure sales and/or margins.

Trend #3: Significant revenue from WCDMA is now showing.

Skeptical analysts have historically opined about Qualcomm's ability to charge royalty for a flavor of its technology -- called WCDMA -- that was purposely developed to circumvent its intellectual property. When announcing recent earnings, Qualcomm reported that royalties from WCDMA products made up 12% of its total royalty income. This product royalty stream is the one that everyone hung their hat on when Qualcomm's stock soared to extreme heights in 1999.

Well, royalty income from WCDMA shipments took years longer to flow in than most expected, due to delays in rolling out networks based upon the technology. But with many European and Asian carriers now bringing WCDMA networks online, Qualcomm is starting to benefit substantially. The 12% figure is significant and, again, this positive trend should continue. The revenue stream derived from this technology segment is also significant in that it will help spread Qualcomm's earnings base across more regions and customers -- reducing the risk cited above.

Currently, there are several major companies and industry bodies negotiating royalties for WCDMA equipment, and there is a chance that pressure will be put on Qualcomm to lower its rates or join a more dilutive structure for IP compensation. Some cite the coming expiration of Qualcomm's fundamental CDMA patents issued in 1989-90 as a concern for the company's licensing and royalty revenue as well.

But Qualcomm has the momentum of dozens of contract agreements signed with equipment manufacturers, so I see this risk as remote. Still, it's good for investors to monitor the state of the industry in this area as circumstances could change.

Trend #4: New markets are developing slowly but surely.

China and India have been on many CEOs to-do list for years as the regions of vast populations have tantalized telecom companies. Qualcomm has been working in both these regions for well over a decade now, longer than many peers. In fact, its solutions were initially targeted to these developing nations as the company was less certain of its chance of success in the domestic market.

Qualcomm has recently scored significant design wins in India and has seen China's CDMA subscribers go from less than a million to more than 20 million in only a few years. While the royalties and revenues earned from these developing markets is less than those earned in premium markets in the U.S. and Asia, the volume scale more than makes up for the shortfall. Continued growth in wireless services in these regions should provide significant revenue for Qualcomm for years to come.

On the downside, emerging markets are inherently risky. The delicate dance between the U.S. and China has been anything but boring lately, and probably always will. Recent rumblings over semiconductor tariffs and boycotts in the Wi-Fi arena have reminded investors that business in China should never be taken for granted. Qualcomm's CDMA could end up being a pawn on a larger playing field of trade relations with the U.S., China, and its neighbors, placing future revenues from this area at risk.

Other risks
On top of these trends that are driving near-term results, there are some long-term issues investors should keep in mind with Qualcomm. Let's start with discontent over royalties. South Korea in particular has made their displeasure with paying ongoing royalties to Qualcomm more public lately. Many manufacturers feel that Chinese companies have been given a better deal on terms of their royalty contracts, placing Korean manufacturers at a disadvantage. Qualcomm has to work hard at keeping customers happy and relationships in the "win-win" category.

Extensive details of the terms of confidential license agreements have been showing up in the Korean press lately, making it more difficult for Qualcomm to address concerns. The company took competitor Texas Instruments (NYSE: TXN) to court on a lesser violation of disclosing proprietary terms of a contract, though there is a stronger competitive element in the latter case that pushed Qualcomm to action.

Then there's the question of chipset market share. New competitors Texas Instruments, Samsung, and Nokia (NYSE: NOK) are all pushing their own chipset solutions for CDMA. Qualcomm acknowledges that its more-than-90% market share in CDMA chipsets will likely shrink, but the company is estimating that the overall effect of volume growth in CDMA and new opportunities in WCDMA chipsets should end in an overall net positive for the company.

Qualcomm also boosted R&D spending significantly this year to shore up its offerings in chipsets and software solutions. A recent hiring fair also targeted hundreds of engineers to fill open positions. While many industry watchers question Qualcomm's ability to capture its self-proclaimed goal of 50% market share of WCDMA chipsets, the company has a strong history of capitalizing on big opportunities. Even if the company falls short of the 50% goal, it is well known for achieving well beyond what most companies would settle for.

The Foolish bottom line
Qualcomm is a very impressive company and noteworthy competitor in the wireless market. For the first time in more than four years, I believe it is an investment that's finally worth a look.

Fools on the Qualcomm discussion board dispense some of the best analysis of the company on the Web. Check out the details and join the discussion here.

Dave Mock wrote the book on Qualcomm -- literally. His corporate biography on the company, The Qualcomm Equation, will be published by AMACOM in the fall. Dave owns shares of Motorola, and can be reached via email. The Motley Fool is investors writing for investors.

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