Qualcomm: The Gift Has Arrived

Qualcomm Incorporated (NASDAQ:QCOM) buyers fled after the company released its FQ2'23 earnings report yesterday (May 3). The company's results for FQ2 showed promise even though it was mixed. However, its forward guidance largely disappointed, as downstream headwinds have shown little signs of sustained improvement.

As a result, Qualcomm guided an adjusted EPS for FQ3'23 that's way below the previous Wall Street estimates.

Management promulgated adjusted revenue of $8.5B at the midpoint of its guidance range for FQ3, well below the consensus estimates of $9.1B. In addition, the company's adjusted midpoint EPS outlook of $1.8 likely caught investors off-guard, well off analysts' estimates of $2.12.

As such, QCOM holders could hardly blame the post-earnings selloff as QCOM gave up nearly 7% in post-market trading.

While the guidance was unwelcome, we assessed that management likely telegraphed a highly conservative outlook. Qualcomm reminded investors that its outlook contemplated several critical headwinds.

Accordingly, the company highlighted that it's "not incorporating improvements regarding expectations for a rebound in China demand in the second half of the calendar year." Management added that the company has seen "no evidence of meaningful recovery in China demand yet."

As such, we parsed that management is likely expecting China's recovery to be delayed further into 2024 at the very least, as China's reopening tailwinds have fizzled out lately.

China's Caixin manufacturing PMI fell to 49.5 in April after notching an improvement to 50 in March. China's economic recovery is expected to remain "uneven" as businesses remain "reluctant to hire more workers."

Moreover, China's job market "also deteriorated," worsening consumer spending sentiments further. As a result, it makes sense for Qualcomm to remain cautious about the recovery tailwinds from China in H2CY2023, highlighting the prudence in its planning assumptions.

Arch-rival MediaTek (OTCPK:MDTKF) also recently reduced its global smartphone shipment forecasts, seeing "a longer replacement cycle and the emergence of used or refurbished phones."

Analysts on the call were also concerned about how the growth of refurbished phones could threaten the recovery momentum of Qualcomm's smartphone segment moving forward.

Management attempted to assure investors that Qualcomm "is closely watching the refurbished phone market and has contemplated it in their numbers." In addition, the company added that the refurbished market is not a new phenomenon and has been "around for a long time in emerging markets."

The concerns intensified recently as India's smartphone market registered "a record decline in Q1 2023, with shipments falling by 19% annually to 31 million units." One of the factors cited for the slump is linked to "growing consumer preference for refurbished phones."

Therefore, should investors be worried?

The Wall Street Journal, or WSJ, ran an article in mid-April highlighting the trend that "Americans are keeping their smartphones longer." Notably, it stressed that it has led to "an increase in demand for used and refurbished devices, particularly iPhones."

Furthermore, Apple (AAPL) likely sees an opportunity in the growing market. The WSJ reported that the Cupertino company "has doubled down on the aftermarket for its phones, with its own secondhand-phone program." Why? This is likely attributed to Apple's stranglehold on the consumer ecosystem, differentiating itself from companies like Qualcomm, MediaTek, or even Samsung (OTCPK:SSNLF).

Apple is the gatekeeper for iOS and can continue to generate revenue from refurbished phones through services and subscriptions, even when it doesn't get a cut from the sale of a used device.

Its wide economic moat through its ecosystem has seen Apple gaining a significant share in the refurbished market. CCS Insight suggests that its iPhones account "for over 80% of the market for used phones by value."

Notwithstanding, Qualcomm is still in the process of diversifying its reliance on handsets revenue. Management stressed that it remains focused on executing its "diversification strategy."

Interestingly, management highlighted its robust generative AI strategy that could provide a tailwind, given the company's technological leadership in smartphones.

CEO Cristiano Amon articulated that "generative AI models need to run locally on devices at the edge to scale." He believes the company is "uniquely positioned to enable AI use cases on edge devices."

Management stressed that running generative AI locally will help "optimize costs" while providing "better latency, security, privacy" and meeting regulatory requirements.

Hence, Qualcomm sees tailwinds from on-device generative AI that could provide further growth impetus moving ahead. Therefore, we urge investors to continue monitoring the developments in this area, even as Qualcomm continues to diversify.

As a result of the post-earnings selloff, QCOM should re-test its December lows in the regular session, taking out dip buyers from March.

We still expect dip buyers to return and defend QCOM's December lows, with headwinds for H2CY2023 likely priced in.

Samsung's optimism at its recent earnings conference could lend credence to a more robust H2 recovery, despite Qualcomm's prudent guidance. The Korean semiconductor leader "predicts that the overall handset market demand in H2 2023 will be higher than in H1."

As such, we assessed that the market is likely pricing in peak pessimism in QCOM for H1. Hence, it should subsequently support a recovery in operating performance, bolstered by Qualcomm's conservative outlook, lowering the bar for it to cross.

With QCOM falling well below our blended fair value estimate of about $150, we assessed that it has moved into significantly undervalued zones, improving risk/reward for investors looking to add more exposure.

Rating: Strong Buy (Revised from Buy).

Important note: Investors are reminded to do their own due diligence and not rely on the information provided as financial advice. The rating is also not intended to time a specific entry/exit at the point of writing unless otherwise specified.

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