Early this morning, one of the biggest drivers of market volatility was Apple Inc. (AAPL), which disappointed investors by slashing their revenue forecast dramatically. AAPL appears to be trying to manage the conversation around the reasons for that, as they attributed the largest portion of the decline to weakness in China. That is clearly spooking the market today, as this news seems to add credence to the notion that China’s economic slowdown is starting to have a long-feared trickle effect on U.S. multinationals. There is an interesting element of the story, however that I think is being overlooked quite a bit by most investors and that could represent an interesting long-term opportunity.
In an interview with CNBC, Tim Cook said that iPhone sales have been dramatically lower, particularly in China. The ongoing trade tensions between the U.S. and China are clearly playing a role, but another dragging element comes from “developed markets” – which means the U.S. and just about every other long-established market the company sells its products in. iPhone sales are clearly lower in those markets as well, and Cook referred to lower carrier subsidy payments as being part of that equation. That is the element that I find interesting.
Carrier subsidies are the way that phone carriers like Verizon, AT&T, and Sprint can offer incentives to consumers not only to buy a new smartphone, but also to keep upgrading year after year to the latest and greatest version of your favorite smartphone. The carrier pays a portion of the cost of that new phone to the manufacturer – Apple, in this case – for you so you can get that greatest new phone at a discounted price. That helps to blunt the ever-increasing cost of a new smartphone, and it is something that AAPL has clearly relied on to help motivate continued strong iPhone sales year after year. A decline in subsidies, I think is a symptom of something that should work to the advantage of Qualcomm Inc. (QCOM), the chip and integrated circuit maker that has been engaged in an ongoing legal battle with AAPL.
QCOM holds a massive number of patents on the wireless network and mobile device technology that most cellular networks, and smartphones are based on, which means that they draw the largest portion of their revenues from licensing revenues from those patents. Historically, AAPL has been, and by most counts continues to be, their largest customer; but over the last year or so, AAPL has made efforts to reduce their reliance of QCOM-driven technology to help manage some of their costs. That has resulted in a bitter, long-term legal fight that has yet to see the end; QCOM, for example asserts that AAPL is withholding more than $7 billion in overdue licensing fees, and they have won injunctions in Germany and other parts of the world to ban certain types of iPhone sales. AAPL’s revenue miss by itself doesn’t give QCOM more leverage in that legal fight, but I think the fact that fewer people are actively adopting the latest and greatest new iPhone, and in fact extending the length of time they hold on to an older, “legacy” version will.
One of the things that has historically motivated carriers to keep subsidizing iPhone sales is the reality that iPhones, by and large, offered the best combination of features and functionality on the network capability of the time. When 3G connectivity was new and exciting, iPhones clearly outperformed better than any other smartphone; the same was true with the introduction of 4G. Part of the reason for that distinction was the fact that iPhones were built with the networking capabilities provided by QCOM. The next big network on the horizon is 5G, a network infrastructure that is still being built out but that isn’t just the next big thing for your smartphone, but offers potential and opportunity in virtually every aspect of business networking and telecommunication, and which many analysts anticipate will offer bandwidth and connectivity that rivals, or in many cases exceeds traditional land-based networks including fiber-optics. One of the biggest investors and developers of 5G wireless networking standards and solutions? That’s right – Qualcomm. Are AAPL’s efforts to reduce their reliance on QCOM a reason that the gap between iPhone and Android smartphones have narrowed, and that it is no longer a given that Apple will offer the best phone on the market for the next generation wireless network? I think it is absolutely a contributor, and that is something that could give QCOM important leverage that will ultimately help prompt both companies to settle their legal dispute and get back to concentrating on doing business instead of the next legal brief or injunction.
Fundamental and Value Profile
QUALCOMM Incorporated is engaged in the development and commercialization of a digital communication technology called code division multiple access (CDMA). The Company is engaged in the development and commercialization of the orthogonal frequency division multiple access (OFDMA) family of technologies, including long-term evolution (LTE), which is an Orthogonal Frequency Division Multiplexing (OFDM)-based standard that uses OFDMA and single-carrier Frequency Division Multiple Access (FDMA), for cellular wireless communication applications. The Company’s segments include QCT (Qualcomm CDMA Technologies), QTL (Qualcomm Technology Licensing) and QSI (Qualcomm Strategic Initiatives). The Company also develops and commercializes a range of other technologies used in handsets and tablets that contribute to end user demand. The Company’s products principally consist of integrated circuits (chips or chipsets) and system software used in mobile devices and in wireless networks. QCOM has a current market cap of about $67.9 billion.
- Earnings and Sales Growth: Over the last twelve months, earnings declined more than -7%, while revenues dropped almost -2%. The picture wasn’t really better in the last quarter, as earnings declined even more, about -16.5%, while sales increased 3.64%. The company’s margin profile is a troubling sign, since Net Income as a percentage of Revenues was -21.3% over the last twelve months and about -8.5% in the last quarter. These numbers are a reflection of the legal battle with AAPL, as a number of other AAPL suppliers have followed their lead and appear to be withholding payments of overdue licensing fees while they wait to see what the final legal result is going to be.
- Free Cash Flow: QCOM’s free cash flow is healthy, at $3.1 billion over the last twelve months, despite the fact that it declined by almost 50% in the last quarter. This number also translates to a Free Cash Flow Yield of about 3.7%.
- Debt to Equity: QCOM’s debt/equity ratio is very high, at 16.56. This number jumped dramatically in the last quarter from a very conservative .67, but I think that isn’t a big a red flag as it might appear. The company’s balance sheet shows that they have more than $12 billion in cash and liquid assets against $15.3 billion in long-term debt. That means that while operating profits are negative, the company has plenty of liquidity to work with for the time being. I’m not minimizing the fact that Net Income is negative; that is a concern, since the longer that persists, the more the company will have to deplete its cash reserves to keep things going. The longer it takes for the company to resolve its legal concerns with AAPL, the more likely it is to see this number keep dropping; on the other hand, the sooner a settlement, of just about any kind, is reached, the more quickly the bleeding ends and the company will return to some of the impressive operating margin and cash flow levels it has enjoyed for most of the last decade.
- Dividend: QCOM’s annual dividend is $2.48 per share, which translates to a yield of 4.44% at the stock’s current price. That is a very attractive yield, but it should be noted that since earnings have been negative, the company is drawing from available cash to pay their dividend.
- Price/Book Ratio: there are a lot of ways to measure how much a stock should be worth; but one of the simplest methods that I like uses the stock’s Book Value. QCOM has a Book Value of $.63. That’s not a typo, and it is a remarkable drop from $15.70 in the quarter prior. Like the company’s debt/equity ratio and negative Net Income, I think of this as another symptom of the ongoing legal war, and so while I don’t completely dismiss the implication such a low Book Value carries, I’m also going to leaven it using the stock Price/Cash Flow ratio. The stock is currently trading nearly 24% below that ratio’s historical average, which suggests the stock could already be undervalued. I don’t think that makes the stock an immediate buy – the risk for the time being remains very high, especially for whatever length of time remains to see a resolution in the legal battle that is clearly weighing on everything right now. I think that it does make QCOM a stock worth watching. When a settlement is reached – and that does seem to be the overriding question, not if it will happen – I expect this stock to offer an impressive and very compelling value argument.
Here’s a look at the stock’s latest technical chart.
- Current Price Action/Trends and Pivots: QCOM’s price decline since the mid-September represents a decline of more than 27%, but the stock is still about 15% above is 52-week low price and appears to be showing some signs of consolidation between support at around $53 and resistance in the $58 price area. A rally to $59 could mark the beginning of a new upward trend, with the most likely next resistance somewhere between $63 and $65 per share. Of course, a drop below $53 could see the stock revisit its 52-week lows around $48.50. The next support point beyond that price is around $45, and occurred in December 2015. A push below that level should see the stock drop into the mid-$30’s and into ranges not seen since the beginning of this decade.
- Near-term Keys: Despite the intriguing possibilities the stock’s current consolidation pattern offers, I’m not sure that there isn’t more, continued downside risk for the QCOM right now. The broad market remains volatile and seems to be looking for more and more reasons to keep dropping than it is to focus on any positive or bullish catalysts. That means that I think the best short-term bets are probably to the bearish side; use a drop below below $53 as a strong signal to think about shorting the stock or buying put options. In the long run, I do think there is going to be a lot of upside to be seen with this stock; but my preference right now would be wait to see some of the fundamentals that have shifted so badly because of the effect of the company’s legal troubles turn back to the positive and then to re-evaluate the value proposition at that point. It’s interesting right now, but I think that it will be far more compelling at that point.