Qualcomm Inc. (QCOM, Financial) is a very profitable chip design company that profits from prior licensing deals for its telecom chips and its growing revenue from cloud, artificial intelligence and automotive-related chip designs.
In effect, the company is a veritable cash cow given that its free cash flow margins are very high.
As a result, the stock looks deeply undervalued. It could easily be worth 30% more than its price of $179.64 on May 3. This analysis will explain why.
Strong free cash flow and FCF Margins
Qualcomm reported nominal top-line fiscal second-quarter results on May 1 for the three months ending March 24. Net revenue rose just 1% year over year, though its fast-growing automotive QCT (Qualcomm CDMA Technology) revenue shot up 35%.
The company divides its revenue into two major segments, QCT and QTL (Qualcomm Technology Licensing). The latter division's revenue was up 2% year over year and includes more than just its legacy telecom chip revenue licensing, (i.e., its popular Snapdragon automotive chip sales).
However, its diluted non-GAAP earnings per share was much stronger, rising 14%.
The key drivers for its growth were low expenses, low capital expenditure requirements and continued growth in underlying licensing volumes.
More importantly, the company generates significant amounts of operating and free cash flow.
Free cash flow is what Qualcomm has left over after all cash expenses and capex spending, as well as net changes in working capital.
Qualcomm reported that in the last six months, its operating cash flow was $6.5 billion, or 42.8% higher than its prior year's six-month period FCF of just $4.55 billion.
Moreover, due to significantly lower capex spending, the FCF for the past six months was $6.1 billion. That represented a huge 65% higher than last year's $3.7 billion FCF. This can be seen in the company's consolidated cash flow statement:
FCF margins and growth
This is also important from the standpoint of its FCF margin. That ratio measures the amount of revenue that eventually turns into FCF. For example, since Qualcomm made $19.32 billion in sales in the past six months, that means its FCF margin was 31.56%.
Moreover, over the trailing 12 months, which helps to smooth out seasonal issues, Qualcomm had a much higher FCF margin.
The table below shows that it made 33.7% FCF in the trailing 12-month period ending March 24 (i.e., fiscal second quarter). This was higher than the 27% FCF margin it made last fiscal year.
Free cash flow projections
Analysts now project Qualcomm will make $38.30 billion in revenue this fiscal year ending Sept. 30 and $42.20 billion next year. This represents 5.20% sales growth this year and 10.10% growth next year.
However, to be conservative, I have projected just 31.50% FCF margins for the next two years. That is similar to the 31.56% FCF margin it made in the last six months, as I pointed out above.
This results in an estimated $12.10 billion in FCF projected for this fiscal year. That represents 23.50% growth over last year's $9.80 billion FCF.
Moreover, next year we project $13.30 billion in FCF.
This implies the stock could be worth significantly more. Let's look at how to calculate a target price.
Valuing Qualcomm using the FCF yield
As in past discussions, I have pointed out that using an FCF yield metric is a good way to value high FCF margin stocks.
For example, using a 5% FCF yield to value Qualcomm assumes the company pays out all of its FCF in dividends.
Qualcomm actually spent a little over half in the past six months on both dividends and buybacks. It spent $3.30 billion on shareholder returns (i.e., $1.515 billion on buybacks and $1.79 on dividends), or 54% of its $6.10 billion in FCF (as seen in the consolidated statement of cash flows table).
But what would the yield be if 100% of the $6.10 billion were to be paid out to shareholders?
The stock would likely have at least a 4% to 5% dividend yield. The reason is its dividend yield now is 1.89%, but that is with a payout ratio of about half of its available free cash flow. So if we doubled that and added a little more (since investors prefer buybacks for tax reasons), the yield would approach 4%.
But just to be conservative, let's assume a 5% yield if 100% of the free cash flow was paid in dividends. This is the same as multiplying the FCF estimates for each year by 20. Here is how that would work for the stock price target:
The net result is the average price target is $227.23 per share. That represents an upside of 26.40% over today's price of $179.64.
Moreover, as this might be too high an FCF yield, let's assume the market gives the stock a 4.75% dividend yield, or multiplies the FCF estimates by 21.10:
This shows the average price target is $239.08 per share, an upside of 33.10%. Moreover, the average market cap is $260 billion, or 30% over today's market cap of $200 billion
So the net result is the market will value the stock at $233 per share, or 30% higher.
Shorting OTM puts is a good way to buy in
One profitable way to play this stock is to buy shares upon an assignment when shorting out of the money (OTM) put options.
That way the investor can set a target buy-in price and gain some income in the play.
For example, look at the May 24 expiry period option chain for Qualcomm puts.
This shows the $170 strike price put option has a bid side premium of $1.06 per put contract. This works out to a 0.62% yield to the short seller of these puts over the next three weeks.
That means if an investor secures $17,000 in cash or margin with their brokerage firm, they can immediately make $106 by entering a trade order to “Sell to Open” one put option at this strike price. This $106 income works out to 0.6235% of the $17,000 invested over the next three weeks.
Moreover, over the next 90 days, if the investor can repeat this play, the expected return is 2.49%. That is greater than the stock's annual 1.89% dividend yield.
The bottom line is that even if the stock falls over 5% to $170, the investor will have made extra income covering some or all of the unrealized loss. Moreover, they will be happy to own the stock over the long term, as I have shown that Qualcomm is worth at least 30% more.
