QUALCOMM, Inc. (NASDAQ:QCOM) is poised to capitalize on this trend through their line of MSM (multi-station modem) products. Over the same period when device sales have grown 15-20%, MSM shipments have increased at 18-22% and are expected to continue growing at 15% per year through 2014. This increase in shipments should translate into year-over-year equipment and services revenue growth of 21% and 12% in 2013 and 2014, respectively. This is a small expectation when considering that in both 2011 and 2012 the company saw increases of approximately 34% year-over-year.
Additionally, the last two times the company’s inventory turnover ratio fell to near 3, Q4 2008 (3.11) and Q2 2011 (3.05), it was followed by increases in quarterly MSM shipments of 30% and 36% within the next 6 months that continued to grow from those new levels quarter-over-quarter. Inventory turnover in Q3 2012 was 3.12 and Q4 2012 MSM shipments were up 30% versus Q3 2012 at 182 million. Estimates here are based on average MSM shipments of 170 over the next 3 quarters providing evidence that these estimates are actually quite conservative.
While revenue has continued to accelerate, the company has quietly hidden ongoing margin contraction. Despite an increase of nearly 25% in the average sale price of MSM products since 2009, the gross margin has fallen from 70% to 62% over the same period. The company has managed to keep net margins relatively flat by reducing their investment allocation towards research and development and cutting back growth rates in their sales force. As a percent of revenue, these expenses have fallen from ~36% to ~29% since 2009; however, on a pure dollar basis these expenses have actually risen approximately 68% suggesting that sales growth is simply outperforming opportunities to invest in these areas. While I do believe there is some expense management occurring in order to maintain net margins, the company is continuing to invest in the future and margin contraction should be expected as the company expands its product line into relatively less profitable areas.
While I don’t believe there is any real concern around margins at the time, it is worth noting that Broadcom Corporation (NASDAQ:BRCM) has recently announced intentions to develop components that, if released to the open market, would directly compete with QUALCOMM, Inc. (NASDAQ:QCOM)’s core CDMA, TDMA, and OFDMA (3G/4G) products. Any price competition stemming from this release would likely have a material impact as it would offset the ~25% increase in average MSM sale price noted earlier.
GAAP-based EPS expectations are $4.04 in 2013 and $4.60 in 2014. Using earnings multiples of 19 and 18, respectively, I arrive at my price targets of $77 and $83 per share. Historically, dividend payouts have been 9% of EPS and on Mar 5 the company boosted its payout 40% in an effort to try and restore these levels. Based on my EPS estimate and expectations that the company will continue to reach for a 9% payout I expect a dividend increase to $0.38-0.40 around March 2014.
In 2012, free cash flow fell 65% versus 2011 levels primarily due to an 89% year-over-year increase in purchase obligations. Excluding the increase in purchase obligations, free cash flow still fell 12.5% primarily due to a 33% increase in capital expenses. Both of these measures are indicative of future sales growth which is a notion supported by historic measures such as inventory turnover as explained earlier. Moving forward, free cash flow is expected to grow 22% and 19% in 2013 and 2014 as the investments made in 2012 are put to work. Using a 3-factor model that accounts for capital structure and market multiples, this increase in cash flow produces an $85 2014 price target that is roughly in-line with my EPS based estimate.
The article Qualcomm a Buy in 2013 originally appeared on Fool.com and is written by Zach Carvalho.
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