Qualcomm (QCOM) has metrics that make many dividend investors salivate.
The company offers a 3.4% yield, has increased its dividend every year since 2003, and has recorded annual dividend growth in excess of 20% over the last five years.
Furthermore, Qualcomm’s stock is down roughly 25% from its 2014 highs and trades around 16.5x 2016 estimated earnings.
These are the types of characteristics we like to see for investments in our Top 20 Dividend Stocks portfolio.
However, with technology trends changing more rapidly and becoming harder to identify, should Qualcomm make the cut?
Qualcomm is a leader in the development and commercialization of digital communication technologies called CDMA (Code Division Multiple Access) and OFDMA (Orthogonal Frequency Division Multiple Access), including LTE (Long Term Evolution).
They own significant intellectual property applicable to products that implement any version of CDMA and OFDMA, including patents, patent applications and trade secrets.
Any companies in the mobile communications industry trying to develop, manufacture, and/or sell products using CDMA and/or LTE standards requires a patent license from Qualcomm.
They also develop other technologies used in handsets and tablets including certain audio and video technologies, advanced WLAN functionality, and memory controllers.
In addition to the licensing areas of their intellectual property portfolio, they design and manufacture products and services based on CDMA, OFDMA, and other digital communications technologies.
Their products mainly consist of chips and system software used in mobile devices and in wireless networks. To a lesser extent they sell integrated circuits for use in broadband gateway equipment, desktop computers, and streaming media players.
The main factor that drives the company’s performance is cell phone penetration, particularly with smartphones.
According to World Cellular Information Service (WCIS), the less than 60 million global mobile connections in 1994 grew to approximately 7.2 billion in September 2015.
One of the other key drivers of growth within mobile is the continued global penetration of 3G/4G technology (CDMA-based, OFDMA- based and CDMA/OFDMA multimode).
In September 2015, this represented 3.4 billion connections, or nearly 47% of total mobile connections, and by 2019 it is projected to reach 5.8 billion.
It is clear that global smartphone penetration continues to grow at a rapid pace. According to Gartner, in 2014 more than 1.2 billion smartphones were shipped and it is projected to increase rapidly with cumulative shipments of smartphones projected to be over 8.5 billion from 2015-2019.
Overall, Qualcomm is primed to ride some secular growth trends for years to come.
Qualcomm operates the business through two main reporting segments: QCT (Qualcomm CDMA Technologies; 68% of revenue) and QLT (Qualcomm Technology Licensing; 32% of revenue).
The QCT segment develops and supplies integrated circuits and system software based on CDMA, OFDMA, and some other technologies for use in voice and data communications along with other technology applications.
The integrated circuits are sold and the software licensed to manufacturers that use their technology in wireless devices (mobile phones, tablets, laptops, etc).
The QTL segment grants licenses to use portions of their intellectual property which includes patents in the manufacturing of wireless products implementing CDMA and LTE standards.
Their licensees manufacture mobile devices, tablets, and laptops along with a whole host of other machine-to-machine devices. The revenue generated in this segment comes mainly from license fees and royalties based on sales by the licensees.
The QTL segment is extremely important for the overall business even though it only contributes about a third of the overall company’s revenue. This is because the licensing business generates extraordinary high margins.
At the segment level, QTL reported a pretax margin of nearly 87% in 2015, which towers over the QCT segment’s pretax margin of about 14% in 2015.
With such a great business benefitting from these strong secular trends and secured by a strong intellectual property portfolio, many investors are wondering why the shares of the company have declined so precipitously.
As noted above, Qualcomm makes most of their profits in the licensing business. However, over the last year or two there have been some negative developments.
The two main issues are declining royalty rates and a weaker intellectual property portfolio for newer wireless technology generations.
Some companies and entities have proposed changes to intellectual property policies with the goal of devaluing Qualcomm’s patents and breaking up its hold on mobile devices.
For instance, in China they reached a resolution with the National Development and Reform Commission (NDRC) where they will charge royalties of 5% for multimode 3G/4G devices but only 3.5% for 4G.
Furthermore, the royalty rates will be based off 65% of the device’s net selling price instead of the full price.
This is a big change in the way Qualcomm has historically generated royalty revenue in China and effectively results in a cut in royalty rates for 3G to 3.25% (5% x 65%) and 4G to 2.275% (3.5% x 65%).
While the percentages might sound small, the differences really add up when applied over millions of units.
Also, many of their key customers have been lobbying standards groups to change their policies away from Qualcomm’s current licensing and royalty structure with the aim of lowering royalty rates.
One of the main contributing factors to the lower rate is that their intellectual property portfolio isn’t as strong in subsequent generations (4G/5G) as it is in 3G.
3G/4G multimode products are generally covered by their existing 3G licensing agreement, but products that implement 4G and not also 3G are not generally covered by these agreements, so their overall royalty rate for 4G is lower than 3G.
These are real issues for the company and given global politics and competitive positions, they are very difficult issues for investors to obtain clarity.
To offset some of these issues management has been executing on a strategic realignment plan that calls for a spending reduction of $1.4 billion. Reducing the cost structure should result in QCT operating margins improving to at least 20% (from 14% in 2015).
Time will tell if internal actions can offset some the negative trends the company faces in the industry, but for now it looks like Qualcomm’s entrenched business might be showing some cracks.
Dividend Safety Analysis: Qualcomm
We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend. Qualcomm’s dividend and fundamental data charts can all be seen by clicking here.
Our Dividend Safety Score answers the question, “Is the current dividend payment safe?” We look at factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more.
Dividend Safety Scores range from 0 to 100, and conservative dividend investors should stick with firms that score at least 60. Since tracking the data, companies cutting their dividends had an average Dividend Safety Score below 20 at the time of their dividend reduction announcements.
We wrote a detailed analysis reviewing how Dividend Safety Scores are calculated, what their track record has been, and how to use them for your portfolio here.
Qualcomm’s Dividend Safety Score is 95, which indicates that the dividend is extremely safe and actually one of the safest in the entire market. The great score is driven by a reasonable payout ratio, solid cash generation, a healthy balance sheet, and stable returns on invested capital.
Currently, analysts expect EPS to be $3.76 for Fiscal Year 2016, and we expect the company to pay out about $2.02 per share in dividends this fiscal year. This implies a payout ratio of about 54%, which is in line with 2015 levels, but above historical levels.
The company has been a great cash generator over time with positive free cash flow every single year over the last decade.
The company is not capital intensive as they spend only about a billion dollar per year on capital expenditures (~4% of revenue), but is very R&D intensive where they spend around $5.5 billion dollars per year. Overall, we feel comfortable that the company should continue to generate adequate cash to fund the dividend in the near-to-medium term.
Qualcomm also has a fantastic balance sheet. As of the end of the June quarter, they had $5.9B in cash, $11.2B in short-term marketable securities, and $13.9B in long-term marketable securities.
The marketable securities are mostly corporate bonds and mortgage- and asset-backed and auction rate securities. This liquidity position is offset by short-term debt of $1.7 billion and long-term debt of $10 billion. Overall, Qualcomm has a net cash position of roughly $19.3 billion, which provides the business with meaningful flexibility.
For fiscal year 2016, we expect Qualcomm to pay out roughly $3 billion in dividends. This means that the company can easily maintain the current dividend just based off the liquidity on the balance sheet alone. In fact, the company can maintain the current dividend for nearly 6.5 years just based on the net cash on the balance sheet.
While it’s true that the majority of the cash and marketable securities are held offshore ($28.6 billion of the $31 billion total), the company should be able to maintain ample liquidity in the U.S. to fund the dividend even in a stressful economic environment.
The historical economics of the business are quite favorable as well. Over the past decade, Qualcomm has generated a relatively stable operating profile with a trough operating margin in the mid-20% range and a peak over a bit over 40%.
This has also led to a stable return on invested capital profile over the past decade as well. Needless to say, the lack of volatility in the business economics allows the company to continue to be a very safe dividend payer, even if it experiences a gradual decline in royalty rates.
Taking everything into account, we consider Qualcomm’s dividend to be very safe based on the company’s reasonable payout ratio, solid cash flow generation, large liquidity position on the balance sheet, and historically stable business economics. While the future is uncertain in many ways for Qualcomm, the dividend should continue to be safe for the foreseeable future.
Dividend Growth Analysis
Our Growth Score answers the question, “How fast is the dividend likely to grow?” It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.
Qualcomm’s Dividend Growth Score is 82, which indicates that the dividend has very good growth potential.
The company initiated its quarterly dividend in early 2003 at $0.025 per share and has increased it ever since, making it a member of the dividend achievers list. Over the last 10 years, Qualcomm has grown its dividend by 18.5% per year.
Dividend growth has been even better over the last five years, averaging an annual increase of 20.2%.
However, given the issues discussed in the Key Risks section above, we expect dividend growth to be more moderate going forward.
Here is the CEO, Steve Mollenkopf, on the fiscal year second quarter earnings call where they announced a 10% dividend increase.
“We also announced a 10% increase in our quarterly cash dividend, reflecting our confidence in the strength of our ongoing cash flows and future earnings growth.”
Looking into the areas where Qualcomm can increase its dividend, it likely has to come from earnings growth.
The payout ratio is already pushing the upper end of where it has been historically at over 50% and above other technology firms such as Microsoft (normalized payout ratio in the 40% range) and IBM (30% range) and above a more pure play competitor in Broadcom (30% range).
While the company can grow the dividend in the near term by using its significant liquidity position, eventually dividend growth will have to come from earnings and cash flow growth.
In the near term the company is likely to maintain around a 10% dividend growth rate, but the business faces some real challenges that can have a large impact on sales and EPS growth. Therefore, it’s more challenging to forecast dividend growth over a longer period of time.
Qualcomm currently trades around 16.5x 2016 earnings estimates and offers a dividend yield of 3.4%, which is meaningfully higher than its five-year average yield of 2.1% and reasonable income for conservative dividend investors.
Management needs to execute on their strategy of lowering the cost structure while still investing in research and development for technology on 4G/5G mobile phones and other applications.
If this occurs, it should lead to sales growth over the medium term with margin expansion. However, there are large unknowns on how much intellectual property they can create for next generation technologies and the royalty rates they will earn on that intellectual property.
As a result, we are unsure what the future economics of the business and can’t forecast a normalized earnings growth rate with much certainty.
However, if Qualcomm were to squeeze out low-single digits earnings growth (essentially in line with GDP growth), the stock appears to offer annual total return potential of 5-7%.
Qualcomm has dominant positions with intellectual property that is used in current and legacy communication technologies.
Typically these are the characteristics we like to see when looking at blue-chip dividend stocks.
However, the company is facing challenges in positioning themselves on next generation technology and declining royalties they earn for their intellectual property on these technologies.
With that said, the current dividend appears to be very safe as it is supported by a solid balance sheet with a significant liquidity position and the company’s internal cash flow generation.
Expectations are not low with the current valuation at around 16.5x 2016 earnings estimates. It appears to incorporate much of the expected growth in mobile shipments over the coming years.
While there is a lot to like about Qualcomm’s business, including favorable secular trends, a very high margin licensing/royalty business, and a solid balance sheet, the nature of the technology, competitive environment, and uncertainty over royalty rates creates enough uncertainty to keep it out of our Conservative Retirees dividend portfolio.
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