Why Qualcomm Has Ruled Against The Spin-Off Of Its Chip Business In The Offing?

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Qualcomm (NASDAQ:QCOM) has been on the defensive in recent months, uncharacteristically so.  March-period earnings were strong, though the company lowered full year guidance, as we noted at the time.  Contributing to the diminished outlook was the exclusion of its application processor from Samsung’s new Galaxy S6 smartphone due to issues with the “Snapdragon 810” part overheating during Samsung tests.  On top of this, the hedge fun Jana Partners, having taken a $2 billion position in the company, has been pushing for the divestiture of the processor business, which have also discussed. Indeed, the executive chairman, Paul Jacobs, has recently reiterated that the board believes the synergies of the processor and IP businesses continue to outweigh their dis-synergies. ((Qualcomm has no plans to spin off chip business at present, Reuters, June 29th, 2015))

We have re-considered this divestiture issue at length and concluded that Qualcomm should retain its current business model, leveraging the close relationship of its semiconductor and licensing and royalty segments. Let us take a closer look below.

Our price estimate of $71 for Qualcomm is approximately 10% higher than the current market price.

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See our complete analysis for Qualcomm stock here

Qualcomm’s QCT and QTL Segments Go Hand In Hand

Qualcomm chip segment’s revenue stood at $19.29 billion while that of the licensing business 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 (Qualcomm CDMA Technologies) and QTL (Qualcomm Technology Licensing) business work in tandem with each other. QCT 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 QCT’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 QCT, but customers of competing device manufacturers as well.

Qualcomm Enjoys The Synergies Of Having The Businesses Together

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 the conflicts. Indeed, if the proposed spin-off of Qualcomm’s chip business had gone through, it could well have impacted 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 have been lost if the two business units were divided, in Qualcomm’s view. Jana Partners, in its letter, argued 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 have addressed 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 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.

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