Undervalued Dividend Growth Stock of the Week: Qualcomm, Inc. (QCOM)

I’m writing this article from Chiang Mai, Thailand.

Because I’m financially independent, I’m also geographically independent.

And so I decided to take both forms of freedom “on the road”, if you will.

Since the cost structure is much more advantageous in SE Asia (relative to America), I look at my unique situation in life as this amazing opportunity to live as an expat and become a global citizen.

And optimistically looking at most things in life as opportunities is what got me here.

Indeed, growing up in America is an amazing opportunity.

The amazing choices of jobs that pay well can allow one to make good money, live on a portion of it, and then save and invest the rest.

That last part – investing – is what leads me to this article today.

See, being in America also gives one access to one of the best long-term opportunities of all: the American stock market, which is chock-full of many of the best businesses in the entire world.

By living below my means and investing in great American businesses, I became financially independent in my 30s.

And the amazing thing about this is that just about anyone can do this.

But you have to take advantage of opportunities when they’re served up.

This has never been easier to do.

For example, an amazing resource here on the site is David Fish’s Dividend Champions, Contenders, and Challengers list.

This list includes key metrics on more than 800 US-listed stocks, all of which have paid an increasing dividend for at least the last five consecutive years.

Mr. Fish has tirelessly tracked down information on dividend growth stocks for years, doing the homework for a lot of investors out there.

Yes, these are dividend growth stocks we’re talking about. And high-quality ones, at that.

I couldn’t be a bigger fan of buying and holding high-quality dividend growth stocks for the long haul, as dividend growth investing is the investment strategy that led me to financial independence in my 30s.

You can see what I’m talking about by checking out my real-life dividend growth stock portfolio, which funds my financial independence via the five-figure passive dividend income it generates on my behalf.

But as fantastic as dividend growth investing is, it’s important to be vigilant when the time comes to invest.

You don’t want to invest in a business you don’t understand. Making sure a company is within your circle of competence is important.

And you also want to take the time to analyze a business and its fundamentals.

Looking for top-line and bottom-line growth, a solid balance sheet, and robust profitability should be automatic.

After all, if I told you I had a business that lost money, was highly leveraged, and had razor-thin margins, you probably wouldn’t be interested in investing in it. Right?

Once you’ve got a great business that’s within your circle of competence, you might have a very good opportunity on your hands.

But paying the right price at this juncture is critical.

What is the “right price”?

Well, I can tell you what the wrong price is.

That’s a price that’s well in excess of what a stock is worth.

If you have a stock worth $50, it certainly isn’t a very good idea to pay $100. That will lead to less income, poor relative long-term return, and unnecessary risk. Simply put, you may end up losing a lot of money doing that.

As such, the right price is one that is as far below intrinsic value as possible.

When a stock’s price is below its intrinsic value, it’s undervalued.

An undervalued dividend growth stock should offer a higher yield, greater long-term total return, and less risk.

That’s all relative to what the same stock would offer if it were fairly valued (price and value being roughly equal) or overvalued (price being above value).

The higher yield comes into play because price and yield are inversely correlated.

All else equal, a lower price will result in a higher yield.

This higher yield means not only more income today, but it also will likely lead to more aggregate income over the life of the investment.

In addition, since total return is comprised of income (via dividends or distributions) and capital gain, you’re giving yourself a shot at greater long-term total return right away through that higher yield (which means more income).

And the other half of total return (capital gain) is also given a possible boost due to the “upside” that exists when there’s that favorable gap between price and value.

While the stock market isn’t necessarily good at pricing stocks appropriately (in line with value) over the short term, the price of a stock tends to roughly reflect its value over the longer term, with value roughly reflecting the underlying profit of a business when stretched out over a long-term lens.

This favorable gap between price and value also tends to reduce one’s risk.

When you’re paying more than a stock is worth, you’re unnecessarily risking capital. Likewise, it’s vice versa when you’re paying less than a stock is worth.

This allows for a margin of safety, because all kinds of things can go wrong in business.

The last thing you want to do is have no buffer for the unknown.

As you can see, undervaluation is highly appealing.

How one goes about valuing a business and its stock is somewhat subjective and individualized; however, fellow contributor Dave Van Knapp has put together a great guide to valuing dividend growth stocks. It’s very much worth a read, especially if valuing dividend growth stocks is new to you.

But I won’t leave you readers there.

I’m going to reveal and discuss what appears to be an undervalued high-quality dividend growth stock today…

Qualcomm, Inc. (QCOM) develops and licenses products and services based on its advanced wireless broadband technology including semiconductors for mobile phones.

Mobile phones are everywhere.

Don’t believe me?

Take a look around you. Better yet, check your pocket.

They’re ubiquitous. And they’re practically necessary for everyday modern-day life.

Society’s fascination with and addiction to mobile phones is a mighty opportunity. And there are few companies that profit more directly from that opportunity than Qualcomm.

That’s because they own the majority of applicable patents relating to CDMA and OFDMA technology, meaning most 3G and 4G handsets are essentially unable to connect to networks without Qualcomm collecting royalties through licensing.

With mobile phones here to day – they’re only going to become more ubiquitous than they already are – Qualcomm is positioned to continue raking more and more profit.

And this situation bodes very well for their ability to pay and grow their dividend.

The company has paid an increasing dividend for 15 consecutive years.

When thinking about investing in tech companies, I gravitate toward large-cap players that are thoroughly entrenched, “proving their mettle” through many years of dividend increases. This means they’ve shown an ability to endure and adapt to changes within tech over a lengthy period of time.

As a ~$76 billion company with a decade and a half of dividend increases, Qualcomm is right in my wheelhouse.

Not only do they have a very solid dividend growth track record in the tech space, but the rate at which they’ve increased their dividend has been pretty phenomenal.

Over the last decade, the dividend has grown at an annual rate of 16.5%.

They’ve been very consistent with this, too. However, the most recent dividend increase is just a slight blemish, as it was only 7.6%.

Still, that kind of dividend increase is mighty handsome when you consider the stock is yielding a monstrous 4.40% right now.

That yield, by the way, is 190 basis points higher than the stock’s five-year average yield.

If every stock I owned yielded me 4.4% and gave me 7.6% dividend growth, I’d be a happy investor.

That said, the payout ratio at first glance appears to be high right now, portending slight danger in regard to the dividend.

At 87.4%, it’s uncomfortably high.

However, the ratio is skewed by a number of recent impacts to GAAP EPS. This has caused Qualcomm’s reported results to be well below the historical average, and well below the actual earnings power of the company.

These impacts are related to lawsuits regarding Qualcomm’s royalties. One major judgment went against Qualcomm, which has served to dramatically reduce GAAP EPS over the last couple quarters. And ongoing litigation with some of their biggest customers (including Apple Inc. (AAPL) isn’t helping.

But the stock price is down almost 25% over the last year, causing the company’s market cap to drop by over $20 billion over that time frame.

So it’s almost like the market believes that Qualcomm is permanently impacted by these issues. While that remains to be seen, there’s far more upside than downside, in my view, as the stock has already been repriced downward as if much of their business is gone forever.

As such, if/when EPS normalizes, so will the payout ratio.

While near-term dividend growth will be as uncertain as some of their legal issues, the long-term picture still appears bright.

But in order to really build an expectation for future dividend growth, we have to build a future expectation for overall business growth.

And there’s no better place to start than with Qualcomm’s long-term results.

We’ll first see what the company has done over the last decade in terms of top-line and bottom-line growth, which will give us an idea of what kind of trajectory the company is on.

And we’ll then compare that to a near-term expectation for profit growth.

Combining the results will give us something to work with when the time comes to value the business and its stock.

Qualcomm has increased its revenue from $8.871 billion to $23.554 billion between fiscal years 2007 and 2016. That’s a compound annual growth rate of 11.46%.

Very strong top-line growth here. I usually like to see something in the mid-single digits for a mature company. Qualcomm obviously blows that out of the water.

The company’s earnings per share didn’t fare quite as well, though, as Qualcomm’s business has been under assault lately. Impacts are being felt and the previously huge margins have compressed of late.

The company’s EPS grew from $1.95 to $3.81 over the same stretch, which is a CAGR of 7.73%.

Still solid. If this were all Qualcomm could manage, it’d still be a very appealing business. But any normalization of business would only serve to accelerate this number and catapult the company (and possibly the stock). As noted earlier, I believe there’s more upside than downside, as the current picture of the business is somewhat fractured.

Looking forward, CFRA believes Qualcomm will compound its EPS at an annual rate of 3% over the next three years.

This assumption seems to be built around the uncertainty regarding the royalty disputes – and rightly so. But these uncertainties are more near term than long term, all in all. And those issues are, to a large degree, priced in.

Meanwhile, the rest of the company’s fundamentals are rather impressive, if just a bit less so than a few years ago.

The balance sheet is a particular strong suit, with a long-term debt/equity ratio of 0.31. The interest coverage ratio is 24.

Furthermore, cash and marketable securities total almost $20 billiontwice the long-term debt.

But the company can’t just stroke a check and pay off debt due to the announced acquisition of NXP Semiconductors N.V. (NXPI).

Qualcomm believes this acquisition will be very accretive to earnings upon closing, with additional growth opportunities across automotive, IoT, security, and networking.

But the deal gives NXPI an enterprise value of $47 billion, and this acquisition will be funded via cash on hand and the issuance of debt.

So the balance sheet will take a hit in exchange for more growth potential, if this acquisition goes through.

Profitability has long been the story around Qualcomm. The numbers of late are a bit less robust than what we’ve historically seen with the business, but the company is still very profitable in absolute terms.

Over the last five years, Qualcomm has averaged net margin of 26.93% and return on equity of 18.80%.

These are fantastic numbers here. And even if some of the recent compression is more permanent in nature, there’s nothing to sneeze at.

Overall, there’s a lot to like about Qualcomm. It’s one of the most dominant tech companies in the world, and they’re positioned incredibly well for the future.

Recent litigation blemishes what is otherwise a phenomenal business.

But many of these near-term issues seem to be already factored in, with the company’s market cap dropping by over $20 billion in the last year.

That has led to what I believe is an opportunity, with the stock appearing to be undervalued right now…

The stock is trading hands for a P/E ratio of 19.85 right now. That is in and of itself not notable, but that P/E ratio is based off of TTM EPS, which has been negatively impacted in a major way by ongoing litigation. If we were to use FY 2016 EPS as a rough guide, the stock’s P/E ratio would be closer to 14 – much lower than the market and the stock’s five-year average P/E ratio. And the yield, as shown earlier, is almost 200 basis points higher than its recent historical average.

If business normalizes even somewhat, this is a cheap stock. But how cheap might it be?

I valued shares using a dividend discount model analysis.

I factored in a 9% discount rate and a long-term dividend growth rate of 6%.

That DGR is much lower than what Qualcomm has delivered over the last 10 years, but all of the near-term uncertainty is being accounted for.

There’s room for a nice surprise here.

But just in case Qualcomm slogs through litigation for some time, lower-than-normal dividend growth is built into the model.

The DDM analysis gives me a fair value of $80.56.

The reason I use a dividend discount model analysis is because a business is ultimately equal to the sum of all the future cash flow it can provide.

The DDM analysis is a tailored version of the discounted cash flow model analysis, as it simply substitutes dividends and dividend growth for cash flow and growth.

It then discounts those future dividends back to the present day, to account for the time value of money since a dollar tomorrow is not worth the same amount as a dollar today.

I find it to be a fairly accurate way to value dividend growth stocks.

So my perspective is that the stock is vastly undervalued right now. However, my perspective is but one of many. I think it adds depth and usefulness to compare my valuation to what professional analysts come up with.

Morningstar, a leading and well-respected stock analysis firm, rates stocks on a 5-star system.

1 star would mean a stock is substantially overvalued; 5 stars would mean a stock is substantially undervalued. 3 stars would indicate roughly fair value.

Morningstar rates QCOM as a 4-star stock, with a fair value estimate of $68.00.

CFRA is another professional analysis firm, and I like to compare my valuation opinion to theirs to see if I’m out of line.

They similarly rate stocks on a 1-5 star scale, with 1 star meaning a stock is a strong sell and 5 stars meaning a stock is a strong buy. 3 stars is a hold.

CFRA rates QCOM as a 4-star “BUY”, with a fair value calculation of $51.95.

The latter firm actually has a 12-month target price of $66.00, which is interesting. Nonetheless, I came out high. But averaging the three numbers out gives us a final valuation of $66.84, which is right there with Morningstar’s valuation and CFRA’s 12-month TP. That would indicate the stock is potentially 29% undervalued right now.

Bottom line: Qualcomm, Inc. (QCOM) is one of the largest tech companies in the world, with a finger (and dollar) on the majority of mobile phones being sold and in operation today. Their patents allow for very lucrative licensing and royalties. The stock has been hammered over the last year, but that looks to be building in the possibility of 29% upside for investors who buy in now, which is on top of a market-smashing 4.4% yield. This high-quality dividend growth stock is certainly worth a look here.

— Jason Fieber

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