Most companies are usually reluctant to make themselves smaller on purpose, but Qualcomm, Inc. (NASDAQ:QCOM) would probably be better off if QCOM spun off its chip-making business, as an activist investor wants.
QCOM is a huge player in the market of manufacturing chips for mobile devices like smartphones and tablets. Indeed, QCOM chips power smartphones ranging from Apple Inc.’s (NASDAQ:AAPL) iPhone to ZTE Corporation‘s (OTCMKTS:ZTCOF) Grand S, but that’s not nearly as a good a business as it sounds.
Making chips that connect mobile devices to cellular networks is a relatively costly and low-margin affair. QCOM’s other main source of revenue — licensing its patents — is very high-margin and profitable.
The imbalance between these businesses is captured perfectly by the fact that although the chip operations generate almost all of QCOM’s revenue, the licensing business contributes almost all of its profits.
Enter hedge fund Jana Partners, which has amassed a stake in Qualcomm stock worth about $2 billion, making it one of the company’s largest shareholders. As reported by The Wall Street Journal, Jana sent a letter to fellow shareholders calling for the breakup of QCOM by spinning off the chip-making business from the patent-licensing business.
Interestingly, QCOM proposed the same thing 15 years ago before calling it off. But Jana’s resurrection of the idea comes at a very different time for Qualcomm. Back in the day, QCOM stock was among the best-performing tech names in the S&P 500.
Today, QCOM stock is mired in a long period of underperformance. Over just the last 52 weeks, Qualcomm stock is off 12% vs. a 14% gain for the broader market.
In addition to the spin-off of the chip-making business, Jana is also calling for costs cuts, more stock buybacks and other reforms.
QCOM’s Breakup Is a Timely Idea
Corporate breakups are in fashion these days — General Electric Company (NYSE:GE) is just the latest big name to spin-off parts of itself — and they often make a lot of sense. After all, there’s a reason why conglomerates are mostly extinct: Simpler businesses tend to make far better investments, especially when a company’s fast-growth operations are being held back by its its slow-growth ones.
It also doesn’t help that the market weighs growth and value differently, and having both types of investments under one roof tends to hurt both of them.
Another factor in favor of a break up is that it happens to be a good time to strike. An independent chip company would likely be able to find a partner in the world of mergers and acquisitions in short order, and that would enhance returns. As Jana said in its letter:
“Semiconductor companies are being rewarded for M&A, with several recent large deals having meaningfully outperformed the market, and with those deals focused on industry consolidation/cost synergy delivering even greater returns.”
As with GE, QCOM stock would be a better investment if it were free of the chip-making business. Not only does the chip business have lower growth prospects and slimmer margins, but it’s also coming under increasing competitive pressure. A tax-free spin-off to shareholders and/or a merger with another chip-maker would put cash in shareholders pockets.
True, buybacks and share repurchases also return cash to shareholders, but a breakup would also improve the QCOM stock’s potential for price appreciation. A QCOM stock based solely on patent-licensing would get a lift on multiple expansion alone.
Qualcomm stock hasn’t done much to distinguish itself lately. If QCOM does indeed go the breakup route, that will almost certainly change.
As of this writing, Dan Burrows did not hold a position in any of the aforementioned securities.
