NXP Merger To Drive Long Term Gains For Qualcomm Inc (QCOM) Stock

  • Qualcomm is reportedly in talks with NXP Semiconductors looking for a potential merger.
  • The deal is reported to be worth more than $30B, easily becoming Qualcomm's largest acquisition in its history.
  • Curiously enough, QCOM stock has been trading up. Why is the market excited about a potential merger between the two companies?

Leading mobile chipmaker Qualcomm (NSDQ:QCOM) is reportedly in talks to acquire Dutch automotive chipmaker NXP Semiconductor (NSDQ:NXPI) in a large deal valued at over $30 billion. The deal could be finalized in as little as 2-3 months, though of course there's a possibility that it won't happen. People familiar with the matter say that Qualcomm is exploring other options. The market has reacted positively to news of the merger, with NXPI shares rallying 25% and Qualcomm shares trading up 10%. That's quite the antithesis of normal M&A activity, where shares of the buyer usually get punished by the market.

So why is the investing universe excited by a potential merger between the two companies?

Qualcomm long-term outlook under pressure

There's little doubt that merging with NXP Semiconductors would radically reshape Qualcomm, a company whose business of supplying wireless chips has lately come under severe pressure due to slowing smartphone growth.

Also Read: This Low Risk Opportunity Could Propel Qualcomm Stock Higher

Qualcomm sports a rather unusual business model. Although the company derives more than 60% of its revenue from designing and selling chips, more than 80% of its operating income comes from licensing wireless patents to smartphone manufacturers. During the last quarter (FQ3), Qualcomm managed to snap out of a 5-year streak of revenue declines after posting revenue of $6.03B, good for 3.4% Y/Y growth. Meanwhile, diluted EPS of $0.97 represented a healthy 24% QoQ and 33% Y/Y growth.

The company's mobile chip division, QCT, posted revenue of $3.853B, flat sequentially but good for 15% Y/Y growth. Chip shipments increased 6% sequentially but fell 11% Y/Y to 201M units.

The technology licensing division, QTL, recorded revenue of $2.038B, -5% sequential growth but 6% Y/Y growth. QCOM recorded an 11% increase in 3G/4G device shipments to an estimated range of 321M-325M, good enough to offset a 7% decline in device ASP of estimated range of $191-$197.

Although those results were a considerable improvement from the past one year or so, they were still a far cry from the prior years when the company managed to grow its top line in the double-digits almost effortlessly. Qualcomm has been suffering from a weakening smartphone market especially in the high-end tier, as well as a refusal by many of its Chinese OEM partners to pay licensing fees. Although the China standoff has been gradually improving, a softening smartphone market is expected to continue being a major headwind for the company. After growing in the double-digits for about eight years, the smartphone market slid into single-digit growth territory last quarter and is expected to remain that way in the foreseeable future. IDC has projected that the global smartphone market will only expand 3.6% in calendar 2016, with the 5-year growth rate expected to clock in at 6.0% CAGR. The fact that QCOM has been facing more competition in the iPhone modem business from the likes of Intel (NSDQ:INTC) does not augur well for the company, either.

New growth runaways for Qualcomm

Unlike QCOM, NXP Semiconductors is still growing rapidly. The company has managed to maintain top line growth for seven straight quarters, with growth during the last quarter coming in at a robust 51% to $2.22B, thanks to the company's merger with Freescale Semiconductors in a $12B deal in 2015. The merged company is officially the world's largest manufacturer of automotive electronics, with 40% of NXP's revenue being auto-related. NXP is a former subsidiary of Dutch consumer electronics giant Philips while Freescale was spun off from Motorola.

NXP Semiconductors now covers new application areas including body electronics and powertrain which reinforce its leadership in security, vehicle networks, and infotainment. By buying a company like NXP, Qualcomm will effectively be diversifying its current product line from mobile chips to adjacent industries outside the volatile mobile space. Qualcomm is currently the largest fabless chip manufacturer while NXP is the fifth largest semiconductor chip manufacturer in the world. The merger would mean that Qualcomm becomes the No.1 supplier of automotive chips, a rapidly growing market that has continued to benefit from growth of the intelligent and connected car concept. The quest by many auto manufacturers to introduce self-driving capabilities to their models is also helping.

Can Qualcomm pull off the deal?

And now the big question, does Qualcomm have the financial wherewithal to pull off a deal of this magnitude? Qualcomm exited last quarter with $30.6B in cash and cash equivalents on its balance sheet, the tenth largest cash pile in corporate America. The bad part is that much of this cash is parked in overseas markets and to repatriate it would mean the company ends up incurring a huge tax bill. Luckily, Qualcomm's long-term debt load of $10.02B is still manageable, with a fair debt-to-equity ratio of 0.38. This gives the company some leeway to take on more debt to finance the acquisition, especially now that Fed rates are so low. Qualcomm has also been buying back its shares aggressively, with the current buyback program pegged at $15B. This gives the company room to make a secondary share offering if necessary to finance the merger.

Also Read: Is VR820 Headset A Risk For Qualcomm Inc. Stock?

QCOM stock is up 34.3% YTD, and the shares could continue making gains in the coming quarters if the company manages to deliver on its upbeat Q4 guidance (ended Sept. 30). The company guided for revenue of $5.4-6.2 billion, good for 14%Y/Y growth at the high end with 195-215 million in chip shipments, a 6% increase at the high end. This could mark the first time Qualcomm records growth in chip shipments in more than a year.

Over the long-term, QCOM stock is likely to make good gains as well if the company is able to successfully execute in the automotive and IoT markets. The NXP acquisition will help the company cover a much wider base and hedge its bets if the smartphone market continues with its lackluster performance.

Evaluating tech stocks? Take a look at our top stock picks from the computer and technology sector.

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