November 2003 Update and Company Reports
Many mutual fund companies, including Charles Schwab and Co., Inc. and its U.S. Trust subsidiary, have disclosed potential violations of securities laws. To quote Schwab President David Pottruck, “We have found a limited number of trades that may have been entered or processed after the 4:00 pm deadline.” I am raising this issue because Schwab serves as the custodian of some of our client’s securities. The Securities and Exchange Commission has stated that it suspects that half of all equity mutual funds have engaged in illegal trading practices, including one called “late trading.” Essentially, fund managers are permitting certain “privileged” clients to trade in fund shares after trading is closed to the public. Mutual fund NAV (net asset value) is set daily at the close of trading. Trades are only to be entered before the pricing, and are executed at that price. Clearly, news reported after the close may change pricing the next day. Market-moving news could be a surprising earnings report from a widely held company, sensitive economic news, or a world event. “Privileged” parties have been allowed to buy after the close at the closing price with assurance tomorrow’s price will be higher. By front-running the next day’s price, a profit is guaranteed, and diluted away from the legitimate shareholders of the fund. Other misbehavior reported over the past couple years pales in comparison to this, because fund managers are fiduciaries. Fee-based managers have a sacred duty to put their client’s interests before their own.
We do not buy equity mutual funds for our clients, because we do not know what individual(s) are making fund management decisions, their thought process, whether they are honest, and what securities they own. So, our clients are not directly damaged by these disgusting and grievous ethical violations. However, if any of our Schwab custodial clients want to go through the effort of moving to another custodian, we will help. Overall, we believe Schwab conducts its business in a reasonably ethical fashion. Unfortunately, it appears that other custodians that also offer mutual funds have been engaging in the same behavior. Let us know.
Company Reports
The fledgling economic recovery has turned investor’s eyes back to technology. A sustained recovery is now priced into semiconductor stocks, forcing us to look beyond next year into the long-term economics of these issues. These economics drive the cash earned on invested capital, in turn the most important driver of stock prices. One must consider:
1. Which companies will grow sales volumes by addressing markets multiple times larger than ones addressed now?
2. Which companies will increase market share?
3. Which companies will be able to maintain proprietary advantage?
4. Which companies will be able to sustain product pricing in markets characterized by rapid obsolescence and declining prices?
5. Which companies satisfy a consumer need that will benefit from further substantial advances of product functionality and the integration of multiple capabilities into one product?
These questions will be addressed for Intel, Broadcom, and QUALCOMM.
1. Volumes: Intel’s addressable market is the huge and relatively mature personal computer market. Attempted diversification into chips for wireless networking and cell phones has brought losses rather than growth. Intel’s great profit margin in processor chips for PCs is not replicated in its other businesses, and neither is its competitive prowess. However, Intel is succeeding in taking over the enterprise server market from the likes of Sun, again a relatively small market compared to PCs. Focusing on PCs, Intel’s chips continue to power incremental performance improvement. However, customers are absorbing the improvements more slowly, ushering in a state of “performance oversupply”, defined by Professor Clayton M. Christensen in his book, The Innovator’s Dilemma. The replacement/upgrade cycle that drove growth in the past is slowing, opening the door to disruptive innovation.
Broadcom, a chipset supplier, is growing into huge markets: network processors, home and business wireless networking, set-top boxes that record programs, HDTV tuners mandated in 2005 by the Federal Communications Commission, VoIP Internet telephony, turn-key GSM cell phone kits, and Bluetooth wireless connectivity for printers, PDA’s, cell phones, etc. The long-term potential chipset volumes from these combined markets dwarf Broadcom’s current business, but there are lots of competitors.
QUALCOMM is comparatively simple. QUALCOMM will make the chipsets for about 100 million cellular handsets this year, about 20% of the 485 million worldwide handset market. Over the next ten years, virtually the entire handset market is expected to shift to QUALCOMM’s CDMA, both WCDMA and CDMA2000. Annual handset volume should grow to 1 billion units. Although guesses of QUALCOMM’s future market share are speculative, it is clear that QUALCOMM has a significant lead in CDMA technology. All major world handset manufacturers have agreed to pay royalties to QUALCOMM on any and all CDMA handsets they manufacture. QUALCOMM is likely to sell multiples of current chipset numbers, collect multiples of current royalties, collect revenues from the relatively new BREW and Snaptrack businesses, meanwhile requiring no additional capital.
2) Market share: All three companies are likely to increase market share in their respective markets. Intel has a very dominant 80%+ position, fueling revenues of about $30 billion, so it has relatively little room to grow. However, Broadcom, with about $1.6 billion in revenues, and QUALCOMM, with about $4 billion, still have a lot of room.
3) Proprietary advantage: No semiconductor company has the scale and magnitude of Intel’s $4 billion research and development budget. The ability to spend more money developing products, and manufacturing them in the most modern of facilities, gradually helps Intel to beat its competition. Broadcom builds competitive advantage by owning its own design components. Broadcom uses this ownership of proprietary chipset building blocks to beat its competitors to market with chipsets that contain the most comprehensive feature sets. QUALCOMM’s proprietary advantage lies in a CDMA patent portfolio that has been successfully tested in patent courts all over the world. All significant manufacturers of CDMA handsets have purchased licenses and pay ongoing royalties to QUALCOMM. Royalty collection is QUALCOMM’s most important business – the operating profit margin on QUALCOMM’s royalty business is 90%. QUALCOMM also has a giant lead in CDMA chipset design, both in terms of feature sets, performance, and handset reliability. At this time, no competing chipset manufacturer has been able to take more than 10% of CDMA market share.
4) Product pricing: One of the laws of technology is obsolescence. Prices decline precipitously in older products. Intel continually pushes PC processor speeds higher. By giving more computing power to the customer, Intel has limited price deterioration, and has forced all competitors other than struggling Advanced Micro Devices out of business. A top-end Intel processor sells for about 40% less than it did five years ago. Broadcom and QUALCOMM also push consumer utility forward rapidly, not just in terms of processing speed, but also in terms of features. A continual series of new capabilities integrated into the chipsets makes the end product more desirable to the consumer, preserving price. For example, adding a color screen and camera to a cellular handset drives the customer to both throw away the old one and pay the same or more for the new one.
5) Convergence: “Convergence,” as the term applies in high technology products, is the concept that products purchased separately for independent reasons are combined into one new product, allowing the consumer to get the utility of two products in one purchase. An emerging example of this is the cell phone with a digital camera. A coming example of huge importance is a single chipset that enables the holy grail of wireless telephony, the “world-phone,” that will seamlessly work in both CDMA and GSM systems. Essentially, CDMA and GSM are converged into one phone. QUALCOMM’s chipsets enable the phone manufacturer to build incredible functionality into the handset: Multi-mode WCDMA, GSM, and/or CDMA2000, data rate up to 2.4 Mbps, 1.3 megapixel integrated camera, camcorder, MP3/4 player, USB, Bluetooth (in partnership with Broadcom), e-mail, IP address, GPS position location, compass, voice recognition, SIM (subscriber interface) card, and removable memory card. By converging all of these capabilities, the cell phone replaces other popular consumer electronics devices, driving sales growth and supporting cell phone prices. Broadcom is enabling the convergence of set-top boxes with integrated wireless networking, HDTV, dual-TV support and personal video recording. This increases volumes for Broadcom and supports pricing by offering the end consumer more utility. Intel does not have convergence opportunities in its major business, PC processors. However, it has developed a highly integrated wireless computing chip called Centrino, and a cell phone chip called Bulverde that merges voice communications, camera capability, and Internet connectivity.
It appears that the long-term growth prospects for Broadcom and QUALCOMM are exceptional. For Intel, starting with a much larger base, the growth drivers are less potent. The maturity of its markets and its dominance of those markets contributes to its status as a blue-chip technology stock.
QUALCOMM (QCOM 46) continues its record of exceptional product execution. In CDMA chipsets, the company is unmatched for its feature set, ahead-of-schedule delivery performance, chipset reliability, and technical execution. Now contracted to make WCDMA chipsets for 14 handset manufacturers, Korean, Chinese, American, European, (don’t underestimate the immense importance of this), QUALCOMM looks assured to extend its CDMA2000 chipset dominance into WCDMA. Only QUALCOMM has passed interoperability testing with 13 different WCDMA operators for both voice and high-speed data. The two flavors of CDMA are projected to hold about 40% handset market share in 2007, 60% in 2010, and 90% in 10 years. The handset market is further projected to be the largest consumer product market in history, much larger than PC’s, TV’s, PDA’s, MP3 players, etc., combined. Although it is hard to see out ten years, there are projections of over 1 billion CDMA units per year in that timeframe. To gauge the growth potential, note that QUALCOMM will provide chipsets for about 100 million phones in 2003. QUALCOMM presently receives a royalty on all CDMA handsets, appears likely to continue to have the largest CDMA handset chipset market share, and will have highly profitable revenues from BREW software and Snaptrack GPS position location services. Louis P. Gerhardy at Morgan Stanley has built a convincing case that QUALCOMM’s operating profit per unit will initially be 45% higher for WCDMA than CDMA2000. A lot can change in technology, but this one is getting to be a lot of fun again.
Currently, the only location service for mobile devices that has passed FCC requirements is QUALCOMM’s Snaptrack. All new US handsets, regardless of technology, will soon be required to have this capability.
Despite much marketing fanfare, the Texas Instruments/ST Microelectronics/Nokia consortium still does not have CDMA chipsets in sampling, and it generally takes a year to go from sampling to production. However, Nokia does have its own CDMA2000 handsets in the market, for which I still await reviews. Meanwhile, Vodaphone, arguably the world’s leading WCDMA operator, recently dumped Nokia as a WCDMA handset supplier. QUALCOMM’s CDMA dominance is reflected in its patent portfolio: 1,100 issued and 3,000 pending. No CDMA competitor has a remotely comparable intellectual property position.
In financial terms this all adds up to somewhat higher long-term earnings, free cash flow production, and intrinsic value. However, fiscal 2004 revenue growth will be invested in WCDMA research, development, and market leadership; so don’t expect much earnings growth over the next several quarters. The stock sells below my estimate of intrinsic value.
Warning: While investing in technology is overall a lot of fun, it is fraught with risk. Proprietary product franchises like Microsoft’s and Intel’s are extremely rare. Competition pushes technological advancement at an incredible, but wonderful, rate. It is easy for today’s winner to end up as tomorrow’s obsolescence, with its investors losing lots of money. Compounding the risk is the sensitivity of technology sales to the economy and the consumer, the potential of regulatory risk, and the generally unpredictable behavior of technology investors, most of who are technologically challenged financial types.
Steven L. Ré, CFA November 19, 2003
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