August 2007 Update and Company Reports

The world financial system is begrudgingly absorbing the losses from speculation in high-yield low-quality securities. Years of appreciation of real estate prices in a low interest rate environment created complacency. Mortgage lenders competed to make thinly collateralized loans to weak borrowers, assuming that appreciation of real estate collateral would bail them out. Then, investment brokers arranged the loans into pools and sold them to investors worldwide. It worked for quite awhile. This is not dissimilar to the overvaluation of the stock market in 1999/2000, the overpricing of residential real estate in 1989/1990, and the over-exuberance for junk bonds of the late 1980’s. Once again, the overpricing of assets will work its way through the system in time. As Warren Buffett said, “today’s mountain is tomorrow’s molehill.” Wisely, we avoided investments in the lower quality mortgage market when they were quite the rage a year or two ago, just as we avoided Internet companies in 2000 and junk bonds in 1987. Outside of the real estate and building sectors, the economy should weather this storm well.

Qualcomm’s (QCOM $38) legal department has proven over the past year to be in a state of complacent disarray. While failing miserably in defending the company, it brought ethical shame to a company that has historically been above ethical compromise. When Paul Jacobs took over as CEO a couple of years ago, he thought that the lawsuits were over. He naïvely believed that “everyone was just going to get along" and compete by pushing cellular products based on Qualcomm’s latest CDMA/WCDMA technology as far and as fast as possible. Thus, the legal department became a very competent mill for filing thousands of CDMA/WCDMA patents around the world, creating the company’s intellectual property moat. However, it lost the exceptional defensive capability it had developed when fighting for corporate survival in the 1990’s.

It is important to note that 1) Qualcomm's CDMA/WCDMA patent estate is not being challenged and 2) CDMA/WCDMA is growing rapidly, and, in turn, Qualcomm’s financial results continue to grow at a wonderful rate. WCDMA subscriber growth alone is running at about 80%. Qualcomm’s market share in WCDMA chipsets is 30% and should grow more next year, as it adds Motorola as a WCDMA customer. It is still the sole supplier of broadband CDMA/WCDMA chipsets, maintaining the company’s one-year lead in chipset technology. For that reason, the company’s chipset market share should continue to grow despite the legal hindrances.

Fortunately for Qualcomm, the U.S. legal system allows multiple chances to get it right. The Federal Courts virtually comprise a new venue for Qualcomm with its new general counsel and new attorneys (who are big league this time around.)

And, the general legal environment for getting patents invalidated has turned 180 degrees in the wake of several very material Supreme Court decisions. This augers well for Qualcomm’s chances to win its appeals and obtain the invalidation of Broadcom patents. One patent in particular, number '983 from the ITC case, could be invalidated in light of the recent Supreme Court decision in KSR v. Teleflex. The Supreme Court ruled that “a patent claiming the combination of elements of prior art is obvious.” The patents upheld against Qualcomm were not judged in the light of KSR vs. Teleflex, because the hearings preceded the Supreme Court’s landmark ruling. But the appeals court will take into account KSR vs. Teleflex, increasing the likelihood that Qualcomm will be successful.

The current stock price reflects the bad legal news, as it should. My expectations are that Qualcomm will do much better in round 2 and the stock price later this year will be more reflective of the impressive growth of the company.

PetSmart, Inc. (PETM $32) is the largest pet retailer in the United States. It is capitalizing on its leadership position to consolidate the huge and highly fragmented market for pet services. Although services compose only ten percent of company revenues, it has enormous potential to contribute to long-term revenue growth.

Approximately 70 million households in the United States own at least one pet. Pets are increasingly viewed as members of the family, and pet “parents” need to spend money on food and pet supplies, regardless of the state of the economy. Aside from the recession-resistant nature of the business, people are spending more on their pets in general, particularly senior citizens with companion pets and young married professionals, who view their pets as their children.

PetSmart derives roughly 90% of its sales from retail merchandise in 928 stores nationwide. However, services are growing at twice the rate of retail, so will be a larger and more important sector in the future. The services business is designed to establish life-long relationships with pet owners so that they turn to PetSmart for every pet-related need. The PetSmart store can literally become a destination for pet owners where they can see a veterinarian, get their pet groomed or trained, leave their dog in “daycare,” and shop for merchandise, all under one roof. These services are the key driver for future growth as they accomplish two things: first, they differentiate PetSmart from its competitors, thus growing the customer base; and second, they increase the frequency of customer visits, thus growing revenues at a faster pace than would normally be experienced by a retailer.

The boarding service, called PetsHotel, is a particularly powerful driver of future revenue and earnings growth. The PetsHotel is a climate-controlled facility located inside the PetSmart store where dogs and cats are cared for when their owners are traveling. The animals get their own rooms and PetSmart employees staff the hotel 24 hours a day, 7 days a week. While staying at the hotel, pets can get playtime, training, and grooming, if requested. A veterinarian is also on call 24 hours a day for any emergencies. In 2006, sales from the PetsHotel business doubled over 2005. In addition, the PetsHotel has a meaningful impact on the PetSmart store in which it is located. PetSmart stores that contain a PetsHotel typically have 30% higher revenue and 100% higher pre-tax income than stores that do not contain one. Currently, there are 70 PetsHotels and the company is projecting 240 by the end of 2010.

PetSmart holds a unique position in the industry as the only major pet retailer that provides both merchandise and services under one roof. The company stands to gain substantial synergies from customers who purchase additional products when they take their pet into the store for one of the services. In addition, the company is in the process of remodeling the majority of its stores. By the end of 2008 its oldest store will be only three years old. Management projects 1,400 stores in total, a 50% increase from the current count. The company pays a dividend and is aggressively repurchasing shares. Consensus earnings estimates for 2007 through 2011 are $1.67, $1.87, $2.21, $2.60, and $3.07, respectively. We have calculated the intrinsic value of the company to be in the low to mid-$30s. Risks to valuation include product disruptions, such as the pet food recall, and the management team’s ability to execute on the growth of the services business.

Steven L. Ré, CFA and David R. Marchesani, CFA August 20, 2007

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.