A year in review
Needless to say, when 1998 began I did not believe that Qualcomm's stock would end up roughly unchanged at yearend. It is also fair to acknowledge my disappointment with the stock's performance over the twenty-seven month period since CDMA has been deployed commercially. In the interest of intellectual honesty, it is probably fair to review what happened in FY98 and what these events mean for shareholder value.
Obviously the Asian crisis in general, and Korea's problems in particular, were critical factors. The year started with a relatively brief, but quite sharp, slowdown in Korea's domestic handset demand. The dislocation prompted a three-to-six month malaise in QC's ASIC sales, a canceled order (remember Hansol PCS) and an impaired won/dollar relationship that reduced royalties and fostered concerns that the Koreans would dump handsets on the world market. Although ASIC sales subsequently rebounded, and the won recovered substantially, many continue to worry about Korean export practices. While the Koreans have been aggressive, many seem to forget that their phones incorporate significant foreign content, ASICs come quickly to mind, and pricing has remained quite rational. As I have pointed out many times, when one considers both the royalty and the ASIC margin, QC likely earns more profit when the Korean's sell a phone than when QPE sells a phone. So while "competition" is not the bogeyman it appears to be, many investors either fail to understand this dynamic or chose to ignore it. However, during this complicated period, Qualcomm inflicted some important wounds on itself.
Had QPE executed flawlessly, Korea would have stung us, but not drawn so much blood. Unfortunately, QC's handset operation has struggled almost from day one. The first phone ("QCP-800) was an engineer's plaything, elegant but overly complicated and expensive to manufacture. It is hard to believe that QC ever made much money on the product. Management recognized this and the QCP family was designed specifically for volume manufacturing, with an eye toward reduced production costs. The pendulum obviously moved too far too fast as production problems, specifically out-of-tolerance connectors, afflicted early production. Add in Q phone cases with less than robust plastics, and it is understandable why some question whether Qualcomm should be in the phone business at all. Painful as this has been, perspective suggests that we are dealing with rookie mistakes and nothing more. As opposed to MOT's multi-year malaise, management responded quickly and admirably. The impact on customers, both operators and consumers, was minimized by the decision to recall questionable Q's and QCP's for rework. As shareholders, you and I footed a pretty darn big bill for this generosity, but I believe the company's handset franchise subsequently emerged unimpaired.
As shareholders we absorbed these two body blows. While only a jackass would suggest that Asia is out of the woods, the Korean Won has recovered to roughly 1200 to the dollar (from its low near 2000) while Korean domestic demand has remained surprisingly good and export sales have continued their strong growth. Meanwhile, Japan has come online and, I believe, monthly net adds exceeded 100,000 recently. This performance should accelerate when IDO launches in April and QC should therefore see decent growth out of Asia even if Korean domestic demand slows. On the internal front, QPE's seemed to fire on at least six of eight cylinders during the September quarter, with more progress expected in December. Courtesy of its expensive lessons, divisional management seems to be executing better and this seasoning is showing up in better yields and higher margins. It would seem that QPE's dark days are behind it, but the Street continues to demand further proof.
Which brings us to the Infrastructure effort. Pegaso was supposed to be the magic bullet that brought the division to breakeven. But just as the ink was drying on the contract, the Russian Federation decided to conduct an exercise in self-immolation. I would presume that most of you have read the Leap Wireless 10K and therefore understand the magnitude of the Russian opportunity. Through Metrosvyaz (sp?) Qualcomm is ultimately partnered with Tass, the Russian news agency, in a multi-billion dollar effort to deploy WLL telephony throughout the country. Opportunities like this, and deployments like Pegaso, are why the company has continued to fund significant infrastructure losses. With OEM relationships providing baseline revenue (maybe more when the Japanese partners get going), the infrastructure effort remains a reasonable, albeit expensive, bet. Were this unit at breakeven, with sufficient revenue to cover its R&D investment and SG&A overhead, I believe that Qualcomm's earnings would be at least $100mm greater after-tax. Management could "get us" this EPS easily, but such a quick fix could prove shortsighted. While the losses continue, Qualcomm's business model remains sub-optimal, but such investments were considered when the company formulated its recent guidance for FY99.
When I invested in Qualcomm, I understood that it was a start-up operation. When revenue went zinging past $2 billion, I think we all considered the enterprise to be "grown up" and past its teething pains. Such optimism was proven to be excessively optimistic last year. While it is possible that I am simply starstruck by the company's potential, I look to calendar 1999 with considerable optimism. With the launch of major networks in Japan, Mexico, Brazil, Peru and Chili and the maturation of the U.S market, Qualcomm is shedding its dependence on the Koreans. Geographic diversity should translate into greater predictability for royalties and ASIC demand, while worldwide subscriber growth should continue to accelerate. Barring more self-inflicted problems at QPE, the profits and visibility of this growth should assuage most, if not all, of the Street's concern for Qualcomm's business model. As for 3G, I will go out on a limb with this prediction, but here goes. The compromise agreement that will, and must, be worked out between Qualcomm and Ericsson will end the destructive antipathy that has existed between the two companies. Ericsson will gain a direct sequence spread spectrum solution for its customers and Qualcomm will see an end to the powerful PR campaign against it in particular, and CDMA in general, plus a greatly expanded market opportunity that encompasses the GSM universe.
Two years of non-performance may seem an eternity to investors watching Internet stocks double daily or to those who simply bought Nokia and enjoyed the ride. If Qualcomm was a dissipating asset, with deteriorating fundamentals and inexplicable problems, I would probably be discouraged myself. However, as I think I have discussed adequately above, the company did make significant progress during FY98, albeit in face of external and internal challenges. Value was created, albeit not reflected in the stock price. Given this perspective and conclusion, my only analytical conclusion is to exercise patience.
Happy New Year to all.
Gregg
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