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QUALCOMM
Morningstar on QCOM

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By DCUnited
October 5, 2001

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Morningstar issued a new, very bearish Quicktake Report on QCOM yesterday. Unfortunately, much as I would like, I can't post any link. If you are a Morningstar subscriber, you may want to check it out.

The report offers one criticism of QCOM which I thought did make sense, and which I haven't seen any discussion of on this board, and that has to do with the accounting framework which QCOM prefers to report trends in earnings and expenses. In particular, the frequency and regularity of one-time charges taken struck me as suspect. Since QCOM excludes these charges from its customary pro-forma income statements, the growth in earnings gets overstated, and the growth in expenses and related costs understated. In some cases, the differences between the pro-forma and GAAP statements for the same quarter are exceptionally large.

For example, in the third quarter of the current fiscal year, QCOM excluded $449 million in after-tax charges in declaring that it had beaten the First Call earnings projection by $.01/share. The largest charge excluded was a major write-down of a QCOM investment in a Brazilian company, something I was not personally knowledgeable about. Once these charges are factored in, QCOM's earnings and expense growth figures for 2001 over 2000 look quite dismal, and probably should give some pause as we contemplate the prospect of better days to come. Of course, all of this information is reported by QCOM under both accounting frameworks. But, the way pro-forma results get trumpeted, and the frequent shifts in how that concept is defined, smack to me of management hyping earnings. Sorry, but that's just the way I feel.

That said, Morningstar's report bothered me because of the lack of understanding it displayed of QCOM's future earnings drivers. The report casts up a series of "straw man" arguments, which echo suspiciously the FUD we've heard so often from the GSM crowd. The analyst expresses perplexity about how QCOM's market price could remain so far above Morningstar's own estimate of its fair value ($29/share) for such a long period.

So, I thought you might be interested in seeing the text of the email I sent challenging some of those assertions. As a long-time lurker, I owe this board for practically everything I've learned about QCOM, so it's only fair I should try to give something back, however meager. Of course, all of the arguments will sound very familiar to long-time posters.

Anyway, I hope I didn't make too much of a hash of the excellent research and analysis so many of [you] have generously shared. Please let me know where and how I messed up this presentation, so I can learn how to do a better job next time of defending the prospects of one of my favorite recent investments. Here's the text:

Hi! I really appreciated your analysis of QCOM's overuse of pro forma accounting, and the stumbles it has experienced in sales and earnings growth in recent quarters.

My comment relates specifically to some of the "bears say" points you make. However, I believe they also address other parts of your Quicktake Report, which appear to take the same stance:

"Nokia doesn't use Qualcomm chips for its CDMA phones."

While accurate, this statement is misleading. Nokia buys its G2 (and, now, G3) CDMA chips from Telson in South Korea, which is a Qualcomm licensee, and thus pays QCOM a standard royalty fee (thought to be around 5%) for every handset chip Nokia buys. Since Telson's royalty cost is passed along in whole or in part to the buyer, Nokia is ultimately paying Qualcomm for its intellectual property, however much Nokia might like to pretend otherwise. Secondly, if Nokia ever manages to produce its own reliable, working 3G CDMA chipsets -- something it has not yet succeeded in doing despite several years of effort -- QCOM will earn exactly the same royalty it would have received if Nokia had bought these chipsets directly from QCOM. More importantly, you omit altogether the fact that, recently, Nokia backed down and signed a 3G royalty agreement with QCOM, on the same terms negotiated in their previous 2G CDMA royalty agreement. With this seminal event, Nokia has acknowledged the validity of QCOM's patents controlling all forms of G3 mobile wireless technology. The main remaining holdout -- Siemens -- is expected to follow shortly. In other words, QCOM's dominant 3G intellectual property has now been acknowledged by virtually all the largest handset and base station manufacturers, making QCOM the 3G gorilla. That fact goes a long way toward explaining its current valuation, which cannot be explained through extrapolation of current sales and earnings trends, but is eminently sensible if the market expects an explosion in earnings over the 2002-05 period, as 2.5G and 3G CDMA and W-CDMA roll out.

"CDMA handset growth is slowing."

This statement requires more context than you have provided. Sales growth of handsets worldwide have slowed, CDMA, GSM, and TDMA alike. The world is in a recession! You say nothing about how CDMA handset growth is doing relative to these competing technologies. In fact, recent huge CDMA wins in China, Korea, and the Western Hemisphere are leading to steady gains in CDMA market share worldwide. And, as noted above, the closer the world gets to 3G, the faster QCOM's royalty base will grow, until it eventually encompasses all 3G flavors. These strong assured future gains in market share are a factor of critical importance in explaining QCOM's current valuation.

"Qualcomm is at the mercy of when the carriers launch costly 3G networks."

While accurate, this statement does not go nearly far enough. 1xEV CDMA is 3G technology, as was recently certified by the International Association of Telecommunications (IATA?, sorry, can't remember exact acronym). It has been rolling out in Korea since September 2000, and now has over 1.2 million subscribers, swapping photos, transmitting data, surfing the net, etc. This striking demonstration of 3G technology is impacting decisions of a number of Asian telecoms (notably China) as to which flavor of 3G CDMA technology they want to adopt, especially since W-CDMA has run into enormous technical and financial obstacles. CDMA's superior spectral and technical efficiency relative to W-CDMA will translate into markedly lower carrier transmission and installation costs, especially for those who had the foresight to adopt 2G CDMA as part of their transition path. This has got to be a message dawning on a number of carriers currently sitting on the fence, possibly even some European GSM carriers (Vodaphone, for example). Then, you allude to KDDI's roll-out delay, but make no mention of the much more serious technical difficulties experienced by KDDI's major competitor, DoCoMO, in rolling out its peculiar version of W-CDMA. (Their recent announcement of a September start-up lacks credibility, in my opinion, after their previous broken deadlines.) Based on Korea's experience with 3G and KDDI's previous upgrade path is clear and relatively low-cost. there seems little reason to You also make no mention of the very considerable progress being made in the North American market by Sprint, Verizon, and others, to bring 2.5 CDMA into operation in 2002, and 3G CDMA by 2003. Finally, if you believe the hype from Europe that, after all, 3G isn't really all that important, how do you think the GSM carriers are going to pay back the expensive spectrum they have purchased, if they don't tap in soon to the higher value-added inherent in 3G technologies. Don't tell me they can continue to make good money in 2G, because everyone can see that 2G services have been driven down to paper-thin margins by the commoditization of the technology. GPRS may offer a temporary expedient. But, so far, early tests have been hugely disappointing, manifesting test rates far below the operational data-transfer rates already available from CDMA2000 in Korea (80 k up to 100+k for the latter, compared to a reported 30-40 k for the former).

"W-CDMA, the rival to Qualcomm's cdma2000 offering, should become the protocol for 3G. This means competition for chipsets and system software."

Where do I begin with this assertion? First, W-CDMA is a rival to QCOM's technology only in the sense that QCOM believes, with good evidence to support it, that pure CDMA has superior scalability, greater internal compatibility, and lower production and operating costs. (Remember, W-CDMA is a technological hybrid, created by a GSM committee in a futile effort to negate QCOM's 3G IPR.) In any case, should W-CDMA become the world's protocol, this is by no means a negative development for QCOM. The faster W-CDMA rolls out, the faster QCOM begins collecting serious royalty income on its 3G intellectual property. Let's not forget that, as part of the 3G agreement Nokia reached with Qualcomm, Nokia agreed to transfer all its GSM and W-CDMA patents to Qualcomm royalty-free. So, why should QCOM fear W-CDMA? And what makes you think QCOM's chipset division won't be a formidable competitor in the W-CDMA chip market? Now that Nokia has caved on paying a standard royalty rate for 3G CDMA, QCOM has started working with Nokia and the other members of the W-CDMA consortium to resolve the soft hand-off, over-heating, and slow data transfer problems W-CDMA has experienced to date. Yes, QCOM's margins on WCDMA chipsets could be shaved because of greater competition, but the royalty rate will be utterly unaffected by the flavor of 3G technology the world's carriers eventually decide to adopt. And, as your own analysis shows, the impact of royalties on QCOM's bottom line is several orders of magnitude greater relative to profits earned from chipset manufacturing.

"CDMA accounts for just 15% of the global total, compared to GSM with 67%. This hamstrings CDMA users' ability to roam extensively."

This is no doubt the case today, although the situation is changing rapidly as we speak. First, roaming agreements have now been established among carriers in at least 9 countries where 2G CDMA is currently available, including the U.S., China, Korea, and some large South American countries. Secondly, you omit the fact that various versions of GSM currently in use in Europe and Japan are not interoperable, and that roaming charges are being collected from users of these GSM phones as they move from one country to another. Thirdly, QCOM is making rapid progress toward development of dual- and tri-mode chips which would allow users to move smoothly from CDMA to GSM and TDMA environments. (The recent concession of royalty-free GSM patents to QCOM will greatly facilitate this development.) These are points which, in the interest of fairness, I think your analysis should have pointed out.

In any event, I want you to know that I very much appreciate the work you and Morningstar are doing to help us investors sort out the stars from the dogs in the stock market. I just happen to think that, in this case, better coverage of the points I made above would have helped you to solve the mystery of why there is such a wide gap between your valuation of QCOM and its current market price. It's not about today; it's about what the near future is going to bring to this company's bottom line.