heres a pretty good case for the Pro-Qcom stance
Here is a more detailed account of the QUALCOMM analyst meeting:
REMEMBERING QUALCOMM
May 27, 2002
QUALCOMM hosted a meeting in New York last week for more than 300 analysts. Many seemed interested primarily in any changes in earnings and revenue guidance for the rest of the year. With estimates virtually unchanged from those issued earlier, QCOM shares remained in the low 30's. Several investment firms maintained long term buy recommendations, but one firm lowered near term expectations based on what it believed were higher than normal inventory levels (no evidence to back this up). QUALCOMM officials stated that inventories remain low and accounts receivables average 29 days (not excessive). What may have gone unnoticed to some, however, was the slow but sure dominance by QUALCOMM of a sector where more and more individuals and corporations are increasing their reliance on wireless communications for voice and data applications. With the markets closed for the holiday, this seems to be a good time to report in detail on the analyst meeting, together with potential impacts on both wired and wireless communications.
FORECASTS for CDMA handset sales and subscribers presented at the analyst conference were based on the average of four independent firms. For 2002, the forecast for handsets is about 81 million, with 170 million subscribers. By 2005, the number of handsets increases to about 256 million, and subscribers more than double to 377 million. For North America (Mexico, Canada, and the U.S.), they expect 10 percent growth in handset sales and 44 percent growth in subscribers for 2002. For Asia, they are estimating 20 - 30 percent growth in handset sales, mostly in Japan and Korea, with China and India coming in with high growth somewhat later in the year. South America is the only area where progress is slow, mainly because of financing problems in Brazil. In the U.S., VERIZON continues to have the largest number of wireless CDMA subscribers--23.7 million. SPRINT PCS has 15.8 million, and LEAP WIRELESS has reached 1.4 million--almost seven times the number of its subscribers at this time last year.
SEVERAL ADVANCES in the technology have helped CDMA service providers grow much faster than those using GSM or TDMA, both of which are experiencing higher costs and other problems in moving toward higher speed systems suitable for data. One important part of the technology involves what QUALCOMM refers to as "RadioOne" or zero IF, and is worth some explanation. In the early 1920s, patents were first issued for the superheterodyne radio, in which a radio frequency signal was first converted to an intermediate frequency (IF) and then amplified and converted to audio. This method of converting RF to IF has been the standard of the industry until last year, when QUALCOMM perfected a chip that would decode an RF signal directly into audio (or video), eliminating IF and producing a smaller, cheaper, and more powerful chip. The technology solves many of the problems associated with multiband handsets, capable of handling the 800 mhz cellular band and the 1800 mhz PCS band, along with what remains of analog cellular. As these chips are built to accommodate features such as position location (GPS), music, photos, and video, zero IF results in a simpler, less costly chip that doesn't draw as much power as older chips containing an IF converter. This means that new cell phones with color displays, which also take more power than black and white, can still have long standby times and long hours of connect time between battery charges. QUALCOMM is the only company with zero IF technology. Competing chips for CDMA (or for that matter for GSM and TDMA) that use the older technology cost more, occupy more physical space, and draw more current. At present, competing CDMA chips are made by MOTOROLA, NOKIA, and SAMSUNG.
EVEN IF competitors obtain a license from QUALCOMM to produce CDMA chips, the fact is that it takes time to learn how to produce a chip that works reliably and meets customer needs. While other chip makers have struggled to get just one model chip into production (Nokia, for example), QUALCOMM is now in its 9th generation of chips, with products differentiated by price and features for all potential markets. For example, for China and India, where the main need is for affordable voice communication, the low end chips do the job at a cost below that offered by any competitor. In Japan and Korea, where consumers are far more demanding than in the U.S., and where third generation, high speed applications are already in use, they want handsets that can download MP3 music from the Internet, take photos and send them, obtain streaming video, and feature games, instant stock prices, and maps that depict the user's location right on the display screen. At the analyst meeting QUALCOMM provided a demonstration of what these new handsets can do. Many of the applications are enabled by QUALCOMM's patented
BREW technology, which not only provides QUALCOMM with another source of continuing revenue (charges based on connect time) but also makes it easy to adapt an application developed, say, in Japan for use anywhere else. BREW is expected to be profitable in 2003. The potential revenue stream from BREW applications is NOT factored into any earnings forecasts that I have seen.
THE CHIPS in the 6000 series now in production are the driving force for the third generation of wireless communication. In particular, the 6000 series, which includes GPS capability, is a major factor in replacement sales. As Tony Thornley, QUALCOMM President and COO explained, "Replacement is where it's at!" Thornley viewed future profits coming first of all from an expanded CDMA market, which would include the so-called "DO" (data optimized) capability as well as the means whereby GSM users can migrate to the WCDMA version of third generation systems. WCDMA will probably never approach the data handling speeds of CDMA2000, which can operate at 2.4 mbps, or about 50 times faster than conventional wire line computer modems. Why would the average user need such speed? To minimize connect time for downloading or uploading data. QUALCOMM estimates actual costs for data access at 2.4 mbps at 2.3 cents per megabyte. (That's a lot cheaper than what Verizon intends to charge for its 14.4 kbps service just starting this year.)
WIRELESS DATA ACCESS is good enough to replace up to 90 percent of current applications with computers and modems connected either to phone or cable TV lines. On top of the high speed data handling built into the 6000 series come varying applications, such as maps, music, video, etc., all of which create demand for replacement handsets (or wireless modems for computers). The revenue stream is further enhanced with the powerful BREW system, allowing QUALCOMM to share in revenues generated by BREW applications. Additional revenue sources come from QChat, a feature that has not received much attention in the press, but which brings to CDMA users the same features in NEXTEL phones with "push to talk" capabilities. Nextel will be doing some of the marketing for QChat. New areas under development include the linking of local area networks with wide area networks, together with fixed wireless applications. CDMA is inherently less susceptible to breaches in security and unauthorized monitoring, making wireless connections for data access the technology of choice--in preference to existing wireline systems. By 2004, QUALCOMM expects to have the first versions of its 7000 series of chips, which will incorporate such additional features as 802.11 wireless local area network connections. Meanwhile, features such as enhanced 911 are currently available, permitting CDMA service providers to meet the latest FCC requirements (while competitors face fines for not meeting the deadline for providing e-911 services).
QUALCOMM STRATEGIC INITIATIVES (QSI) is perhaps the most controversial part of the business, since few investments have paid off so far. Total amounts invested come to about $2.3 billion, with another $1.0 billion in unfunded commitments. Among the failures (at least for the moment) is GLOBALSTAR. Among the successes is the investment in Chile, which QUALCOMM made several years ago, and which now has been liquidated at a profit. Among the most promising is a $200 million commitment to develop a wireless local loop (limited mobility) system with Reliance Industries in India. Because the technology is far less costly than other forms of wireless, competitors filed suit in Indian courts to prevent the operation of the new system. The Indian supreme court dismissed the suit. A venture known as Inquam has spearheaded the development of CDMA operating in the 450 mhz band in Rumania. The same system is now being implemented in Russia and is scheduled also for use in Denmark. The 450 mhz band used to be reserved for analog cellular in Europe. It has proven to be very economical for voice and data, requiring fewer base stations than comparable systems operating at 800 or 1900 mhz. (GSM uses 1900 mhz.) QUALCOMM concedes that Leap Wireless is "not a great investment yet." But it notes that subscriber growth rates are much higher than for any other wireless phone companies in the U.S. This is the first nationwide system whose flat monthly rate for unlimited service is designed to replace conventional wireline phone service.
PEGASO AND VESPER currently are QUALCOMM's two largest strategic investments. Pegaso, the second largest wireless operator in Mexico, represents about $704 million investment, which QUALCOMM calculates to have returned $137 million (19.5 percent) since 1999. That's not a great investment yet. But the Spanish wireless phone company Telefonica Moviles has recently agreed to take over part of this investment, resulting in a reduction of QUALCOMM secured debt of greater than $200 million. The effects of this restructuring will show up gradually in future financial statements. Telefonica is now sampling 6000 series chips with the zero IF features for lower cost. Vesper, the Brazilian company, has grown very slowly so far, due partly to shortages of low cost handsets. At the end of March, Vesper had 450,000 subscribers and expects to reach 800,000 by year end. Vesper, which is selling handsets made by LG (Korea) at the rate of 1000 per day, now offers only fixed wireless services but is pushing for a full mobility license. The key here is cost. Fixed wireless actually costs less than the wired phone service in Brazil and compares favorably with the cost of services offered by Pegaso. QUALCOMM recently made an investment with KT Freetel, the second largest Korean wireless phone company to upgrade facilities for data optimization. The packet of materials presented to each person attending the analyst conference contained advertising materials taken from the Brazilian, Japanese, and Korean markets.
ALTHOUGH GUIDANCE for near term earnings did not change, there are several reasons to be optimistic. A video prepared by Bell Mobility of Canada assured shareholders and investment analysts that a 10 percent investment in upgrading their facilities would increase total capacity by 70 percent (i.e., going from the current CDMA system to the third generation enhanced voice and data optimized). CDMA operators in the U.S. also see a smooth transition to third generation with only a small capital investment needed. In contrast, the two largest non-CDMA wireless operators, AT&T WIRELESS and CINGULAR, face major upgrade costs. Not only will they need more base stations but they will have to install complete new CDMA base station modems, whereas existing CDMA base stations require just a new chip to replace earlier models. Going from CDMA to CDMA 1X (the first level of improvement) doubles voice capacity without the need for additional spectrum required for TDMA and GSM. The 1X improvements, moreover, provide features that increase the average revenue per unit (ARPU) by up to $12 per month. With subscriber fees ranging around $40 per month, this represents a 30 percent increase in subscriber fees at virtually no additional capital cost. In short, the economics of third generation CDMA are so compelling that existing CDMA providers are motivated to upgrade, and non-CDMA firms either lose out or are forced to switch to CDMA.
WHAT DOES THE BALANCE SHEET look like? Shareholder equity currently stands at $5.2 billion, or about $7 per share, with no debt. Of this amount $2.5 billion is in cash. Excluding the effects of the strategic investments, QUALCOMM's other operations are expected to generate over $1 billion in free cash flow in FY 2002, which ends September 30. QCOM shares are currently selling at less than five times book value. Compared with other technology companies, or slower growing blue chip companies, QCOM is selling at close to a 50 percent discount. That's why the shares are reasonably priced, but as noted above, since the guidance remains virtually unchanged, and since tech stocks in general are out of favor, investors should not expect an immediate surge in price. The value, nevertheless, keeps improving.
WHAT DOES THE FUTURE look like? One of the key features that QUALCOMM has developed in its chip designs as well as in its BREW software is ease of integration. That means, first of all, existing handsets are compatible with third generation CDMA, though they would not be able to take advantage of new features. Secondly, the BREW software works on any system, whether CDMA or GSM. Europeans, still stuck on GSM, seem to be receptive to BREW applications and want to see them available on their phones. BREW also is used with OmniTRACS, the communication system designed initially for trucking companies. Turns out that these systems have started to be used for homeland security by allowing continuous monitoring of trucks hauling hazardous materials. (The only sour note here came from a question I asked concerning the possibility of installing aircraft monitoring systems using CDMA technology. QUALCOMM officials said they were unable to generate any interest from the federal government for requiring commercial aircraft to carry these systems, and of course the airlines are not in very good financial shape to buy anything additional for their planes.) Features such as the ability to send high resolution photos, enhanced 911, high quality music reproduction, better voice quality, and many others tie service providers to QUALCOMM chipsets. And differentiation in features available on chipsets means that QUALCOMM can address virtually any market, from the lowest cost basic voice only applications to the more sophisticated, higher margin (and higher royalty) chips. Continuing advances in chip design, moreover, result in lower cost chips that require less battery power. Don Schrock, president of QUALCOMM's chip division, summed it up when he stated that QUALCOMM is "incredibly well positioned as we approach the future."
THE FUTURE for QUALCOMM also has an impact on the future of all forms of telecommunications. As noted above, the ability to transmit data at 2.4 mhz assures that most data communications from ordinary e-mail to accessing large files on web sites will shift from phone lines or cable TV to wireless. High speed wireless is potentially cheaper than wired facilities, though the connections from wireless appliances usually make use of wirelines. Phone companies, such as the regional Bell companies, are in danger of continuing losses on their wired lines, particularly those that are used mainly for voice. Fiber optic equipment manufacturers are also likely to face lagging demand for at least two or three years. The reason is that there is already enough domestic capacity, though additional facilities will be needed in foreign markets.
ONE ISSUE that stands out clearly is the difference in future prospects between companies laden with excessive debt and those few, like QUALCOMM (and also TOUCH AMERICA) without any debt. High debt is one of the reasons that a Washington based investment advisory firm, known as the Precursor Group, as reported in the latest issue of BARRON'S, believes that some two dozen companies are at risk of insolvency. These include JDS UNIPHASE, NORTEL, COVAD COMMUNICATIONS, XO COMMUNICATIONS, SYCAMORE NETWORKS, FOCAL COMMUNICATIONS, ALLEGIANCE TELECOM, NEXTEL, LEVEL 3, CORNING, TIME WARNER TELECOM, PAC-WEST TELECOM, BROADWING, WORLDCOM, QWEST, CITIZENS COMMUNICATIONS, CIENA, SPRINT, LUCENT, AT&T WIRELESS, RIVERSTONE, JUNIPER, AT&T, and CENTURY TEL. With the exception of Nextel and AT&T Wireless, all the companies have wired facilities. Because of increasing demand for data communications, I believe the danger of insolvency for many of these companies, particularly Corning, is overstated. But many will probably have to write off certain assets in wired equipment or services, as Nortel and Lucent have done already. Part of the problem in wired facilities is caused by the great improvements in wireless, and the continuing lower costs in wireless. Companies such as Nortel and Lucent, which make a great deal of wireless equipment, can probably weather the storm. But others will experience at the very least a long period of low or no profits. MERRILL LYNCH also is skeptical about most of the telecom sector. Among some 89 global telecom companies it follows, it has, according to the BARRON'S article, strong buy recommendations on only 9 companies, none of which are U.S. based. Whether or not one agrees with these recommendations, it is clear that the effect is to downgrade ALL telecom companies.
THIS IS WHERE I disagree with the conventional wisdom. The obvious feature neglected by many analysts (including many at the QUALCOMM conference) is debt, and what it means for companies that have little or no debt, compared with the rest. The less obvious feature that might not have been recognized by a group of analysts mostly in their 20's, 30's, and 40's (only four or five appeared to be above 60, and there were almost no women in the entire group of more than 300 attendees) was the value of seasoned management combined with a passion for innovation. These are among the reasons on which I base my continuing BUY recommendation. A.S.B.
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