I have been skeptical toward Qualcomm (NASDAQ:QCOM) stock for some time — to be honest, too skeptical. Like many investors, I overreacted to the impact of the company’s dispute with Apple (NASDAQ:AAPL). And I underestimated the company’s ability to navigate regulatory uncertainty.
That said, I’m not ready to turn bullish just yet. I understand the bull case for Qualcomm, given the company’s exposure to 5G wireless and IoT (Internet of Things). I believe the company’s guidance given last month for strong growth over the next three years.
But there are two big stumbling blocks to the bull case for the stock, even after a recent pullback. First, Qualcomm’s current valuation seems to incorporate much, if not all, of the good news at the moment. And second, the risks that pressured Qualcomm in 2018 (and before that) haven’t completely disappeared.
To be clear, I’m not recommending a short of Qualcomm stock, nor do I believe the stock is destined to plunge. Rather, even after a solid fourth quarter earnings report, my argument remains much the same as it has been in recent months. Qualcomm deserved its rally, but I’m not sure at this point investors can ask for much more.
Qualcomm Guides to Fiscal 2022
At its Analyst Day on Nov. 19, Qualcomm gave three-year guidance that on its face seems like good news. Qualcomm expects that the addressable market for its QCT (Qualcomm CDMA Technologies) segment will grow at a 10% annual clip, driven largely by cellular IoT applications. QCT revenue should grow at a faster rate as the company expects to take market share.
In the QTL (Qualcomm Technology Licensing) segment, the news isn’t quite as good, with the company expecting a continuation of recent negative trends, with help from the resolution of the complicated situation with customer Huawei. But thanks to recent cost cuts, Qualcomm expects operating margins in the segment to improve to roughly 70% from a current 64%. In QCT, adjusted EBIT margins should expand from 15% in fiscal 2019 (ending September) to over 20%.
On a consolidated basis, those targets suggest impressive growth. Revenue should grow at a double-digit pace annually from the $19.4 billion posted in fiscal 2019 on a non-GAAP basis. (That latter figure excludes $4.7 billion in licensing revenue recognized thanks to the settlement with Apple.) Operating margins should expand from 24% in fiscal 2019 to the high 20s by fiscal 2022. As a result, adjusted EPS has a path to clear $6 from the $3.54 posted this past year.
That’s hugely impressive growth. It dwarfs that of other mature, large chipmakers like Intel (NASDAQ:INTC) or former suitor Broadcom (NASDAQ:AVGO). In fact, it’s closer to the performance of growth plays in the sector like Advanced Micro Devices (NASDAQ:AMD) and Nvidia (NASDAQ:NVDA). That type of growth profile would seem to be notably bullish for Qualcomm.
Yet investors didn’t treat the news as such. Qualcomm stock dropped 2.8% on the 19th, and another 2.7% the following day. It has now pulled back 9% in three weeks, during a stretch in which the iShares PHLX Semiconductor ETF (NASDAQ:SOXX) has been basically flat.
The Qualcomm stock price is a key reason why. Yes, Qualcomm is going to grow nicely in coming years — but it’s not as if investors weren’t aware of that fact. Based on trailing earnings, the stock is relatively expensive, at nearly 24x FY19 earnings per share. That’s not a huge multiple in the context of the overall market or tech, but for the chip sector it’s rather high. INTC and AVGO, for instance, trade around 13-14x earnings for their respective current fiscal years.
Qualcomm, however, trades at a similar multiple to its fiscal 2022 profits. If investors expect 10% annual returns (including the roughly 3% dividend) over that stretch, that multiple needs to hold at least at 17x three years from now.
That’s a bigger ask than it sounds like. Qualcomm traded well below 17x earnings before the Apple dispute accelerated in early 2017. And even if targets are hit, Qualcomm’s long-term profile won’t suggest anything like a growth multiple.
Yes, fiscal 2022 earnings should come in above $6 per share, thanks to strong growth in the next three years. But adjusted EPS came in at $5.27 back in fiscal 2014. The FY22 targets still imply roughly 2% annual profit growth over an eight-year stretch.
The seemingly impressive growth Qualcomm plans to generate in the next three years is coming in part because fiscal 2019 earnings have been depressed by the battle with Apple. On a normalized basis, the trend is nowhere close to spectacular. Despite that, investors have to believe the market will price the stock at a premium to other mature chipmakers simply to drive reasonable annual upside from current levels. That doesn’t seem a compelling bet to take.
The Risks to Qualcomm Stock
What’s more worrisome is that the valuation problem exists even if an investor assumes Qualcomm will hit its Analyst Day targets. That’s obviously not guaranteed.
Qualcomm does have an enormous competitive edge, but Apple is developing its own chips after buying assets from Intel. Qualcomm already has paid billions of dollars in antitrust fines worldwide, and regulators may not be done questioning the company’s business model. It’s anyone guess how the Huawei situation will play out, or how China more broadly will perform in coming years. 5G is an opportunity, but as Nokia (NYSE:NOK) shows, market growth alone doesn’t guarantee upside.
To be fair, investors like myself overestimated risks in recent quarters. Qualcomm has been a star even with the recent pullback, gaining 70% off its lows. The 5G opportunity is large enough that Qualcomm may receive a growth multiple through the next decade. And analysts see the story differently: the average price target of $94 suggests roughly 16% returns (including dividends) over the next year.
Still, the risks are real — and they matter more above $80 then they did below $60. Qualcomm then wasn’t priced for much growth. Now, it is. That means that the company’s promises of growth, even if true, aren’t enough. For real upside, Qualcomm has to manage external risks — and likely has to outperform its own expectations.
As of this writing, Vince Martin has no positions in any securities mentioned.