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Morningstar | QCOM Updated Star Rating from 26 Jul 2018

After 21 months of trying to acquire NXP Semiconductors, Qualcomm finally threw in the towel on July 25 and will terminate its purchase agreement. We had been highly positive on the diversification benefits of the deal, but the delay in receipt of clearance from the State Administration for Market Regulation in China, concurrent with the escalating trade war between the U.S. and China soured the likelihood of approval. NXP will receive a termination fee of $2 billion, while Qualcomm intends to redeploy its sizable cash hoard towards a new stock repurchase program of up to $30 billion by the end of fiscal 2019. Meanwhile, Qualcomm also reported fiscal third-quarter results that exceeded our expectations, thanks to $500 million paid under an interim agreement with Huawei (the licensee other than Apple in dispute for licensing payments). We are reducing our fair value estimate to $72 per share from $75 per share as we digest the implications from today's flurry of events. Shares of narrow-moat Qualcomm rose nearly 7% during after-hours trading thanks to the repurchase program, but continue to trade at a discount to our fair value. Although investors will be understandably disappointed the deal did not go through, we continue to see a margin of safety (albeit smaller) thanks to Qualcomm's position in 5G and organic pursuit of non-smartphone markets.

Third-quarter revenue rose 4% year over year to $5.6 billion, thanks to a partial payment by Huawei for royalties due after the second quarter of fiscal 2017. Negotiations are ongoing, and the payment does not include the full amount of royalties due, with $100 million set to be paid during each of the next two quarters. Despite the ongoing dispute, we think the interim agreement is a step in the right direction, and foresee Huawei making the remainder of catch-up payments during fiscal 2019. On the contrary, Apple and its contract manufacturers continue to withhold royalties, and Qualcomm has not recorded any licensing revenue due on sales of Apple's products dating back to the second quarter of fiscal 2017. With multiple hearings and judgments in the U.S., China, and Germany set to occur over the rest of 2018 and early 2019, we think Qualcomm will be able to successfully defend itself, with Apple making catch-up payments beginning fiscal 2019.

QCT (chip) revenue was $4.1 billion, up 1% year over year, with strong demand from Chinese OEMs for 700 and 800 series Snapdragon processors mostly offset by lost market share in the iPhone for discrete modem chips. Management expects to be fully designed out of the upcoming flagship iPhone, with Qualcomm collecting revenue from Apple for only legacy models going forward, consistent with our assumptions. We were pleased to see another quarter of QCT operating margin improvement, as margins rose to 15% from 14% during the same period last year. Sans NXP, we think Qualcomm can still drive some growth in areas such as RF front-end, automotive, and industrial Internet of Things spaces. These noncore smartphone segments accounted for $3 billion in sales during fiscal 2017 and are poised to generate $5 billion in sales during fiscal 2018. Within automotive, Qualcomm has a robust pipeline of design wins for infotainment and connectivity in the car, with a backlog increasing from $2 billion in January to $5 billion.

Management foresees fourth-quarter sales at a midpoint of $5.5 billion, which would represent a 7% year-over-year decline predominantly stemming from lost modem share at Apple. QTL (licensing) revenue is expected to be at a midpoint of $1.1 billion, down 8% year over year. We expect Qualcomm to focus on organic growth going forward, as the current geopolitical environment will likely make it challenging for any firm to make a sizable acquisition, let alone a firm embroiled in a litany of litigations with Apple. The firm's $1 billion cost reduction plan remains on track, while its fiscal 2019 non-GAAP EPS target of $5.25 (or $6.75 to $7.50 with licensing resolutions) also remains intact thanks to the share repurchase plans. For fiscal 2019, we assume the firm will reach the high-end of this range with meaningful catch-up payments. The pace of buybacks will be hastened, as the firm looks to take advantage of the depressed share price. All in, we think Qualcomm will be able to successfully defend the viability of its licensing model, while ushering the industry into 5G. The firm's connectivity portfolio remains second-to-none, in our view, and we think ubiquitous connectivity bodes well for its chip and licensing prospects, particularly as its smartphone addressable market continues to plateau.