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QUALCOMM, Inc.
Re: Quick QCOM Look

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By RaplhCramden
September 24, 2004

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Cool post Ben! I'm reading "Value Investing" right now and have spent years cogitating over Qualcomm and Value. There was a few years ago a fellow named Gregg Powers of Private Capital Management, who bought Qualcomm into what was primarily a Value shop. The price of QCOM was ~$40 when he did that. But that was 16X split ago.

I won't pretend that I own Qualcomm as a "value" play. The uncertainties about its future make it something other than a value stock. But of course, non-value stocks have made people wealthy in the past: Xerox, Microsoft, Kodak come to mind historically.

Not being a value stock doesn't mean it will not make you money.

But it also doesn't mean that you can't gain incredibly valuable insights into what you are doing by looking at it using some value concepts. So I applaud your approach.

Some comments on some of your comments:

Trading at around 5X projected F2005 Book Value

Qualcomm derives roughly half its earnings from royalties. I believe that thanks to GAAP the underlying assets generating that income are valued at $0. (GAAP says R&D and patents are not assets, unless I am mistaken). So trading at 5X its book value, 1/2 its earnings derived from assets which GAAP says can't go on the books.

Royalty accounting methods and recent guidance should at least make investor look into potential risks here. I would look closely at the accounting aspects of this.

I believe this is a trivial issue of potentially switching to recognizing royalties when actually received vs. when "earned." The royalty payers have something like 60-90 days to send in their reports with their checks. SO I don't believe there is ANY business risk here, I don't believe there is ANY chance of discovering over-reported earnings or any such thing.

If you use an F2004 EPS of 1.09, assign a 18% 10 year growth rate (that is very healthy and maybe should be assigned a 5 year 18% growth rate, and then a remaining terminal growth rate of say 10%, but for this example, I will use 18%. I have no reason to know whether that is an accurate rate or not, I am merely picking a number out of a hat.

Using 1.09eps, 10N and 18%, you get EPS FV of 5.70 in year 10 (2014). Assign a P/E at that time of 15X, you get Future Stock Value of 85.57.

You now want to discount the Future Value and see what return would be for 10N, FV 85.57, PV 39. Hence you get an annualized ROI of 8.17%.


ANYBODY INVESTING IN QUALCOMM SHOULD RE-READ THIS SECTION AND PLAY IN EXCEL UNTIL THEY UNDERSTAND IT.

This company is already priced to succeed. How much? This analysis says that if Qualcomm grows its earnings by nearly 7X over the next 10 years and then is seen to have slowed its growth, the stock might ONLY DOUBLE. This means that if it grows 3.5X or less and is seen to have stopped growing, the stock will be FLAT or DECLINE.

The company earnings need to be a 7-bagger in order to make you as a stock holder a 2-bagger with some confidence. The bar has been set high.

In fact, I think Qualcomm the company could be a 10-bagger in 10 years, the only two continents it has penetrated are still growing customers faster than 10%/yr, the groundwork has been laid to succeed in Europe, and this company never stops looking at the rest of the world. The company also never stops looking at what technologies it might sell in the future (it has championed data since before it was widely accepted for voice, for example.)

If I were to invest in QCOM, I would investigate Flarion, and make sure disruption risk was minimized.

I agree, and this is what I conclude so far:

Growth in CDMA certainly has 10 more years, and probably has 20 more years. And that is for GROWTH. There will be BUSINESS after the growth for at least another 10 or 20 years after growth stops.

I base this on the following observations. 1) OFDM or whatever next technology is adopted (and OFDM looks likely), will NOT give the same gains over CDMA as CDMA gave over GSM, so the cost for switching will be harder to justify 2) GSM grew for at least 10 years after its replacement (CDMA) came out, and indeed is still growing, 3) OFDM will not be OWNED by somebody else, Qualcomm will be able to put OFDM into its existing standards in an evolutionary way where it makes sense. Flarion will not displace Qualcomm unless Qualcomm does something VERY stupid. 4) Qualcomm may transition its franchise from owning the intellectual property in CDMA, to a franchise supported by great engineering serving the largest single market share of any wireless company. As CDMA patents expire and OFDM is deployed (by Qualcomm and others), this will be necessary if Qualcomm is to maintain high franchise returns.

I would be cognizant that QCOM will generate about 1/4 billion dollars of cash by selling stock to their very own employees during F2004.

You are referring to the $ employees pay to exercise employee stock options (ESOs). When employees exercise ESOs, they virtually always sell the new shares publicly, immediately.

The best interpretation of this is this: Qualcomm will effectively offer publicly a 3% dilution of its current stock. That will raise about $2 billion, of which the company will keep 1/4 billion and the remaining $1.75 billion raised will go to employees as bonuses. That cash flow represents ~10% of Qualcomm's total cash flow.

I would study stock option compensation and see that eps drops big time when being used.

An earnings based valuation of Qualcomm's present value does not depend on how options are expensed or not. The future cash flow per share is independent of how GAAP says that must be allocated between assets vs. retained earnings, vs. paid-in capital. It is the future cash flows per share, which dictate the value of shares.

After a lot of study on the issue, I do believe that using 3% dilution/year accurately and completely covers the impact of options grants and exercises on the future cash flows per share of Qualcomm. I think further reducing earnings by any of FASB's suggested techniques significantly moves profit/earnings statements AWAY from reflecting actual cash flows attributable to shares.

My quick look, I note that I have no reason to invest in QCOM. I think the metrics look pricey. If I did look, and thought there was aggressiveness in reporting, estimates or growth rate, option abuse, I would possibly consider a short position.

You would be shorting against a business that generates a relatively quickly increasing pile of cash, from real live customers, every year. Sounds risky to me.

I wish more people around here WANTED to see the contrarian view, though. Thanks for helping me walk down valuation lane here.

R:


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