For many years, Qualcomm (NASDAQ: QCOM) seemed like a rock-solid tech stock. Its chipmaking business, which generated most of its revenue, dominated the booming mobile chip market. Its licensing business, which reaped most of its profits, generated a steady stream of royalties from every smartphone maker in the world.
Qualcomm also constantly repurchased shares, and has paid a decent yield that's fluctuated between 2% and 5% over the past five years. Today Qualcomm trades at 16 times forward earnings and pays a forward yield of 3.5% -- which might look tempting to income investors. However, investors should avoid this stock for the moment, for four simple reasons.
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1. Its licensing business faces a gloomy future
During the third quarter Qualcomm's licensing (QTL) revenue fell 10% annually to $1.3 billion, or 26% of its non-GAAP revenues. The unit's EBT (earnings before taxes) fell 13% to $898 million.
Both figures rose from the second quarter, but the unit remains besieged by fines, regulatory probes, and OEMs, which claim that its royalty rates are too high. The QTL unit was already forced to lower its fees in China and fined in several markets, and now faces new FTC demands to lower its fees -- as well as the expiration of an interim deal with Huawei, which could cause the Chinese smartphone giant to suspend all future licensing payments.
2. Its chipmaking business isn't faring much better
Qualcomm's chipmaking (QCT) revenue declined 13% annually to $3.6 billion last quarter as smartphone sales slowed to a crawl. The unit's EBT also tumbled 17% to $504 million. Both figures also fell quarter-over-quarter. IDC expects smartphone shipments to decline another 2% this year, so that pressure won't cease anytime soon.
Qualcomm also faces fresh competition from first-party chipmakers like Huawei and Samsung, which use their own chips in select handsets, and cheaper chipmakers like MediaTek, which supplies chips for many lower-end smartphone makers.
Qualcomm investors breathed a sigh of relief when it settled its legal disputes with Apple (NASDAQ: AAPL) earlier this year, which resulted in Apple parting ways with Intel (NASDAQ: INTC) and buying Qualcomm's 5G modems again. Unfortunately, Apple turned around and acquired most of Intel's 5G modem unit for $1 billion, indicating that Apple will eventually cut Qualcomm out of its supply chain. To make matters worse, the escalating trade war is pushing China to produce more domestic chips, which could eventually extend into the mobile chipset market.
3. Prioritizing buybacks over long-term growth
Back in 2016 Qualcomm made a bid for NXP Semiconductors (NASDAQ: NXPI), the largest automotive chipmaker in the world, to diversify its core businesses away from mobile devices. The deal collapsed last year due to a lack of interest from NXP's investors, regulatory resistance in China amid escalating trade tensions, and Broadcom's (NASDAQ: AVGO) hostile bid for Qualcomm knocking the deal off course.
Image source: Getty Images.
Faced with that defeat, it would have been wise for Qualcomm to reallocate the $44 billion it set aside for NXP toward other acquisitions. Instead, Qualcomm replaced its existing $10 billion buyback plan with a fresh $30 billion one -- a short-sighted move that failed to address its long-term challenges.
As a result, promising targets like Cypress Semiconductor and Integrated Device Technology were scooped up by other chipmakers. Qualcomm logged a $4.7 billion gain from the Apple settlement during the third quarter, but that cash will also likely be spent on buybacks instead of any forward-thinking acquisitions.
4. There are better chipmaking stocks to buy
If Qualcomm stubbornly sticks to its guns and refuses to cut its licensing fees, it will be hit by more probes and lawsuits. If Qualcomm relents, its main profit engine will sputter out. That's why investors aren't willing to pay much of a premium for the stock.
There are also plenty of other chipmakers with less long-term baggage than Qualcomm. Texas Instruments (NASDAQ: TXN), for example, sells its cheaper analog and embedded chips to a wide range of customers across multiple industries.
It doesn't face regulatory headwinds, and its sales could improve once demand in the automotive and industrial markets picks up again. TI is pricier at about 20 times forward earnings, but that's likely because investors are willing to pay a premium for its stability.
Qualcomm needs a wake-up call
Qualcomm has been spinning its wheels for years. It resisted change by fighting off a major activist investor, rejected Broadcom's generous buyout offer, and even resisted a go-private offer from its former CEO.
Instead, Qualcomm keeps defending its controversial business model, spends billions on buybacks to buoy its earnings, and hasn't presented any long-term avenues of growth beyond mobile chipsets and licenses. Qualcomm isn't headed off a cliff, but it desperately needs to alter its course.
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Leo Sun owns shares of Apple and Cypress Semiconductor. The Motley Fool owns shares of and recommends Apple. The Motley Fool owns shares of Intel, Qualcomm, and Texas Instruments and has the following options: short September 2019 $50 calls on Intel, short January 2020 $155 calls on Apple, long January 2020 $150 calls on Apple, short January 2020 $155 calls on Apple, and long January 2020 $150 calls on Apple. The Motley Fool recommends Broadcom Ltd, Cypress Semiconductor, and NXP Semiconductors. The Motley Fool has a disclosure policy.
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