Qualcomm: Stable Core Handsets Business With Great Upside Potential In Adjacencies (QCOM)

Thesis Brief

Connectivity is the future and QUALCOMM (NASDAQ:QCOM) has the best modem and RF-front end for smartphones and adjacent markets such as autos and various IoT markets. As a result, it is in a solid position to retain its status as the go-to chipset for premium Android phones but also has great upside potential in emerging markets – in fact, it has recently made multibillion dollar deals with various automakers. However, despite its industry leadership in connectivity and its growth outlook, it is trading at a substantial discount to intrinsic value and is trading at a notable discount relative to peers.

QCOM is at a Discount

At 11x P/E NTM and 3.6x EV/S NTM, it is very clear that QCOM is at a discount. Similar to other technology names, QCOM suffered from the meltdown due to the broader sector rotation from growthy technology names into protective consumer staples. Like many other times of market turmoil (Dec 2018 and Mar 2020), this is a great opportunity for investors to add high conviction and high quality names that can come out of crises and thrive in years to come.

Following the market turmoil, there will be companies who will make a great come back and deliver compounded returns over time, and there will be companies who can’t revive growth and deliver results, and hence will generate poor investor returns. Following some deep dive research for our subscribers, we believe QCOM falls in the first category and this new earnings release has further solidified our conviction.

The Core Handset Business is Surprisingly Strong

A huge part of the bearish thesis around QCOM has been the recent headwind towards global consumer spending. As inflation is running high and consumer confidence is low, we are seeing a softening spending pattern for consumer technology and this has led to declines in major semiconductor names and even FinTech names as they are heavily exposed to the broader consumer economy.

Furthermore, the sudden outbreak of COVID-19 in China ramped up the bearish sentiment against QCOM. QCOM is heavily reliant on Chinese OEM vendors to procure the Snapdragon chips and assemble them as the final smartphone product to consumers globally.

According to numerous reports including this one from Counterpoint, the new lockdowns have substantially impacted the Chinese smartphone market. If this trend continues, Chinese market shipments could even decline back to where it was in 2008, the time when the smartphone was just been introduced.

This has scared off many investors, institutional investors in particular. As a long-term fundamental equity research firm, we don’t typically pay too much attention to the volatile quarterly results that may be non-indicative of the firm’s longer term outlook. However, we are surprised by the tone of the management in terms of their confidence to keep growth of the handset business at 50% this year.

For context, the handsets business is up 56% YoY but less growthy QoQ. This means that the company needs a second boost in the 2H22 to meet their guidance. Apparently, management is very confident on this. Management cited a strong demand over supply situation, strong growth in premium Android devices (whereas most of the impact in the Chinese market is at the lower end), an almost certain-to-repeat holiday season demand, and a new flagship platform launch in September.

More specifically, a large part of the growth is contributed by QCOM’s further strategic negotiation with Samsung (OTC:SSNLF). Samsung’s latest flagship S22 uses the Snapdragon chip in c. 75% of volume vs. c. 40% last year for the S21. As the biggest vendor of premium Android phones, Samsung’s decision to ramp up the usage of QCOM chipset provides a big boost to the handset business.

This doesn’t come without cost, however, as Samsung reached the agreement with QCOM upon the further lock-in of QCOM using Samsung’s outdated process nodes. Samsung is increasingly trailing behind TSM on the fab business. For context, although QCOM and Samsung marketed the Snapdragon 8Gen1 as the most powerful mobile SOC manufactured by the 4nm process node. It is very clear to everyone in the fab world that Samsung’s 4nm is no different to its 10nm back a few years ago, with only a slight improvement in power efficiency. At the same time, TSM is making very consistent progress in its advance nodes and its latest 4nm leads Samsung’s by 1-2 more generations. By choosing Samsung’s own fab over TSM, Samsung made concessions to QCOM. Samsung forfeited its proprietary Exynos fabless unit and chose to adopt QCOM’s chipsets more aggressively. Samsung also offers the fab solution at close to COGS, which in term should mean the highest GM possible for QCOM.

More specifically, thanks to QCOM’s deal with Samsung, Samsung’s latest flagship S22 uses the Snapdragon chip in c. 75% of volume compared to c. 40% o
f volume last year in the S21. The deal also includes Samsung manufacturing the Snapdragon chip, which has a few implications:

1) Choosing the less advanced node over TSM’s 4nm node results in substantial cost savings for QCOM and is gross margin supportive.

2) To drive scale economies, Samsung’s phone business unit has ordered a load of these Snapdragon chips to make the slim margins worthwhile.

However, 3) forgoing TSM’s 4nm node means that QCOM has sacrificed quite a lot in performance, which makes iPhones even more appealing, and the Samsung deal now means QCOM is locked into an outdated process.

However, over the longer term, we view QCOM as still the best player for the SoC (System-on-Chip), as it continues to own the best modem and the best RF front-end, and has the upside potential of Nuvia, which has a good chance of getting them a strong foothold in the server market. If you believe that QCOM’s position in the smartphone market is well secured, then QCOM is trading at a fair discount.

Non-Handset Business is the Future

A fair discount means a good investment opportunity only. We need more parabolic upside potential to make it a great investment opportunity. We are very surprised to see that QCOM is already making great strides in executing its diversification strategy.

Our long-term thesis is that connectivity is at the core of many intelligent edge devices, including consumer & industrial IoT, wearables, and automobiles; however, compared to the AI/ML aspect of autonomous drive and IoT, the connectivity aspect appears to be less hyped. For autos in particular, once the autonomous drive technology becomes commoditized, we view the connectivity that will bring better in-car digital experiences as the real value adder. Furthermore, QCOM’s immense amount of knowhow in collaborating and nurturing the OEM ecosystem would be a core competitive advantage, especially when it is competing with vendors like NVDA who may have better technologies.

This quarter, QCOM announced that they have landed $16bn worth of deals with auto makers. One particularly strategic deal is that made with BMW (OTCPK:BMWYY) whereby QCOM will supply chips for BMW’s endeavours to transform the digital cockpit.

We believe the Arriver acquisition has given QCOM a very compelling auto SoC solution to virtually every auto maker bar TSLA, catalyzed by gas autos needing some other way to add value and better compete against TSLA, NIO and other EVs.

In addition, QCOM announced the latest chip for WiFi7 connectivity. This is another area where QCOM was new to the space but quickly took market share and establish itself as the unquestioned leader.

Management also affirmed their optimism on the tablet and notebook business. We agree that the overall trend for Android devices including tablets, smartphones, and Chromebook, will continue to be strong. These devices have traditionally centred around price leadership instead of high ASP (Average Selling Price). As Microsoft (MSFT) is trying to fight back against Apple’s (AAPL) M1 Mac, we’ll see greater GTM success for QCOM’s PC SoC with Nuvia technology.

Satya Nadella Moment?

Another key discount factor to QCOM has been its management chaos. The founding father and son leadership has been challenged by regulatory concerns, and subsequently the QCOM board of directors found it hard to find a great leader to take QCOM out of regulatory turmoil and reignite growth. Cristiano Amon, a long time Brazilian engineer at QCOM was chosen as the CEO in 1Q21. This is a similar move to Pat Gelsinger’s return to Intel (INTC). Although Amon appears to be less stellar and accomplished than Gelsinger – absent of a prominent timeline of accomplishments and leadership.

In many ways, we can draw potential parallels between Amon of QCOM and Satya Nadella of MSFT. Both of which were little known to the general public but worked in the firm for years. Nadella regained control of MSFT back when the company was facing mounting challenges including the legacy-fying Windows and Office business, tumbling mobile business, disorganized business units, and an unclear culture. Nadella emerged as a surprisingly strong leader who successfully directed MSFT into new areas of business where it could capture the long-term tailwinds whilst leveraging its existing capabilities and customer base.

We view Amon’s new strategy for QCOM, centred around connectivity, as a great fit for QCOM, and we will continue to monitor its progress in the future to come.

Valuation and Forward Expectations

We expect QCOM to be able to grow at more than an annualized 10% during the next five years and maintain more than a 25% FCF margin. We view QCOM’s management’s long-term guidance as pretty conservative and there is a substantial amount of room for QCOM to beat the estimates.

Our DCF model yields QCOM’s EV at c. $340bn, which represents more than 100% upside at the current price. We believe QCOM’s EV/S should stand at least at 10x EV/S considering its strong future potential and hugely profitable unit economics. In addition, QCOM’s EV/NTM EBITDA stands at just 8.8x, which is at 50% discount to a typically less growthy but highly profitable legacy tech business.

It is very clear that the market is pricing in a very challenging demand for QCOM in years to come. While we do believe the handset business could be facing a tailwind soon, we see QCOM’s connectivity story as a very convincing one per our deep dive. If you believe that QCOM’s leadership in premium Android phones isn’t fading, and its pipelines in Autos, IoT, Wearables, and PCs are solid, then in our opinion, you should consider adding QCOM as part of your tech portfolio for mid-to-low volatility and solid future returns.