COMPANY REPORT, August 17, 2007
Qualcomm Inc (QCOM ) BUY
Argus........
HIGHLIGHTS
*BUY-rated Qualcomm Inc. replaced its chief counsel in the wake of several legal setbacks; while we do not regard these setbacks as crippling, ongoing legal wrangling is working against the stock price.
*On a pro forma basis, our EPS estimates remain $2.00 for FY07 and $2.36 for FY08. On a GAAP basis, our forecasts are $1.69 and $1.87, respectively.
*Our long-term EPS growth rate forecast for QCOM remains 15%. Our financial strength rating is High.
*QCOM shares are trading at 18.7-times our FY07 pro forma EPS forecast and at 15.8-times our FY08 projection, compared to an historical P/E of 31.8.
*Our 12-month target price of $58, combined with the dividend yield of 1.3%, implies a potential risk-adjusted total return of 43%. We particularly recommend buying QCOM shares during times of weakness, such as now.
ANALYSIS
INVESTMENT THESIS
We are maintaining our BUY rating on Qualcomm Inc. (NGM: QCOM) with a target price of $58. The company replaced its chief counsel in the wake of several legal setbacks. While we do not regard these setbacks as crippling, the seemingly incessant legal wrangling among Qualcomm, Broadcom and Nokia is taking a toll on the QCOM stock price.
Meanwhile, Nokia has ramped up its assault, asking the ITC to ban the import into the U.S. of certain Qualcomm chips. In June, the ITC blocked the importation of QCOM chips that allegedly infringe Broadcom patents. So far, Qualcomm's legal strategy has been to sue Nokia for GMS infringement. In light of the serious steps that Nokia and Broadcom have taken, we are puzzled by Qualcomm's moderate approach. We do, however, expect Carol Lam, the new interim general counsel, to get tough; her first act might be to launch lawsuits against Nokia alleging infringement of CDMA-based patents.
We note that Qualcomm's business remains robust; the company's previously reported 3Q07 results featured record levels of sales, earnings and chipset shipments. We continue to recommend QCOM on weakness. We do warn investors that the market is focusing on the company's legal scuffles, and that might hinder near-term prospects for the QCOM shares.
RECENT DEVELOPMENTS
Qualcomm continues to be burdened by legal woes, which threaten to obscure the company's strong financial performance. It is difficult for investors - and even for analysts who have long covered the company - to assess the import of each legal development; some are rulings, but most involve posturing, maneuvering, claims and counterclaims.
Qualcomm is waging a multi-front legal war with chip rival Broadcom and handset maker Nokia. One way to assess the legal fortunes of the parties involved is to trace changes in their respective legal teams. On this score, Qualcomm's rivals scored a win on August 13, when Qualcomm announced that its general counsel, Louis Lupin, had resigned. Mr. Lupin joined Qualcomm in 1995 and was elevated to chief counsel in 2000. Carol Lam, one of eight U.S. attorneys fired by the Justice Department earlier this year, joined Qualcomm in February and was named interim chief counsel. While the disruption is unfortunate, we believe that Qualcomm needed to do something to change its legal strategy. We do not think the various legal battles have grown so one-sided that Qualcomm will reduce its contractual terms in negotiations with Nokia, Broadcom or any other firm.
Meanwhile, among the most notable legal developments that Qualcomm has faced recently is the June decision by the International Trade Commission (ITC) to ban imports into the U.S. of Qualcomm chipsets that allegedly infringe patents owned by Broadcom; these patents relate to power management. The ban affects only new handset models, meaning those first marketed after the ITC decision. While it had little immediate effect on Qualcomm's business, carriers and other handset-manufacturing customers have been scrambling to circumvent the ban, find new chipsets or otherwise minimize its effects.
In the wake of the decision, Qualcomm sought a presidential override of the ban. On August 6, however, the Bush administration upheld the ban. Broadcom successfully undermined Qualcomm's rationale for a presidential override. Broadcom first announced that it would waive the import ban for devices slated for use by first responders, government, state and civic workers, as well as other emergency personnel. Broadcom then struck a separate deal with Verizon Wireless, which will pay a $200 million royalty to Broadcom in exchange for rights to import any such offending phone.
In addition to the ITC maneuvers, Broadcom sued Qualcomm in U.S. district court regarding similar power-conversion patents, as well as patents on technology that helps phones process video, hand-off calls between networks and hand-off push-to-talk communications. On August 13, a federal judged in Santa Ana, California, ordered Qualcomm to pay $39.3 million for violating three Broadcom patents; that is double what a jury awarded Broadcom in May.
On August 14, the Santa Ana district court began to hear arguments regarding Broadcom's request for a permanent injunction against the infringing Qualcomm chips. Under questioning, however, Broadcom Chairman Henry Samueli acknowledged that Broadcom does not currently sell WCDMA chips to customers in the U.S.; that appears to undermine the company's position that it would suffer irreparable harm if Qualcomm were allowed to continue selling WCDMA chips in the U.S.
Qualcomm attorney Evan Chesler argued that the permanent injunction would give Verizon Wireless an unfair advantage over rival Sprint Nextel. In July, Verizon Wireless agreed to pay Broadcom $6 per phone, or $40 million per quarter up to $200 million altogether, for the right to import phones with patent-infringing Qualcomm chips. Sprint Nextel is seeking to shift its Nextel phones from iDEN technology (sourced from Motorola) to a more packet-friendly and more robust push-to-talk technology that Qualcomm and Sprint Nextel call QChat. Qualcomm executives calculated that Sprint Nextel's inability to move forward with this transition would cost Sprint Nextel as much as $2 billion. Sprint Nextel executives, notably, have not supported such as figure. Sprint Nextel CEO Gary Forsee has stated that the company has 'lots of options' to work with 'both companies' to eliminate the negative effects of the Santa Ana decision.
Throughout these events, Qualcomm's legal approach has been to portray itself as a company facing such severe damages that its viability is in question. Careful analysis does not support these claims, in our opinion, but investors certainly have been spooked. On August 14, Qualcomm Chairman Irwin Jacobs testified in the Santa Ana hearing that the injunction sought by Broadcom could cost the company $2.4 billion over five years. We note that even with the request for a permanent injunction, Qualcomm would still be allowed to make and use the offending chips for 18 months, during which time it would pay a royalty. Chairman Jacobs questioned whether 18 months would be enough time to devise a 'workaround' that would enable it to legally create or license an equally effective alternative technology.
The issue of workarounds shows the lack of coordination between the Lupin-led legal team and Qualcomm itself, along with its customers. On the one hand, companies such as Verizon Wireless have been saying for several months that workarounds are not only in the works, but in some cases are in place. That is in contrast with Qualcomm's legal arguments before the ITC, in which the company's lawyers portrayed such workarounds as having uncertain efficacy and unlikely to be ready until well into the future. The net effect of overstating potential damage to the company has been to create skepticism in the courtroom and to harm the stock price.
To make a bad week even worse, on August 17 Nokia announced that it filed a complaint against Qualcomm with the ITC. The complaint alleges that Qualcomm has infringed five Nokia patents in its WCDMA and CDMA chipsets. The patents in question, according to Nokia, improve performance and efficiency of wireless communications devices while enabling lower manufacturing costs, smaller form factors and better battery life. So far, Qualcomm - perhaps with an eye toward a comprehensive licensing deal with Nokia - has sued Nokia for GSM infringement, but has not sued for any CDMA, WCDMA, UMTS or HSDPA infringement. We expect that Ms. Lam's first act as interim chief counsel could be to initiate lawsuits alleging massive infringement of hundred of patents related to spread spectrum technology.
We also believe that the dispute between Qualcomm and Nokia has grown too bitter, and the positions too far apart, for the two companies to come to an agreement on their own. We expect this matter to be settled by an arbitrator or by a series of court cases. Qualcomm may only now be realizing that to reach contract terms with Nokia, it must step up its legal attack.
Still, even in cases that Qualcomm has initiated, like the one it brought against Broadcom in 2005 alleging that the company violated video technology patents, it has fared poorly. On August 6, Judge Rudi Brewster of San Diego district court criticized Qualcomm for 'gross litigation misconduct' in the case because Qualcomm did not share highly relevant documents with the Broadcom legal team until after a jury trial ended in January. The judge said that Qualcomm, by its actions, had waived its rights to enforce the two video compression patents in dispute.
As for relations with Broadcom, we expect these two companies to continue battling in the courts at least through the end of the year. Broadcom, which has never signed a licensing deal with Qualcomm, now has less incentive to do so than ever - particularly now that Qualcomm's own chip customer Verizon Wireless (an indirect customer, granted) is negotiating with Broadcom.
In contrast to the legal landscape, the business case for Qualcomm has perhaps never been stronger. Overlooked in the recent 3Q07 report was the across-the-board improvement in margins. Historically, Qualcomm's industry-leading margins have dipped for a few years when the company embarked on a major engineering initiative. Such initiatives included introducing CDMA 1x EVDO earlier this decade and launching a complete family of WCDMA chipsets, including 65 nm system-on-a-chip products, in the past few years. Afterwards, Qualcomm's margins have typically improved as it reaped the fruits of these endeavors. With the main R&D and engineering expenditures possibly in the past in WCDMA, Qualcomm could be in for a long period of improved margins.
The company's book of business is superb, with or without Nokia paying its royalties. In brief, the Qualcomm earnings machine continued to rumble in 3Q07. Cash generation was again exemplary, and Qualcomm raised its guidance for all key metrics, including semiconductor shipments, total company revenues and earnings. |
