Qualcomm (tkr: QCOM) has been a core holding in our technology sector based on the thesis that it should benefit from continued expansion of global smartphone usage. Qualcomm not only sells chips that go into smartphones, but it also collects license revenue for phones that connect to cellular networks using its patented license technology. Qualcomm’s revenue is broken down in two segments: chip revenue and licensing revenue. Although the licensing segment accounts for about 30% of total revenue, it brings in nearly 70% of Qualcomm’s pretax income.

Legal and regulatory challenges to Qualcomm’s licensing business model have battered the stock in recent years. Beginning in late 2013, the China National Development and Reform Commission announced that it was investigating the licensing business relating to Chinese Anti-Monopoly Law. Qualcomm was ultimately fined $1 billion and the challenge has since been resolved. However, even after the official resolution, Chinese licensees refused to pay license fees. As a result, Qualcomm faced an uphill battle of signing agreements with each individual Chinese device maker, while baking in lower revenue guidance to account for the failure to collect payments. Furthermore, similar regulatory bodies in Korea, Japan Europe as well as the Federal Trade Commission (FTC) in the US have also launched investigations, calling into question the sustainability of Qualcomm’s lucrative licensing business model.

On January 17, 2017, right before the inauguration of the new administration, the FTC filed a complaint charging Qualcomm with using anticompetitive tactics. Analysts anticipate that the new Republican-majority FTC will withdraw the complaint, but Qualcomm faces this legal headache in the meantime. Three days later, on January 20, Apple filed a similar lawsuit against Qualcomm. Qualcomm will fight these lawsuits, but Apple contributes roughly 25% of Qualcomm’s licensing revenue, which gives the iPhone maker leverage in the lawsuit. These two events caused Qualcomm’s stock to drop significantly, taking its PE ratio from 17.5 to 14. In 2017, Qualcomm is down 12% while the rest of the technology sector is up about 10%.

At this point, we believe the bad news is in the price of Qualcomm’s stock. Furthermore, we see upside opportunity as Qualcomm has just begun to diversify its revenue beyond smartphones. In October of 2016, Qualcomm announced it was acquiring NXPI Semiconductors for $47 billion. This acquisition gives Qualcomm exposure to emerging technologies such as self-driving cars and the Internet of Things. Intel (tkr: INTC) recently made a similar acquisition when it purchased MobilEye (tkr: MBLY) for $15.3 billion. Remarkably, Intel paid over 110 times earnings for MobilEye, while Qualcomm paid only 18 times earnings for NXPI. We continue to hold Qualcomm in spite of near-term challenges because we believe it carries a low valuation, pays a high dividend and it is positioned well to capitalize on the next waves of technology.

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