Qualcomm: Highest ROE Chipmaker Stock To Buy

Summary

  • Qualcomm's high return on equity is driven by effective financial leverage, favorable net margins, and enhanced operational efficiency.

  • The company's net margins are expected to improve modestly, rising to 31.3% by 2027, while its asset turnover ratio is anticipated to progress due to its fabless business model.

  • Despite a slightly lower price target of $231.24, the company maintains a Strong Buy rating with a 110% upside, as it is expected to maintain stable margins and a lower 5-year forward growth rate of 7%.

Qualcomm Office Building in San Diego, CaliforniaQualcomm Office Building in San Diego, California

In our prior examination of QUALCOMM Incorporated (NASDAQ:QCOM $Qualcomm(QCOM)$ ), we conducted an assessment of the company's prospects in the VR/AR sector as it ventured into the market through the introduction of new products. This subsequent evaluation of Qualcomm encompasses a profitability analysis of the top chipmakers, focusing specifically on their return on equity (ROE) metrics as presented in the table below. Notably, Qualcomm emerged as the chipmaker with the highest ROE. To ascertain the reasons behind this notable performance, we performed a DuPont analysis, a methodology that considers a company's net margins, asset turnover, and financial leverage ratios.

Company

Return on Equity (TTM)

5-year ROE

Revenue TTM ($ bln)

Samsung (OTCPK:SSNLF)

17.07%

13.90%

240.01

Intel (INTC)

8.07%

24.03%

63.05

Qualcomm

78.69%

78.94%

42.96

SK Hynix

3.56%

18.03%

39.46

Broadcom (AVGO)

55.27%

26.54%

34.41

Nvidia ()

17.93%

37.00%

26.97

Advanced Micro Devices (AMD)

4.24%

30.37%

23.6

Micron (MU)

3.39%

22.05%

23.06

Texas Instruments (TXN)

62.69%

59.57%

20.03

STMicroelectronics (STM)

37.50%

19.47%

16.13

Average

28.84%

32.99%

52.97

Source: Company Data, Khaveen Investments

Solid Profitability Margins

Symbol

Net Income Margin (TTM)

5-year Net Margins

Samsung

18.11%

13.97%

SK Hynix

8.97%

21.16%

Intel

12.71%

25.56%

Qualcomm

27.40%

15.91%

Broadcom

37.19%

26.25%

Nvidia

16.19%

29.34%

Advanced Micro Devices

5.59%

11.58%

Micron

6.99%

25.93%

Texas Instruments

43.68%

37.38%

ST Microelectronics

26.80%

12.87%

Average

20.36%

22.00%

Source: Company Data, Khaveen Investments

The first component of ROE is the profitability of the company as measured by its profit per dollar sales or its net income margin. As seen in the table, the company's net income margins in TTM are higher than its 5-year average. However, in comparison with other companies, its net income margins are not the highest. Instead, Texas Instruments has the highest net margins TTM at 44% and Broadcom at 37%. On a 5-year basis, the company with the highest net margins is Texas Instruments followed by Broadcom.

The average margin for fabless and IDMs are fairly similar at 22% and 21% for TTM respectively and 22.2% and 20% for the 5-year average.

In terms of the top 10 chipmakers by markets, the average margin for the DAO companies (TI, STMicro and Broadcom) is the highest in both TTM and the 5-year average (35% and 25% respectively) followed by Logic chipmakers (Intel, Nvidia, AMD, Qualcomm) with an average of 15.5% and 20.6% on TTM and 5-year respectively. Memory chipmakers have the lowest average at 11.4% and 20.4% on TTM and 5-year respectively.

Thus, this highlights the market and type of chipmaker as not the potential main factors for its high net margins. Instead, we believe the high margins for Qualcomm, Texas Instruments and Broadcom are due to company-specific factors. For example, as we previously determined, Texas Instrument's focus is on 300mm wafers which it claims are more cost-effective by 40% compared to 200mm wafers which are used for analog chips based on SemiEngineering. For Broadcom, the company's margins are supported by its software margins as its Infrastructure Software segment (22% of revenue) had operating margins of 71% in FY2022 compared to 58% for its Semiconductor Solutions segment. For Qualcomm, we previously highlighted that we believe the company's performance advantage over MediaTek provides it with pricing power as reflected by its superior margins to MediaTek in the premium smartphone AP market as discussed in our previous analysis and the company had a solid share of 68% of the premium market according to Counterpoint Research.

qualcomm marginsqualcomm margins

We examined Qualcomm's earnings and margins in the chart above. Although the company's current margins are much higher than its 5-year average, its 5-year net margin is comparatively lower due to a significant decline in net margins in 2018 with a negative margin of -22%.According to its annual report, its net income was impacted by the amendment to tax legislation in the US through the US Tax Cuts and Jobs Act.

As a result of the Tax Legislation, we recorded a charge of $5.7 billion to income tax expense in fiscal 2018, comprised of $5.2 billion related to the estimated Toll Charge - Qualcomm

In 2017, the company's net margins were also impacted by its dispute with Apple which the company did not record loyalty revenues from Apple for the second half of the year for its high-margin QTL segment based on its annual report.

qualcomm expense analysisqualcomm expense analysis

Excluding 2018, the company has an average net margin of 24%. From 2019, the company's net margins have risen from 18.07%. Based on our expense analysis, the company's operating expenses as a % of revenue including R&D and SG&A decreased from 2019 to 2022. Its SG&A as a % of revenue declined from 22% to 18.5% in FY2022 while its SG&A as a % of revenue declined from 9% to 5.8%, indicating its improving scale over the period.

Overall, we expect the company's net margins to improve slightly going forward to 30.3% in FY2023 and reach 31.3% by 2027 as we previously determined its performance advantage and leadership in the high-end smartphone AP market, and we forecasted the company's scale to keep growing larger with our 5-year forward average of 11.7%. Moreover, based on its latest earnings briefing, management cited its strength from its gross margins which continues to increase.

Our gross margin dollars per device continues to grow, and that's the strength and it kind of adds scale and profitability to the business - Akash Palkhiwala, CFO

Improving Efficiency Supported by Fabless Model

Company

Asset Turnover (TTM)

5-year Asset Turnover

Samsung

0.69

0.69x

SK Hynix

0.45

0.45x

Intel

0.36

0.51x

Qualcomm

0.93

0.71x

Broadcom

0.47

0.36x

Nvidia

0.63

0.78x

Advanced Micro Devices

0.59

1.28x

Micron

0.35

0.53x

Texas Instruments

0.77

0.84x

ST Microelectronics

0.86

0.86x

Average

0.61

0.70

Source: Company Data, Khaveen Investments

Moreover, asset turnover is the second component in DuPont Analysis which indicates the efficiency of a company to generate revenue per unit dollar of assets. As seen above, the company's asset turnover is the highest among the top companies based on TTM at 0.93x. Qualcomm's asset turnover is higher compared to its 5-year average, indicating improved efficiency in generating sales. On a 5-year average, the company with the highest asset turnover is AMD at 1.28x. We believe examining the TTM ratio is more appropriate to reflect the company's efficiency trend.

In terms of chipmaker type by IDM and fabless, the average asset turnover ratio for fabless companies is higher on a 5-year average at 0.78x compared to 0.67x for IDMs indicating that fabless companies have higher efficiency compared to IDMs.

By markets, Logic companies have the highest average asset turnover ratio based on a 5-year average at 0.82x followed by DAO and Memory (0.69x and 0.56x respectively). Only Intel had below average asset turnover ratio as it is the only IDM within the Logic companies. However, the average asset turnover had declined in TTM for Logic companies to 0.63x as all logic companies had lower ratios.

Qualcomm Profitability Analysis (FY)

2018

2019

2020

2021

2022

Asset Turnover

0.35x

0.74x

0.71x

0.94x

1.07x

Source: Company Data, Khaveen Investments

Based on the table, the company's asset turnover has improved to 1.07x in FY2022 from 0.35x in FY2018. This is because its asset growth was less than its revenue growth during the period with average revenue growth of 19.6% compared to an average asset growth rate of -0.4%.

Overall, we expect its asset turnover ratio to continue to improve as Qualcomm is a fabless company that has superior asset turnover compared to IDMs. This is because fabless chipmakers and IDMs have different business models. Unlike fabless companies which outsource the production of chips to dedicated foundries, IDMs incur capex to produce their chips in their own facilities. Thus, fabless companies do not need to increase their asset bases significantly to increase supply and generate sales due to their dependence on foundries. As such, we expect Qualcomm as a fabless company to continue to improve its efficiency going forward with relatively faster revenue growth than asset growth.

High Financial Leverage Support ROE

Company

TTM (Financial Leverage) (TTM)

5-year (Financial Leverage)

Samsung

1.37

1.44

SK Hynix

0.88

1.89

Intel

1.76

1.84

Qualcomm

3.09

6.99

Broadcom

3.16

2.81

Nvidia

1.76

1.62

Advanced Micro Devices

1.29

2.05

Micron

1.39

1.60

Texas Instruments

1.86

1.90

ST Microelectronics

1.63

1.76

Average

1.82

2.39

Source: Company Data, Khaveen Investments

Finally, the last component of ROE in Dupont Analysis is the financial leverage ratio which is a measure of the solvency of a company based on its assets relative to its equity. Higher financial leverage contributes to higher ROE because it acts as a multiplier to a company's ROA.

As seen in the table, Qualcomm has the second-highest financial leverage at 3.09x TTM behind Broadcom which has the highest at 3.16x which we believe is due to its M&A strategy as discussed in our analysis of Broadcom previously. However, compared to the 5-year average Qualcomm's financial leverage is higher at 6.99x, ahead of the other companies. Though Qualcomm's financial leverage ratio had decreased, indicating lower leverage by the company.

In terms of chipmaker type, fabless companies have a higher 5-year average financial leverage compared to IDMs at 3.37x compared to 1.77x. However, this is mainly due to Qualcomm for the 5-year average. Excluding Qualcomm, the average financial leverage would be 2.16x, which is still higher than IDMs but a lower average without Qualcomm. Based on TTM, fabless companies' average financial leverage ratio is also higher than IDMs (2.3x vs 1.5x). Both Qualcomm and Broadcom's high ratios above 3x contributed to a higher average.

Thus, this indicates chipmaker type by IDM or fabless is not a potential factor for its high financial leverage ratio and instead could be more company specific. We then examine its financial position below.

qualcomm financial positionqualcomm financial position

Based on the company's financial position chart above, the company's total assets and equity had a significant decline in FY2018. The company's equity declined as a result in FY2018 as well as its cash used for the share repurchase. The company conducted share repurchase agreements following its failed takeover of NXP (NXPI). In total, the company spent $22.8 bln on share repurchases.

On the other hand, the company repaid its debt a net of $5.5 bln in 2018 along with its share repurchase program. This is larger compared to subsequent years when the company had an average total net debt repayment of $1.1 bln per year. The company repaid debt every year. Its liabilities growth in the past 4 years since 2019 had average liabilities growth of -0.4% and total assets growth of 11%.

All in all, we believe despite the company's failed takeover of the NXP, the company still benefitted shareholders by substantially repurchasing its shares ($22.8 bln) instead of repaying its debt ($5.5 bln) boosted its financial leverage ratio which resulted in a boost to its ROE with a higher multiplier of its ROA. This is better for shareholders as the company returns cash to shareholders rather than repaying debtors for its debt. Moreover, the company's cost of debt is lower than its cost of equity, thus resulting in a lower cost of capital (WACC) and is better from an investor perspective as it does not increase the equity base and dilute earnings but instead depends on loans for its business expansion. We believe this further incentivized management to manage its financial leverage. Even before 2018, the company's financial leverage had increased from 1.3x in 2013 to 2.13x in 2017. Thus, we expect the company to continue managing its financial leverage to at least maintain or increase its ratio to benefit its ROE.

Risk: Sacrifice Share and Growth for High Margins

In our first point, we identified Qualcomm's strong net margins. Compared to MediaTek, Qualcomm's net margin of 27.4% is higher than MediaTek's at 21.53%. However, Qualcomm's market share in the smartphone AP segment has been relatively flat over the past 2 and a half years. Whereas MediaTek has seen a surge in its market share going from 24% in Q1 2020 to 39% in Q2 2022. This is mainly due to MediaTek having a larger share in cheaper phones such as Realme, Xiaomi, Oppo, and Vivo. Previously, we analyzed MediaTek's lower pricing advantage for the lower-end AP market. MediaTek had taken market share in the lower-end market and had better revenue growth of 18.2%, higher than 14% for Qualcomm. Thus, we believe Qualcomm's focus on catering to the high-end market and higher margins came at a cost of lower growth compared to MediaTek.

Verdict

qualcomm valuationqualcomm valuation

Our analysis reveals that Qualcomm's superior ROE is underpinned by several key factors, namely its effective utilization of financial leverage, favorable net margins, and enhanced operational efficiency. Looking ahead, we anticipate a modest improvement in the company's net margins, projecting it to rise to 31.3% by 2027. As Qualcomm operates as a fabless entity, we expect its asset turnover ratio to continue progressing, benefiting from the ability to drive sales without substantial increases in asset investments. Despite the unsuccessful NXP takeover attempt, the company has prioritized repurchasing shares over debt repayment, bolstering its financial leverage ratio and consequently magnifying its return on assets ('ROA'). Going forward, we anticipate that Qualcomm will sustain or augment its financial leverage management strategies to preserve or increase its ratio, thereby enhancing its ROE for the benefit of its shareholders. Based on our updated valuation with a revised revenue forecast for FY2023 at -14% based on prorated Q1 and Q2 revenues as the company continues to face headwinds this year, we obtained a slightly lower price target of $231.24 (compared to $244.23 previously). This still leads to a Strong Buy rating with a 109.6% upside with higher projected margins as we see the company being able to keep margins stable but lower 5-year forward growth of 7% compared to 11.2% previously.

Source: seeking alpha

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Disclaimer: Investing carries risk. This is not financial advice. The above content should not be regarded as an offer, recommendation, or solicitation on acquiring or disposing of any financial products, any associated discussions, comments, or posts by author or other users should not be considered as such either. It is solely for general information purpose only, which does not consider your own investment objectives, financial situations or needs. TTM assumes no responsibility or warranty for the accuracy and completeness of the information, investors should do their own research and may seek professional advice before investing.

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