Should You Chip in on this Semiconductor?

ROUNAK is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

The technology sector is known for two things: growth and risk. The latter is averted to a great extent when one is dealing with a company as fundamentally strong as Qualcomm (NASDAQ: QCOM). It is a rare company that has a market-leading position in a growing business.

Qualcomm's business model consists of selling chipsets as well as collecting royalties on 3G and 4G smartphones being sold in the market. Its healthy royalty business represents just 30% of the company's total revenue, but accounts for 75% of its margins. On the other hand, the mounting R&D expenditure also points towards the company’s rising interest in its chipset business.

The royalty Qualcomm collects is based on device ASPs. The recent lackluster performance of Qualcomm was basically due to falling ASPs of the devices and narrowing of the semiconductor’s margin in the quarter. It posted a margin of 17%, which, though, it was in line with expectations, was far lower than the 26% figure seen in fiscal year 2011. But let us try to break down this situation and understand the other variables at play.

Recent Quarter

In its second quarter earnings, revenue at the San Diego outfit climbed 24% year over year to $6.12 billion, while the net profit grew a similar 17% to $2.07 billion. This was low in comparison to the annual outlook. But the company maintained its full year operating margin guidance for the chipset and licensing business. This suggests that the company sees support in the ASPs with a rise in margins over the latter half of the year. In line with the company’s optimistic outlook for fiscal 2013, the growth in third quarter revenue is expected to increase by another 25%.

Conduct of the rivals

Qualcomm’s competitor Intel (NASDAQ: INTC) is betting big on the chipset market with huge amounts of money being put into R&D. The company finally seems to be getting it correct with its Silvermont processor, a potential competitor for Qualcomm. But it will take time to match the economies achieved by Qualcomm because of its scale of operations. Due to this, Intel will have no option but to take a hit on its gross margins for several years. Whereas Qualcomm's stock has returned 63% in three years, Intel has returned –3.97% over the same period.

For its part, NVIDIA (NASDAQ: NVDA), with its acquisition of Icera, demonstrates its ability to compete with Qualcomm and Intel. Nvidia’s Tegra 4i, its first applications processor with an integrated LTE modem, proves to be a major competitive obstacle and might give stiff competition to Qualcomm’s processors. Despite all of this, the Snapdragon processor manages to beat Tegra in terms of various benchmarks. In terms of business, NVIDIA is split into its mobile segment, NVIDIA GRID, its cloud virtualzation graphics segment, and its GPU segment. It generated $4.3 billion last year, suggesting it operates in small but distinguishable segments. It has a trailing P/E ratio of 15.5 times, lower than its peers, as analysts expect a drop in future revenue with no upward catalyst. The going has been tough for NVIDIA as Qualcomm continues to dominate the smartphone market. And both NVIDIA and Intel lag behind Qualcomm with the absence of an integrated model, which is why Qualcomm is expected to outplay them with its size in the near future.

Broadcom (NASDAQ: BRCM), one of the smallest players in the business, also posted rising revenues and has been expanding its reach in the baseband market. The company's gross profit stands at 55%, while the net profit percentage is 12.06%. The net profit percentage is significantly lower than industry average. Its market cap is just $19 billion, making it one of the smallest players in the business. Also, in its first quarter results, the company posted revenue of $1.83 billion, beating market expectations. Besides operating in the baseband segment, the company has a 35% market share in the high growth wireless connectivity segment and is more attractively valued than Qualcomm. It has also announced its first LTE chipset. But since its a smaller company, it cannot provide the stability that Qualcomm offers. Qualcomm remains the leader in the baseband segment and the application processor market in which Broadcom has a long way to go. Moreover, the margins of Qualcomm are better than those of Broadcom

The Asian Route

Like many other product markets, the smartphone business is reaching its saturation level in the United States, and the only way ahead is going to emerging markets like China and India. Qualcomm reacted early to this factor, and hence now its major chunk of sale of smartphones and chips come from these Asian markets. The Asian population accounts for more than half the world population and if there is one product that is revolutionizing these markets, it has to be smartphones. Qualcomm seems to be well positioned to reap in the rewards stemming from this major industry advantage. These markets have a flip side too, which is the need of cheaper smartphones that bring down the ASP. But this factor is thwarted by the growing demand and the race of launching expensive phones with more features than another among the handset makers.

The strategic direction

Qualcomm has worked well with its Snapdragon processors, and is expected to maintain its dominance with its Snapdragon 800, which is better than the previous Snapdragon S4 Pro in terms of performance. The top-selling smart phones, whether it’s Samsung Galaxy S4, HTC One, Nokia Lumia 925 or Sony Xperia Z have used Qualcomm’s Snapdragon Processor. Even the iPhone Mini is rumored to have Qualcomm inside it.

 CDMA-based technologies are Qualcomm's greatest IPR stronghold, but its early foray into LTE technology has also made it the market leader, signing many 4G deals with handset vendors. It is ready with its third LTE version, while other chipmakers are only preparing for their first ones. It is guiding the transition of the developed nations to the LTE 4G technology, and to 3G technology in the developing nations. Both these technologies are the new future of the telecommunications industry, and Qualcomm will always have the first-mover advantage. It has a 97% share of the expanding LTE modem market and about half the share of the baseband market.

Also, the near future in mobile technologies is interconnected devices and near field communications. Qualcomm has been the first to integrate these technologies. Moreover, adding such features results in more expensive phones, leading to higher ASPs and hence higher royalties for the company.

Should you buy it?

The financial strength of the company stems from its experience and innovative capabilities. The company has a huge cash chest of $4.9 billion, reflecting its ability to invest into R&D. A quick ratio of 2.9, another important indicator, suggests that Qualcomm should have no problems with its liquidity in the near future. In the past the company has shown a commendable earnings growth rate of 27.6% since 2009.

The booming mobile industry is yet in the infancy stage of its growth, and communications is a field that will drive the world in the years to come. Although the P/E ratio close to 18 is significantly lower than the estimates, Qualcomm's past numbers and growth plans remain very strong. Its stock has been a little volatile of late and is trading at prices lower than estimates. This represents a good time to buy the stock of a company whose fundamentals are so compelling.

The stock price now hovers in the lower $60s' and the analysts have weighed in on the share at this price. The company is affected by the falling ASPs, but this does not effect the competitive strength and fundamentals of the company. With such good numbers in the past and bright future outlook, the company is a definite buy for mid to long term investors.

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ROUNAK KHEMKA has no position in any stocks mentioned. The Motley Fool recommends Intel and NVIDIA. The Motley Fool owns shares of Intel and Qualcomm. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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