Welcome back to the Dividend Growth Stock of the Month series. Thus far in 2016, these are the stocks that we have covered:
|Month, 2016||Company||Ticker||Article Link|
This month, for the second month in a row, we will look at a tech stock that seems to have turned into a dividend machine: Qualcomm (QCOM).
Qualcomm’s Dividend Characteristics
Always remembering that past performance does not guarantee future results, this is a very good dividend resume. Highlights include:
• The current yield of 4% is nearly twice that of the S&P 500.
• At 14 years, QCOM’s dividend growth streak makes it a “Contender” on the Dividend Champions document. Contenders have increased their dividends between 10 and 24 years in a row.
• The dividend growth record is very good. This year’s increase of 10% is down from last year’s 16% but still healthy.
• Given the payout ratio of 67%, I think that QCOM may be settling into a pattern of lower dividend increases that are in the range of its earnings growth rate. This is often a sign of a maturing dividend growth company. Dividend growth rates of 20%+ cannot last forever, and 67% payout from earnings is far enough to go for most companies.
• Share count has been declining for several years (see chart below).
• High dividend safety grade from Safety Net Pro.
Here is a chart of Qualcomm’s share count over the past 10 years. As you can see, the number of shares began to decline in mid-2013, and the number has fallen about 15% since then.
Declining share counts are good for dividend growth investors. Fewer shares mean not only that each share represents a larger piece of the total pie, but also that the dividend pool is spread over fewer shares. That makes dividend maintenance and increases easier for the company.
In a recent presentation, the company stated its commitment to distributing 75% of its free cash flow in the form of share repurchases and dividends.
Business Model: How Does Qualcomm Make Money?
Formed in 1985 and public since 1991, San Diego-based Qualcomm develops, licenses, and continually upgrades an important digital communication technology called CDMA (Code Division Multiple Access).
Today all 3G networks are based on CDMA.
Qualcomm’s intellectual property is licensed by most wireless device makers.
That is one way QCOM makes money.
In addition, Qualcomm is the world’s largest manufacturer of wireless chips.
It supplies handset makers with cutting-edge microprocessors. It is the market leader in 4G (4th generation) LTE (Long-Term Evolution) chipsets.
The company’s revenue comes in primarily through two business segments: Qualcomm CDMA Technologies (QCT) and Qualcomm Technology Licensing (QTL).
[Source: All of the displays in this section are from recent company presentations.]
QTL grants licenses to use pieces of QCOM’s intellectual property, such as patent rights involved in the manufacture of wireless products based on QCOM’s technology. The company also charges a royalty fee, usually around 3%-5%, of the price of each 3G device sold. As you can see, this business enjoys a very high profitability rate (EBT, earnings before taxes, is 87%).
Qualcomm believes that growth opportunities for its QTL licensing business are good. This display shows how Qualcomm expects the device market to grow over the next 5 years.
The QCT segment develops and supplies integrated circuits and software based on CDMA and other technologies for use in voice and data communications, networking, application processing, multimedia, and global positioning system (GPS) products.
Qualcomm’s chip business for mobile devices is the market leader today, although the business is extremely competitive. Qualcomm’s high-end Snapdragon processors were in virtually every premium smartphone in 2014, but Samsung has shifted to internally developed chips in its Galaxy S6 smartphone. Competition comes from the likes of Intel, MediaTek, Apple, and Samsung.
As you might expect, Qualcomm has strategies in place for continued growth and for keeping its technology at the forefront. (In the display below, “SoC” means systems on a chip.)
Qualcomm is in a legal situation with the China National Development and Reform Commission. That body is investigating the company with regard to QCOM’s licensing business, the calculation of royalties, its policy of selling chipsets only to patent licensees, and related matters. At the current time, it is hard to predict the outcome of this investigation. QCOM is cooperating with the investigation.
In January, 2016, QCOM announced a joint venture with TDK Corp., valued at $3 billion total, to manufacture radio frequency front-end modules and filters for mobile devices. The deal is expected to close in early 2017. QCOM expects it to be accretive to EPS in the first 12 months after closing. QCOM will own 51% of the venture and has the option to purchase TDK’s stake after 30 months.
Putting everything together, here is the summary table of Qualcomm’s business model and overall quality as an investment. In my own assessment at the bottom, I give QCOM a middling score, based mostly on the perils presented by the continuing pressure to stay at the forefront of technology in the midst of heavy and motivated competition.
You may notice that I have added a new line to the table above: Gross Profitability. The reason is based on the research of Robert Novy-Marx, who has been examining quality factors in companies and how they relate to long-term market returns.
Without going into deep detail here, Novy-Marx has found that of all the quality factors he has examined, the simple metric of gross profitability has been most associated with favorable market returns. For more detail, check out Forbe’s interview with Novy-Marx here.
Morningstar has a convenient display of gross profitability and other useful metrics under its “Key Ratios” tab for every stock. Here is the current display for Qualcomm:
I put a red dot next to the gross margin percentage line. I have not settled on an exact scoring system for this metric yet, but after examining a variety of stocks, it is clear that 59% gross profitability is better than average. So for now, I score it “Good” and give it a light green color.
On the other hand, you will note that Qualcomm’s gross profitability has been slowly declining. In 2006 it was 71%. The most recent 12 months registered 59%. It is hard not to interpret this as a negative trend.
Concerning Morningstar’s moat rating, in April they lowered QCOM’s rating from wide to narrow. The reason was regulatory inquiries into QCOM’s intellectual property rights.
While we still think it is more likely than not that Qualcomm’s IP will hold up to regulatory scrutiny over the next few years, we can no longer say with near certainty that a quickly rising number of regulatory investigations will all work out in Qualcomm’s favor. Regulatory investigations…have simply been too unpredictable in the past to guarantee outcomes that will ensure excess [returns] for Qualcomm with 100% certainty.
Qualcomm’s Financials and Outlook
This is a good financial resume if you just look at the numbers, but when you look at trends, some concerns pop up.
Here is a display of Qualcomm’s ROE over the past 10 years. You can see the variability.
Similarly, the company’s EPS has varied over time, with a recent drop.
Qualcomm’s D/E has gone from practically 0 to 0.4 in just a couple of years.
Overall, I am reticent about the trends.
Qualcomm’s Stock Valuation
Let’s apply my 4-step process for valuing companies as described in Dividend Growth Investing Lesson 11: Valuation.
Under this approach, the company’s total valuation is the average of 4 discrete steps, and valuation is graded on a 5-step scale as follows:
The color coding should be obvious: Green = a better opportunity, and red = a worse opportunity. The “opportunity” referred to is the investor’s opportunity to obtain good returns.
Since no one knows the future, valuation should be viewed as an estimate of the probability of future outcomes, not as a definite call about what is going to happen or how long it will take to happpen. I view valuation with a long-term focus (meaning 5+ years).
Step 1: FASTGraphs Default. The first step is to compare the stock’s current price to FASTGraphs’ theoretical estimate of its fair value. The theoretical estimate is based on a price-to-earnings ratio (P/E) of 15, which is the long-term average P/E of the stock market as a whole.
That is shown by the orange line on the graph (using the scale at the right edge of the graph).
By this first method of appraising valuation, Qualcomm is underpriced. Its actual price (the black line) is 17% below its fair value when calculated by this method. Here is that calculation: At an actual P/E of 12.5, QCOM would be considered undervalued by 12.5 / 15 = 0.83 = 17%.
Working backwards, Qualcomm’s fair price by this method calculates out to $63.
Step 2: FASTGraphs Normalized. The second valuation step is to compare Qualcomm’s current P/E ratio to its own long-term average P/E ratio. This step lets us adjust for the fact that some stocks, in the view of the market, seem historically to deserve higher or lower valuations based on investors’ views of the companies.
As I usually do, I have used Qualcomm’s 10-year average for this step. We can see that Qualcomm has, in fact, been dearly valued on average, with a 10-year P/E = 18.5, compared to the market-average value of 15 used in the first step.
Using the historical P/E of 18.5, Qualcomm appears far undervalued. I calculate a fair value of $77. The company’s actual price is about 32% under that right now.
Please note that Qualcomm’s P/E ratio has been declining for a many years.
With the exception of the period following the Great Recession (indicated by the gray band), you can see that QCOM’s P/E ratio has been steadily declining for the past 10 years, indeed since the dot-com bubble burst in 2000-2002.
The upshot is that if I had used a shorter average P/E ratio in this valuation step, the degree of Qualcomm’s undervaluation would have been diminished for each year removed from the average calculation.
Step 3: Morningstar Star Rating. Morningstar uses a comprehensive net present value (NPV) technique for valuation. Many investors consider this approach to be superior to using P/E ratios as we just did with FASTGraphs.
In its NPV approach, Morningstar makes a projection of all the company’s future profits. The sum of all those profits is discounted back to the present to reflect the time value of money. That is called DCF or discounted cash flow analysis.
The resulting net present value of all future earnings is considered to be the fair price for the stock today.
On Morningstar’s 5-star system, Qualcomm gets 4 stars. That means that they believe the company is undervalued. They calculate a fair value of $68.
Step 4: Current Yield vs. Historical Yield.
Finally, we compare the stock’s current yield to its historical yield. It is better to be near the top of that range than the bottom.
Qualcomm is undervalued by this method. Its current yield of 3.8% (as shown by Morningstar) is far above its average 5-year yield of 2.1%.
The ratio of those two yields is 1.8x, but for this method of valuation, I cut off the maximum difference at 1.2x, or 20%. I do that because the ratio is often disproportionately afffected by the company’s most recent dividend increases. As noted earlier, Qualcomm’s most recent increase, earlier this year, was 10%.
Using the 20% maximum ratio, I get a fair price for the stock of $65 under this valuation approach.
In computing valuations, I consider prices within 10% of the calculated fair value to be within the fair value range. Assessing valuation is inherently imprecise, so rounding prices to the nearest dollar and using sensible ranges is, in my opinion, better than trying to achieve false precision.
Using the 4 approaches just described, our valuation summary for Qualcomm looks like this:
For a reality check, I also looked at S&P Capital IQ’s fair value estimate. Their 12-month price target for Qualcomm is $59, and they have a “buy” rating on the stock.
There are a couple of factors that do not fall into the earlier categories.
Beta measures a stock’s price volatility relative to the market as a whole. Most dividend growth investors like to own stocks with low volatility, because then you are less likely to become emotional about them when their price drops.
Qualcomm has been more volatile than the market. That is typical of cyclical and technology stocks. If you are the kind of investor who frets over price drops, Qualcomm might not be a comfortable holding for you. If you are the type who does not worry much about price volatility, but instead focuses on rising dividends and other fundamentals, QCOM may be a good choice.
The analysts’ recommendations come from S&P Capital IQ. Their most recent report shows the opinions of 33 analysts. Their average recommendation is 3.7 on a 5-point scale, where 3.0 = Hold and 4.0 = Buy. Most analyst reports are tilted toward short-term trading expectations rather than long-term dividend growth goals. Nevertheless I find them useful as a reflection of sentiment mong analysts that study the stock.
Here are Qualcomm’s positives:
• Good yield at 4.0%.
• Dividend safety is good (but not the highest rating), protected by good cash flow, earnings, and company commitment.
• Strong dividend growth record: 14 years of dividend increases (since it began paying a dividend). I expect growth going forward will be roughly in line with the company’s earnings growth rate.
• Stock is undervalued by more than 20%.
• Good ratings of company quality from many perspectives.
• Dominant business position in 3G technology, plus strategy to be a leader in developing advanced technologies.
• Declining share count over the past few years, with a current buyback authorization in place.
• Decent financial numbers, although there are some concerning trends.
Here are Qualcomm’s negatives:
• Inherent riskiness and complexity in technology companies. Extreme pressure to stay ahead of technology curve in highly competitive businesses.
• Cyclical and variable business results, with some years showing declining ROE and profitability compared to prior years, as well as recent rise in debt.
• Above-market price volatility, which could be a worrisome factor for some investors.
My own bottom line is that while Qualcomm is a high-quality company with a good yield (4%) and dividend growth record, and appears to offer very good valuation, it is too risky an investment proposition for me. To buy this would constitute “reaching for yield.”
Obviously, reasonable minds can differ about such a conclusion. If everything goes well for the company over the next few years, Qualcomm could turn out to be a fabulous investment. But there are too many complexities and variables for my taste.
As always, do your own due diligence, and please do not take this article as a recommendation to buy, hold, or not to buy Qualcomm. Instead, use it to inspire your own research. Always make your investment decisions with an eye to your tolerance for price volatility and other risks.
– Dave Van Knapp
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