However, let's avoid dwelling too much on the past. Our debate concerns whether Qualcomm is a worthy investment to make right now, not whether someone made the right decision to invest in the company back in January, when the shares peaked at $179.31. (Incidentally, if you're interested in what mutual fund "window dressing" looks like, check out Qualcomm's chart toward the end of last year. Mutual funds piled into the stock, right before they reported year-end holdings to customers, so they could say they owned the hottest stock of the year.)
The bearish view
In short, there are two main reasons I am bearish on this company, the first being that it is too dependent on its CDMA patents. While the odds are probably in the company's favor that it will earn royalties from all varieties of CDMA for many years into the future, there is a substantial risk that they won't earn nearly as much as the bulls expect. Secondly, there are a couple of items lurking in the company's financials that threaten its ability to produce the earnings it needs to justify its current share price.
The big bet
While I don't know what Tom's bull argument will be, I can take a pretty good guess, since the Qualcomm story is a familiar one: As the world evolves toward third-generation (3G) wireless networks, Qualcomm will ideally earn royalties on practically every wireless device made, since they will all use some variant of the company's CDMA technology. Regardless of whether it's CDMA2000 -- the company's version of 3G -- or W-CDMA -- a standard developed by Qualcomm's competitors, including Nokia <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: NOK)") else Response.Write("(NYSE: NOK)") end if %> and Ericsson <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: ERICY)") else Response.Write("(Nasdaq: ERICY)") end if %> -- Qualcomm will earn a flood of high-margin royalties, or at least that's the idea. Some even call Qualcomm the toll booth on the road to 3G.
While Qualcomm's bulls presumably consider that a good thing, it's also a problem. After all, other businesses may not want to pay any tolls, or at least not very substantial ones. As Texas Instruments' <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: TXN)") else Response.Write("(NYSE: TXN)") end if %> CEO Tom Engibous told Fortune, "If intellectual property is too blocking in one area, people will go another way."
In fact, several big players are trying mightily to do just that. Dominant handset company Nokia has still not reached a licensing agreement with Qualcomm for a 3G version of CDMA. NTT DoCoMo, Japan's leading wireless provider, has also attempted to avoid paying royalties for Qualcomm's technology. Recent court rulings in Japan have gone in Qualcomm's favor, but there is still the prospect of litigation ahead.
One way that both Nokia and DoCoMo attempted to circumvent Qualcomm was by developing W-CDMA, their own version of 3G CDMA that incorporates elements of Europe's GSM standard. There has been plenty of confusion around W-CDMA, which some news reports have referred to as a "European" standard that won't require royalty payments to Qualcomm. Meanwhile, Qualcomm maintains that it will earn royalties from W-CDMA, and that you can't develop any version of CDMA without paying them. While the company is probably correct, W-CDMA may earn lower royalties than current CDMA technologies, since so many different companies have contributed technology to W-CDMA. More importantly, the very development of W-CDMA -- and its growing adoption in countries like South Korea -- indicates how far companies will go to try to avoid paying royalties to Qualcomm.
Finally, the South Korean decision to choose W-CDMA over CDMA2000 reflects another hazard facing the company: Many decisions regarding wireless standards are still being made by governments, with their capricious interests, not private companies faced with market discipline. China, for one, has been notoriously unreliable in its dealings with Qualcomm, in part as a result of bureaucratic infighting.
In the end, the company's future depends on its CDMA patents, and it's not at all clear that they will provide as big a payoff as the company hopes.
The spin-off
An example of the lengths Qualcomm will go to protect its royalty stream is the recently announced spin-off of its chipset business. While Qualcomm's previous divestitures of its money-losing handset and infrastructure divisions made sense, the chipset business was a successful, high-margin unit that raked in about half the company's revenues and a third of its earnings. So why get rid of it?
The public justification for the move was that Qualcomm had trouble selling chips to companies it was competing against in its intellectual property battles. As an independent company, the chipset business -- tentatively named Spinco -- will be able to develop chips for standards other than CDMA, and not worry about whether its customers are fighting with Qualcomm about something.
Yet there were additional reasons for the move, which starkly demonstrate Qualcomm's dependence on its CDMA patents. Having included plenty of GSM technology in W-CDMA, companies like Nokia planned to charge Qualcomm royalties in order for it to develop W-CDMA chips, which would cancel out much of the royalties Qualcomm would receive for its contributions to W-CDMA. By countering that move with this spin-off, Qualcomm's new incarnation as an intellectual property (IP) company will not have to pay any royalties for GSM technology, since it won't be making any chips, and yet it will continue to receive payments for W-CDMA equipment.
All well and good. But if this strikes you as quite a bit of extraneous rigmarole to have to go through in order to defend the company's primary business, and if you're wondering what Nokia's next move might be, you're getting an idea of why many investors have taken a wait-and-see attitude toward Qualcomm.
What lies beneath
Finally, there are a few financial question marks surrounding Qualcomm, two of which I'll briefly mention here. First, the company maintains a stake in troubled satellite phone company Globalstar <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: GSTRF)") else Response.Write("(Nasdaq: GSTRF)") end if %>, which recently defaulted on a loan payment and cost Qualcomm $22.5 million in loan guarantees. Qualcomm's CFO admits the company could lose EPS of $0.10 in 2001 if Globalstar goes under, which puts the company's liability (based on 806 million shares outstanding) at only $81 million. However, Motley Fool Research analyst Bob Fredeen -- soon to issue a report on the company -- notes that Qualcomm is carrying about $614 million of accounts receivable and other financing for Globalstar on its balance sheet (as of June 30), meaning the company's losses from Globalstar could be much, much higher.
Secondly, as fellow Fool Bill Mann has pointed out, about $0.06 of the company's EPS in its most recent quarter resulted from investments, rather than operating activities. On an operating basis, the company's EPS actually declined from the previous year. This is not a good thing for a company with a trailing P/E of 61.
Qualcomm is certainly going to be an important player in tomorrow's wireless world, but right now it's an overvalued company dependent on a single technology. Fools ought to put their investing dollars to work elsewhere.
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