Markets & Finance

Qualcomm: Top of the Wireless Food Chain


By Kenneth Leon We at Standard & Poor's Equity Research Services view Qualcomm (QCOM

; buy; recent price: $63.50) as the best in its class, with one of the most attractive business models in the telecommunications industry. In many ways, we see parallels to the success Microsoft (MSFT

; buy; $26) enjoyed in the last decade.

Qualcomm has a unique position, thanks to its intellectual property from designing code division multiple access (CDMA) for the mobile wireless industry. Its patents' strength have enabled the outfit to receive high-margin license royalty fees from all users, handset and infrastructure suppliers, as well as service providers that use CDMA for software-enabling applications.

In addition, Qualcomm is the leading fabless semiconductor concern, with more than 98% of the worldwide market for CDMA chipsets. Fabless means it designs and upgrades its portfolio of CDMA chipsets and then outsources the manufacturing to foundries operated by IBM (IBM

; buy; $94) and Taiwan Semiconductor Manufacturing (TSM

; $10.80).

CASH PILE. Having foundries in each major region of the world is what San Diego-based Qualcomm is planning, with Europe the next major target as the Continent's telcos begin to upgrade for third-generation (3G) technology known as WCDMA (wideband code division multiple access) or UMTS (universal mobile telecommunications systems).

Plus, Qualcomm generates substantial operating cash flow to meet capital requirements, make strategic investments, and pay a dividend on common shares. As of Dec. 31, it had approximately $5.4 billion in cash and cash equivalents, or 61% of its total assets, with long-term debt under $130 million. As its Board of Directors declared a 43% hike in its annual cash dividend, to 40 cents per share, we anticipate that the stock may become more attractive to a broader group of mutual funds that seek growth and income in their portfolios.

Aside from its $5.4 billion in cash equivalents and nominal long-term debt, the 25% sales growth and net margins near 30% that we expect for 2004 are favorable drivers to boost higher earnings growth and bigger p-e gains for the shares.

A CLOSER LOOK. Our 12-month target price of $80 is based on discounted cash flow and forward price-to-sales and price-to-earnings valuation metrics. (Our model assumes a weighted average cost of capital of 12.48% and a terminal growth rate for free cash flows of 7% after year 15. We believe our assumption of mid-20% cash-flow growth for the next five years is reasonable, followed by a gradual slowing to 8% in year 15.) The shares trade near peer levels on a 2004 p-e multiple basis, and we would buy the stock based on our view of a strong company outlook.

Digging deeper into the numbers, let's take a look at Qualcomm's major products and services. It reports results in four operating segments: CDMA technology, technology licensing, wireless and Internet, and strategic initiatives.

The CDMA segment, which accounted for 61% of total sales in the December quarter, provides integrated circuits and system software to many of the world's leading wireless handset and infrastructure manufacturers. After shipping 32 million chipsets in the seasonally strong December quarter, Qualcomm raised its forecast for the March quarter to 31 million to 32 million units, from a previous range of 29 million to 31 million units.

CHIPS AHOY! The comparisons get easier in the June and September quarters, as Qualcomm should not experience the same weak demand as last year, when SARS and an inventory glut in China reduced chipset shipments. We're forecasting 123.5 million chips to be shipped in fiscal 2004, up 23.5% from the prior year.

Dominating the CDMA market, Qualcomm has developed a family of chips called mobile station modems (MSM) for 2G and 3G wireless handsets. Average selling prices (ASPs) are stable to slightly higher as it introduces higher functioning chips for audio, video, camera, and graphics capabilities. By 2005, Qualcomm's enhanced multimedia and graphics chipsets will allow camera-ready phones to deliver images of up to 4 megapixels.

In November, 2003, Qualcomm was selected by 13 global manufacturers for its integrated chipsets and software to deliver a wide variety of enterprise and consumer wireless devices to support WCDMA (UMTS) markets. In February, 2004, Huawei Technologies and ZTE Corp., two major Chinese equipment suppliers, selected Qualcomm's MSM6250 MSM chipset and system software to enable cost-effective, data-enhanced handsets for the WCDMA (UMTS) market.

CDMA ADVANTAGE. This month, Qualcomm announced its first delivery of a 90-nanometer, low-power MSM chip with its foundry, Taiwan Semiconductor, thus reducing mobile-application power consumption, boosting processor capability, and enabling the integration of more service features on a smaller chip. We believe it will be a steep challenge for Qualcomm's competitors to catch up in the CDMA integrated-device market, when so much is demanded from handset suppliers and wireless service providers.

Qualcomm's CDMA offers superior performance compared to other digital technologies, allowing a greater number of calls within the allocated frequency. The outfit holds many patents related to CDMA and derives royalties from more than 100 license agreements tied to its technology. Royalties are paid when the manufacturers earn revenue from the sale of CDMA-based equipment. The technology-licensing business accounted for 28% of its December-quarter revenues.

Qualcomm's third-generation CDMA2000 1X technology was commercially deployed in October, 2000, in South Korea and had picked up 17 million subscribers as of February, 2003. In North America, most CDMA-based operators had commercially deployed CDMA2000 1X at the end of 2003.

GROWTH NICHE. In January, 2004, Verizon Wireless (VZ) selected Qualcomm's CDMA2000 1X-EV-DO third-generation technology for high-speed, wireless data service applications. We expect Vodafone (VOD) to deploy WCDMA or UMTS in its markets in Asia and Europe during the second half of 2004.

Global CDMA handset forecasts are a useful gauge to determine Qualcomm's expected royalty stream from vendor and carrier license agreements. S&P's Equity Research forecasts total handsets to reach 515 million to 520 million in 2004, compared with 472 million handsets shipped in 2003. Qualcomm expects CDMA handsets to reach 142 million units in 2004, from 100 million in 2003.

Hence, the CDMA market segment is growing four times faster than the overall handset market. Qualcomm should benefit from the expanding demand in emerging markets, such as China and India, as well as a faster handset-replacement cycle in North America, Japan, and South Korea.

STRONG BREW. Qualcomm forecasts that WCDMA in Europe and other markets should contribute 10% of total CDMA handset shipments in 2004, compared with less than 2% in 2003. It targets North America at 37% of total CDMA handsets shipped in 2004; China and India at 19%; South Korea, Japan, and Southeast Asia at 22%; Latin America at 9%; and the rest of the world at 3%. Qualcomm sees ASPs for handsets declining only 7%, as the market looks to buy more high-end phones in developed countries to offset low-end phones shipped in emerging markets.

The wireless and Internet segment accounted for 11% of Qualcomm's December-quarter sales. It provides satellite-based, two-way data messaging and position-reporting equipment to transportation companies. The segment shipped 10,900 products in the quarter, bringing the total to nearly 500,000 units shipped.

Qualcomm's BREW software is reported within this segment, and we expect it to be the outfit's third sales driver. BREW is software on a chip capable of providing a user interface in the handset with e-mail, photo sharing, messaging, location-based services, push to chat, a Web browser, video player, and a Java applet. Qualcomm has established partnerships with hundreds of software developers to leverage BREW, which is able to operate on different radio frequency technologies, including GSM/GPRS, UMTS, cdmaOne, as well as CDMA2000 1X-EV-DO.

The fourth business segment is Qualcomm's strategic investments in wireless-technology developers and service providers in emerging markets. This unit has materially reduced Qualcomm's reported earnings, but with the sale of its 16% interest in Vesper, a Brazilian carrier, we expect this segment to have less of a negative impact on earnings.

Note: Kenneth Leon has no stock ownership or financial interest in any of the companies in his coverage area. He's a registered representative of Standard & Poor's Securities, Inc. Other S&P affiliates may provide services to the companies under discussion. Analyst Leon follows telecommunications equipment and services stocks for Standard & Poor's Equity Research Services


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