Amidst global slowdown and US recession fears, the world also appears to be entering a new phase of radical innovation. Nothing has brought this to the fore better than the recent launch and uptake of GPT-4, showcasing the possibilities of Artificial Intelligence (AI).
As in many advancements the world has witnessed in the past, while the progress of this too may not be linear, its time appears to have come. Disruptive innovation and changes are certain in the current decade. Thus, for investors looking to capitalise on this trend, it is important to be invested in the right technology companies that can make the most of this trend.
While under normal conditions, technological moat and high growth prospects would be the key determinant in picking technology stocks, that approach alone might not work in the current context of high interest rates and global slowdown. Stocks trading cheap, offering adequate margins of safety for risks to earnings prospects, and at the same time high in technological moat and levered to disruptive trends make for optimal bets in this context. Nasdaq listed Qualcomm (ticker: QCOM) fits these conditions reasonably well.
Trading at a one-year forward PE of 12 times versus five-year average of 15.4 times, the stock is cheap for a leading technology company levered to new digitisation trends. With a well-established wireless semiconductor chip business and ownership of advanced intellectual property that will have high use cases in an AI/wireless powered digital world, Qualcomm, at current valuations, offers attractive risk-reward for long term investors. We recommend a buy on the stock. However, we would like to note that given elevated near-term risks to global economy and markets, the stock may see declines along with broader markets and hence investors must be ready to average on declines as well if required, with a long-term perspective.
Business and prospects
Founded in 1985, Qualcomm has been a pioneer and at the forefront of wireless technology and innovation for the last four decades. It today owns some of the leading intellectual properties related to foundational system level technologies for the wireless industry that are essential for commercial development of wireless products (3G to 5G now, and 2G earlier).
Qualcomm primarily operates through two segments – Qualcomm CDMA Technologies (QCT) and Qualcomm Technology Licensing (QTL).
Under QCT, Qualcomm develops and supplies integrated circuits and system software based on 3G/4G/5G and other technologies. Qualcomm semiconductor chips find application across a broad range of devices —from mobile phones to automotive systems. Chip functionalities encompass mobile connectivity (RFFE/baseband chips), CPU, security, graphics, display, audio, video, camera and AI for wireless devices. Qualcomm operates on a fabless model – ie focusses on design and development of integrated circuits, while manufacturing is outsourced to third party foundries.
QTL segment monetises the intellectual property portfolio of Qualcomm. As indicated in company filings, any company seeking to develop, manufacture or sell certain wireless products (3G/4G/5G devices) that use CDMA/ OFDMA based technologies, requires licence or rights to use Qualcomm patents. Licensees either pay quarterly royalties based on sale of end devices or sometimes fixed licence fee depending on the contract.
Qualcomm’s dominance in this space stems from ownership of foundational technologies in the wireless industry. Qualcomm has had a history of legal disputes with mobile manufacturers in enforcing its patent/royalty rights, but has been able to successfully enforce it so far. Notable in recent years was the legal dispute between Apple and Qualcomm, that finally ended in an out-of-court settlement in 2019. This settlement was a huge win for Qualcomm against the smartphone giant which had, in 2017, stopped paying royalties relating to Qualcomm patents.
In FY22 (September ended), QCT accounted for 85 per cent of revenues, while QTL accounted for 14 per cent. In terms of profits (before intercompany reconciliations), QCT contributed 73 per cent, while QTL contributed 27 per cent. QTL is a highly profitable and stable business although its revenue contribution is smaller. Thus, it provides some support to earnings during cyclical downturns in the semiconductor industry.
Recent performance
In FY22 (September ended) Qualcomm reported revenue of $44.2 billion and net profit of $13.95 billion; strong Y-o-Y growth of 32 per cent and 76 per cent. Post two good years (FY221/FY22), consensus expectations are for revenue to decline by 14 per cent and net profit to decline by around 25 per cent in FY23. The semiconductor industry is going through a cyclical downturn after the pandemic-driven boom years drove outsized growth in smartphone and PC sales. Once this gets adjusted, expectations are for a recovery, starting next year.
Qualcomm’s December quarter (Q1) results were a little mixed with revenue approximately 1 per cent below consensus and earnings 1 per cent above. Post earnings release, the company noted its expectations for handset/smartphones recovery to begin in the September quarter as excess inventories get digested and growth in China and India giving a fillip.
However, given recent developments in the US and Europe indicating stress in banking sector, the rebound that is expected in FY24 may get delayed and ultimately depends on the extent of global slowdown. Qualcomm however remains well-positioned, given its strong balance sheet/cash flows and entrenched position in the wireless world.
Recently, Qualcomm CEO noted that the explosive popularity of ChatGPT was an opportunity to show off the capabilities of AI on smartphones and a milestone to establish Qualcomm as an AI company. As AI use on smartphone increases, there will be a huge demand for more processing power in smartphones without compromising battery life. This, and the opportunity that the growth in connected devices/IoT has to offer, make Qualcomm an interesting bet. While investors must always take management optimism with caution, the risk is worth taking as an investor at current levels/valuation.
