- Qualcomm’s royalty business is exhibiting patterns of rapid recovery.
- However, I believe the recent deal with Vivo isn’t completely captured by sell-side models.
- In other words, there’s a compelling opportunity to buy the stock ahead of a sales/earnings beat.
Qualcomm, Inc. (NSDQ:QCOM) reached a settlement with one of the fastest growing smartphone franchises (Vivo) in China with a negotiated royalty settlement. It’s hard to determine whether the incremental impact will be felt by shareholders, or if the impact of a settlement with Vivo was already reflected in Qualcomm’s guidance for FY’16 revenues of $7.4 billion to $7.8 billion for the QTL segment. The settlement occurred on August 7th 2016, after the earnings report.
That being the case, I feel fairly compelled to suggest the stock as a buy at the given juncture, as the vast majority of patent settlement cases have been resolved. As such, a sustainable earnings ramp seems probable given the deflated guidance estimates by Qualcomm, and the conservative nature of sell-side models despite the potential for demand recovery in the immediate quarter.
Setting the stage
Determining the impact of Vivo’s settlement is a bit of an exercise in mathematics. After all, it’s hard to get exact figures, but industry data gives me enough conviction to state that the impact will be roughly in the $400 million range between the low and high-end of the revenue guidance. While it’s hard to tell if the CFO of Qualcomm had little or high conviction on signing a deal with Vivo, the signing of the Vivo agreement gets us really close to the high-end of QCOM CFO's guidance estimate for the QTL segment.
Notwithstanding the loss of some revenue from Apple iPhone 7, impact on the top line will be limited given both Oppo and Vivo have substantial margin accretion and sales impact. Vivo and Oppo combined generated 80 million in unit shipments in CY’15, according to Bank of America Merrill Lynch (BofAML) research. The additional royalties from the two handset makers should contribute significantly to QCOM’s revenue and earnings given the high margin contribution of the royalty business in comparison to QCT.
In the prior earnings call Qualcomm mentioned that the royalty rate should stay constant at approximately 2.9%. However, according to Credit Suisse, the royalty rate from Chinese vendors is currently 2.5%. In FY’15 Vivo sold 36.7 million units, and grew Q1’16 shipments at 123% according to IDC, however for the sake of conservativism I extrapolated 120% growth for Q1’16 to Q4’16. This could ultimately prove conservative as smartphone manufacturers typically exhibit healthier q/q growth trends in Q4’ of any given year given the seasonal impact of winter holidays.
That being the case, I arrive at a fairly conservative estimate of 77.07 million units, and multiply the guided 2.5% royalty rate against a $165 ASP (average selling price came from Bank of America Merrill Lynch). This implies that in FY’16 Vivo will generate $12.716 billion in revenue, and of that amount Qualcomm will earn its 2.5% spread, which implies contribution of $318 million in revenue in FY’16, which has 94% gross margins as per QCOM’s reported results.
In other words, the Vivo deal should translate into appx. $300 million in gross profit contribution and any deferred royalty payments that Vivo has not made to Qualcomm should translate into perhaps $130 to $150 million revenues from prior year shipments.
So how does this translate into the investment thesis?
Given the incremental impact of Vivo, I feel fairly compelled to anticipate higher q/q revenue ramp, as revenue recognition should imply immediate contribution from a settlement in FY’16.
Unless I’m mistaken, typically royalty settlements are paid in full, or if Qualcomm is more amenable they may defer the payment terms so the settlement is paid over a protracted period of perhaps three to four years. But there wasn’t any significant uptick in the unearned revenue component of the balance sheet in the sell side models (Morgan Stanley), and receivable balance didn’t increase either.
Qualcomm may receive the settlement in a lump sum over the duration of the single quarter or perhaps earn revenue over a period of years. But in that case, earning revenue from deferred payments should translate into a figure which is much higher than 2.5% average royalty rate, and higher receivable balances over the immediate quarter and full fiscal year.
As such, I have a lot of conviction that the financial models on the sell side are extremely conservative, and that Qualcomm will exceed the consensus earnings and revenue estimates by around 3% to 5%. This could result in a positive stock move to the tune of 3% to 5% above the S&P 500 return rate for the day. In other words, stocks that beat on both sales and earnings tend to perform above the S&P 500 return by 3 to 5 percentage points, according to a BofAML research study. As such, I feel fairly confident that investors will earn a fairly sizable one-day performance gain assuming the sales and earnings outperform the consensus models by a narrow range of 3% to 5%, which seems highly probable given the contribution from the Vivo settlement in the immediate near term.
While it’s generally inadvisable to speculate on short-term price moves, I believe there’s a compelling argument for initiating a position in anticipation of q/q strength in both earnings and revenue that will likely come above the mid-point of the consensus estimate range. As such, investors should consider a position in Qualcomm stock.
The long-terms fundamentals of the business aren’t exactly appealing given the impending expiration of patents from 2019 onwards, and the potential to miss out on the 5G modem cycle given increased competition. Notwithstanding this, I believe these risk factors are already priced into the stock, and given the near-term bias of the market, it’s a compelling buy and hold for the duration of the next couple quarters.
As such, I’m re-rating the stock from sell to buy. I will also provide a more in-depth fundamental overview of Qualcomm in the coming weeks.