Will Spinning-Off Its Chip Business Be A Good Move For Qualcomm?

Qualcomm (NASDAQ:QCOM), currently the leader in the global cellular baseband chip market as well as the smartphone applications processor market, is being pressed by one of its key investors, Jana Partners, to spin off its chip business from its patent-licensing business to restore investor confidence in the company. The hedge fund Jana Partners also wants Qualcomm to cut costs, accelerate its share buyback program, improve disclosures and refresh its board, including considering strategic deals. (Read Press Release)

Jana Partners, which has assets of about $11 billion, owns 4.4 million Qualcomm shares that gives it a 1.75% stake in the company.  Responding to Jana’s comments, Qualcomm pledged to maintain an active dialogue with all stockholders and act in their best interests. The company also emphasized other actions it has taken to boost shareholder value, including recently increasing its stock buyback authorization by $15 billion. After news of the Jana Partners letter hit the market, Qualcomm shares opened nearly 3% higher than their closing price. They fell later in the day, however, closing down 43 cents, or less than 1%, to $68.73.

Qualcomm chip segment’s (QCT) revenue stood at $19.29 billion while that of the licensing business (QTL) stood at $7.45 billion in CY14.  While the majority of Qualcomm’s revenue comes from selling baseband chips, most of its profit comes from licensing patents for its widespread CDMA cell phone technology. Qualcomm’s chip unit’s adjusted gross profit margins stood at 48.1% while that of licensing unit’s adjusted gross profit margins stood at 88.1% in CY’14.

Qualcomm’s QCT and QTL business work in tandem with each other. QTC sells applications processors and cellular baseband devices, manufactured by TSMC and other foundries, to handset manufacturers.  Competitors of its QCT segment are other semiconductor companies, including Broadcom, MediaTek, and VIA Telecom. Qualcomm and QTC’s competitors must establish some sort of royalty arrangement  based on the relative importance of their patent portfolios, which varies widely. On the other hand, QTL exists to monetize Qualcomm immense IP portfolio, especially in CDMA and related technologies.  It thus derives royalty fees and income from handset manufacturers at an above-average rate of the wholesale unit phone price.  Notably, this includes not only customers of QTC, but customers of competing device manufacturers as well.

There are inherent conflicts of interest in the combination of Qualcomm’s businesses and the interests of their customers. These conflicts have sparked regulatory concerns in the US, Europe and (most notably) China, where the company recently completed a deal that lowered royalty rates and imposed a sizable fine. ^[1] Indeed, it has led Qualcomm twice to consider a split of the companies itself. ^[2] Yet Qualcomm and others continue to believe the synergies of the business combination exceed  the burdens of these conflicts. Indeed, if the proposed spin-off of Qualcomm’s chip business goes through, it could well have an impact on its ability to leverage future patent negotiations on both sides of the businesses.  Pending regulatory changes may as well.

Since there are obvious synergies between the chip and the licensing business, benefits would be lost if the two business units were divided, in Qualcomm’s view. Jana Partners, in its letter, argues that Qualcomm’s share price, which has lagged the Nasdaq 100 index over the past year, shows that investors are placing little value on the company’s chip business. Splitting the two businesses, either fully or partially, could address this anomaly, the firm argues.

That said, much of the company’s duress arises out of market and regulatory changes in China, the belated emergence of 4G competitors (at both the low and high ends), and the failure to qualify for the just released Samsung Galaxy 6. In short, increased competition and mis-execution have weakened both Qualcomm’s growth and market position. It is no surprise, that stock performance has suffered. Still, though Qualcomm expects the above factors to impact its QCT (Qualcomm CDMA Technologies) revenue growth and operating margins in the near-term product cycle, its view of the long-term strategic environment and QCT’s leadership position remains strong. The question now is how the company defines a path forward from this rough patch.

We have a $69 price estimate for Qualcomm, approximately in line with the current market price.

See our complete analysis for Qualcomm stock here

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1. Read our articles on the topic here and here. [↩]
2. Read the multiple posts in the Wall Street Journal via the following link. [↩]