Shorting Qualcomm Seems Like a Bad Idea

Seeking Alpha contributor Michael Blair offers up an interesting set of reasons to sell shares of Qualcomm (NASDAQ: QCOM  ) short. Indeed, Mr. Blair's arguments are the following:

  • Average selling prices for handsets are set to decline.
  • Growth rates for smartphones/tablets are declining fairly rapidly.
  • Chip competitors are mounting an aggressive assault.

While these factors are all undeniably true, it's still difficult to comfortably go short on Qualcomm as the company's fundamentals -- despite these headwinds -- are set to continue to improve. Shorting a stock with improving fundamentals is generally tantamount to financial suicide.

Average selling prices decline, but volume rises
Qualcomm's business is unique in that it gets to double dip in the smartphone market. Many of Qualcomm's competitors profit from -- or hope to profit from -- sales of chips in handsets. Qualcomm not only profits as a component vendor, but also from the license of wireless patents. Indeed, about two-thirds of Qualcomm's earnings before taxes comes from royalties collected on all 3G/4G LTE devices. That means that every time Samsung sells a smartphone, Qualcomm immediately receives a meaningful percentage of that device's selling price.

The argument that Blair makes is that the average selling prices of smartphones are declining, and that's a negative for Qualcomm. While it is true that the average royalty per device will decline by virtue of lower average selling prices, this ASP dilution is largely due to the explosive growth of low-end devices that now support 3G/4G and now become royalty-bearing. Yes, high-end device growth is much slower than low-end device growth, but the high end is still growing.

Growth rates are declining rapidly? So what?
All secular growth trends eventually slow, and the smartphone boom that began in 2007 will eventually be subject to slowing growth. This, of course, means that Qualcomm's technology licensing growth will slow, and its components business will see muted growth as well. However, Qualcomm trades at just 20 times trailing 12-month GAAP earnings, and even a modest 10% growth of EPS and revenue over the next five years is enough to suggest a fair value of $79 today -- a modest bump from today's roughly $77 trading price. This is not an expensive, hyper-bubbly growth stock -- it really is growth at a reasonable price and it can withstand slowing growth in its core end markets without a sizable correction.

The competition question
There is no doubt that a bear case can be made, predicated on meaningful market-share losses in the handset/tablet space. That being said, there are no competitors in the chip space today that offer as complete and as fully featured a set of solutions for the handset market as Qualcomm. MediaTek has seen high growth in the low end of the market, principally due to aggressive pricing and an ability to stitch together off-the-shelf IP quickly, but this is not a truly durable competitive advantage.

Qualcomm, on the other hand, has been very aggressive in the development of its own CPU, GPU, and modem IP and is currently world-class on every IP block. Longer-term, only the companies willing and able to spend the most to win in this space will survive. This means Qualcomm and Intel (NASDAQ: INTC  ) , particularly as the latter seems to be the only company that is investing just as heavily as Qualcomm and has the modem/RF chops to be a long-term threat, particularly if Intel can deliver as promised on its XMM 7260 LTE-Advanced modem. The other players seem to be fast followers at best with respect to modem technology. 

However, the bigger point here is that Qualcomm doesn't actually derive the majority of its earnings from components -- it does so from licensing/royalties. As long as there is no significant risk to the royalty stream, and as long as Qualcomm can maintain a strong position in the smartphone-chip duopoly, it doesn't really face as large a competitive risk to its bottom line as one might initially suspect.

Foolish bottom line
In a bull market, shorting a company with improving fundamentals is often very hazardous to one's financial health. While there are reasons to be less bullish or neutral on Qualcomm, it is probably better to save the outright short sales for companies with shaky fundamentals or untrustworthy management teams. There are plenty of these companies out there, so trying to make a few bucks shorting a high-quality name like Qualcomm seems to be a fairly poor risk/reward proposition. 

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