Mid-year 2006 Update and Company Reports

Every so often, the stock market abruptly reassesses the future. The nose-dive that started on May 10^th was catalyzed by the Federal Open Market Committee’s indication that additional interest rate increases were forthcoming to control inflation, even to the detriment of the economy. The drop from 11,670 to 10,747 of the Dow Jones Industrial Average and from 2375 to 2038 for the NASDAQ Composite Index manifests the market’s forecast that two basic costs to all levels of the economy are likely to be sustainably burdensome over coming years. Higher interest rates and higher oil prices offset consumer income growth and increase the cost of doing business. This reduces both the wealth accumulation of the consumer and the return on capital invested in businesses. Then, add in the hopefully temporary violence in the Mideast and the world looks very different from where it was a few months ago.

The past five years have seen significant growth in real income and real wealth for the U.S. consumer. Corporate income, free cash flow, and government tax collections have also grown an incredible amount. The market is opining that even without a recession, future growth will be slow for some time to come. Housing stocks (down 50% from highs) and semiconductors (down 30% from highs) reflect a much slower consumer. As slowing demand curbs inflation worries, interest rate increases from the Federal Open Market Committee will cease. Then, significant profit opportunities will emerge from individual stocks made excessively inexpensive by this decline.

QUALCOMM (QCOM 37) has performed poorly during the correction, albeit in-line with other communications semiconductor companies. The best business economics in the group have been offset by royalty rate battles with Broadcom and Nokia. The uncertainty created by inflammatory and often inaccurate press depresses the stock price. QUALCOMM’s historic success in patent court has driven Nokia and Broadcom to more political forums, such as the European Commission, International Trade Commission, and Korean Fair Trade Commission. They do not question whether QUALCOMM owns the basic intellectual property behind all flavors of CDMA, including WCDMA. They just want to pay a lower royalty rate than other CDMA licensees such as Motorola, Samsung and LG. It is a vital issue for Nokia and Broadcom, who now see the whole world transitioning to CDMA. Nokia dominates the GSM handset market, and currently owns a market-leading 33% share of WCDMA (also called GSMA and 3GSM) handset sales. Such dominance is truly impressive in any category of consumer goods. It must maintain that dominance in order to sustain its substantial corporate girth. In December of 2005, 20% of handset shipments in Western Europe, Nokia’s prime market, were WCDMA, up from 0% two years earlier. GSM handset sales are widely predicted to decline in 2007 and beyond, replaced by WCDMA. Nokia's current CDMA license expires on April 9, 2007, hence the anxious intensity of negotiations. All parties benefit significantly from settling.

Broadcom and Nokia’s specific complaints principally consist of antitrust charges, based on the fact that QUALCOMM both collects royalties and dominates the CDMA2000 chipset market. These parties contend that this amalgamation causes the consumer to pay more for handsets. Nokia’s monopoly charges against QUALCOMM lack credibility, in view of Nokia’s dominance of GSM and lead in WCDMA. Nokia’s 2005 market share in handsets was 33%, compared to QUALCOMM’s 21% share of the mobile phone chipset market.

Chipset technology	2005 actual chipsets (millions)	2005 market share	2005 Qualcomm share of total market	2006 projected chipsets (millions)	2006 market share	2006 Qualcomm share of total market	2009 projected chipsets (millions)	2009 market share	2009 Qualcomm share of total market
GSM	607	74%	0%	631	69%	0%	614	50%	0%
WCDMA	50	6%	1%	96	11%	2%	344	28%	14%
CDMA	160	20%	20%	187	20%	20%	278	22%	22%
Total	817	100%	21%	914	100%	23%	1236	100%	36%

Data sources: Gartner Group and QUALCOMM

The truth is that QUALCOMM chipsets facilitate competition, halving the price of WCMDA handsets over the past year, as LG and Samsung entered the market with sub-$200 handsets. These two companies represent many of the over 150 QUALCOMM licensees who have built profitable CDMA businesses from scratch, thanks to QUALCOMM’s chipsets and technology. Now, they threaten Nokia’s handset domination as the world transitions from GSM to WCDMA. While only five companies share the great majority of the GSM handset market, 14 share the WCDMA market, with more coming soon. The stakes are huge – there are currently over 2 billion GSM subscribers worldwide.

Five years ago QUALCOMM shelved a plan to separate the licensing division and chipset division into two distinct companies. Activating it would eradicate the basis for most of the complaints, plus increase shareholder value in the short run. Merrill Lynch analyst Tal Liani estimates the value of the two independent companies at $68.

The real economic issue for QUALCOMM is the transition of the world to CDMA, and that, if anything, is looking bigger than ever. The enormous size of the burgeoning CDMA market is the reason the royalty rate fights exist. Current world CDMA penetration is 10 - 20%, and eventually should approach 100%. WCDMA infrastructure was built over much of the world last year, and is already undergoing a significant data speed upgrade to HSDPA (High Speed Downlink Packet Access.) QUALCOMM is the only supplier of working chipsets for this upgrade.

The stock is trading below estimated intrinsic value and has exceptional prospects for intrinsic value growth over the next five years. The long-term drivers continue to be very positive, but skirmishes in the royalty battle may be won or lost, and will have immediate short-term influence on the stock price. The recent poor behavior of the stock has made it inexpensive, as the proprietary franchise of the company is intact and growth opportunities abound.

Procter & Gamble (PG 56) is the undisputed world leader in the consumer products business. It continues to grow faster than its overall market by taking share from competitors worldwide. Despite its large size, the company continues to innovate, introducing new products and capturing more prominent display space at retail. P&G’s brands include Gillette, Tide, Cheer, Bounce, Cascade, Swiffer, Febreze, Olay, Pantene, Head & Shoulders, Secret, Tampax, Pampers, Luvs, Charmin, Crest, Prilosec OTC, etc. In the past five years, the company has consciously shifted product mix to higher growth categories, such as beauty and personal care, along with completing a margin-improving restructuring program.

Acquisitions are needed to maintain revenue growth above the 5-6% range. Last year’s acquisition of Gillette will drive 20% revenue growth in 2006 along with improving profit margins for years to come. Integration of the acquisition is ahead of schedule. P&G has seen inflation in feedstock prices, such as the petroleum-based surfactants that go into Tide detergent and other soap products. However, the formidable scale and geographic reach of this company give it immense bargaining power over suppliers. In fact, operating margin improved 1.1% in the last quarter, even after a 1% negative impact from higher commodity prices. P&G will generate $2.8 billion of 2006 revenues in China, one of the company’s fastest growing markets.

Analyst consensus earnings per share estimates for the next five years are $2.63 for 2006, followed by $3.00, $3.33, $3.70, and $4.10, respectively. Cash earnings drive intrinsic value, so an intrinsic value estimate based on these earnings is currently a little over $50 and should approach $90 in five years.

Steven L. Ré, CFA July 17, 2006

This report contains the current opinions of the author and such opinions are subject to change without notice. It has been distributed for information purposes only and is not to be construed as a recommendation to purchase or sell securities. The information contained herein is from sources deemed reliable but is not guaranteed. It should not be assumed that investments in any of the above-mentioned securities will be profitable, and past performance is no guarantee of future results. Earnings projections often miss and markets go up and down. The employees and families of Quality Growth Management, Inc. may own the above-mentioned securities in their own accounts, and may trade them at any time without notice.