Can Qualcomm Stay King of the Mobile Chip Market?

With a more than 50 percent market share, Qualcomm (NASDAQ:QCOM) dominates the smartphone chip market. The global semiconductor manufacturer has become a hot growth stock, as the smartphone industry continues to grow at an impressive rate.

The share price, however, is actually down around 4 percent year-to-date. Can the company reverse this downtrend in the second half of 2013? Let’s use our CHEAT SHEET investing framework to decide whether Qualcomm is an OUTPERFORM, WAIT AND SEE, or STAY AWAY.

C = Catalysts for the Stock’s Movement

Qualcomm’s competitive advantage in the mobile semiconductor market is twofold:

1. Qualcomm has several key contracts with smartphone giants Apple (NASDAQ:AAPL) and Samsung (SSNLF.PK). Earlier this year, the company signed a contract to supply its Snapdragon processor to Samsung for use in its popular Galaxy S4 smartphone. Additionally, the California-based semiconductor company manufactures several key components for the iPhone. Increased production orders for the impending new iPhone later this year will boost Qualcomm’s sales.
2. Qualcomm owns valuable patents on CDMA technology for 3G phones. This means anytime a 3G phone — or 4G phone, for that matter — is activated, Qualcomm receives a portion of the proceeds. Because the company is using technology it has already produced, margins from CDMA royalties are very high. Qualcomm’s intellectual property is well protected, and company profits in this division should ramp up from this operation as the smartphone industry grows.

Qualcomm reported a solid fiscal second quarter, with revenues increasing by 24 percent from the previous year’s quarter. Net income, however, fell 16 percent, and some analysts worried about a weaker-than-normal earnings guidance for next quarter. The recent downward pressure on the company’s stock price has been fueled by worries that the average selling price of chips is decreasing, as competition from the likes of Intel (NASDAQ:INTC) into the smartphone space intensifies.

A decline in average selling prices shouldn’t worry investors too much, as these decreases will be offset by growth in the smartphone industry and Qualcomm’s CDMA patents. Qualcomm reports its third quarter earnings on July 19.

E = Earnings Are Mostly Increasing Year-over-Year

Qualcomm’s quarterly earnings per share fell 17.19 percent from the previous year’s quarter. However, the company demonstrated steady earnings per share growth in the four previous quarters. Analysts anticipate that Qualcomm will announce an earnings increase of around 21 percent in the next quarter, with the next earnings report scheduled for July 19. Investors should pay special attention to Qualcomm’s operating margin — a weak point from the previous quarter’s report.

*Data sourced from YCharts

E = Excellent Performance Relative to Peers?

Qualcomm is expensive relative to its two major competitors — Intel (NASDAQ:INTC) and NVIDIA (NASDAQ:NVDA) — with a trailing price to equity ratio of 17.19. However, its higher price is justified based on higher growth prospects and a more attractive operating margin. It has a price-to-earnings growth ratio of less than one, implying the company is undervalued relative to its growth prospects.

This isn’t surprising given that Qualcomm has the most exposure to the quickly growing smartphone industry. Additionally, Qualcomm is able to maintain its high operating margins, despite lower average selling prices for chips, because of the royalty fees it collects on CDMA patents — a high-margin operation. In terms of dividend yield, however, Qualcomm is yielding the lowest of the three. Still, with a payout ratio of only 28 percent, Qualcomm has room to increase its dividend in the future.

Conclusion

With the greatest amount of exposure to the high-growth smartphone industry, a high operating margin, and a sustainable competitive advantage, Qualcomm should continue to enjoy profitability in the telecommunications industry. Qualcomm’s stock has experienced a downtrend over the past five months — trading below its 200-day moving average — mostly due to concerns about the company’s declining average selling prices, soft earnings guidance, and rising competition. Qualcomm’s position within the chip market is well protected, however. With an impressive product line and several key contracts with smartphone giants, Qualcomm is a strong buy for those who are bullish about the future of the smartphone market. Qualcomm is an OUTPERFORM.

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