Qualcomm’s Fight With Apple Is A Trading Opportunity
After the close on Wednesday, QUALCOMM Incorporated (Nasdaq: QCOM) reported earnings. The numbers for last quarter were strong with the company beating analysts’ expectations for both revenue and earnings per share (EPS). But guidance for the current quarter was disappointing.
Traders responded by selling the stock.
The response from traders might be overdone. The earnings report contained a lot of news, some of which was bullish and some of which was bearish.
The company reported EPS of $0.83, two cents better than the consensus forecast. Revenue was also slightly ahead of forecasts. QCOM also rewarded shareholders with more than $844 million in dividends and another $300 million in share buybacks.
The company increased the amount of cash on its balance sheet to $37.8 billion from $31 billion a year ago, leaving the company well prepared to complete its acquisition of NXP Semiconductors NV (Nasdaq: NXPI) by the end of the year
These were all bullish factors. Traders were focused on the company’s guidance and Qualcomm’s legal battles. For the current quarter, Qualcomm is forecasting EPS of $0.75 to $0.85, below analysts’ estimates of more than $0.90.
Management also told investors to expect revenues to be in a range from $5.4 billion to $6.2 billion. The Wall Street consensus forecast has been $5.51 billion. Qualcomm’s guidance excluded all licensing revenues pertaining to the sale of Apple products.
The guidance indicates Qualcomm’s management is settling in for a long battle with Apple.
Lawsuits and Countersuits
In January of this year, Apple filed a $1 billion lawsuit against Qualcomm for unfair practices. Apple contends Qualcomm’s licensing fees for its technology are illegal. Qualcomm obviously disagrees and is fighting to protect the fees which represent about 80% of its net income.
Since filing the initial suit, Apple instructed its suppliers to suspend royalty payments and guaranteed to protect them against potential legal claims. QCOM is expecting a compromise and has estimated that there could be a significant 31% to 41% drop in licensing revenues.
But, Qualcomm is fighting back, and the company has a long history of effectively defending its intellectual property. QCOM is also working to diversify its business, taking steps including the acquisition of NXP Semiconductors and moving into emerging growth areas like the Internet of Things.
But, the problem with Apple is not going to go away. Apple seems dedicated to the effort to reduce the amount it pays in licensing fees. And, in what is certainly bad news for QCOM, Apple has adequate resources to make this a long and expensive court battle.
In the earnings announcement, Qualcomm seemed to confirm that Samsung is also fighting the payment of licensing fees. In previous court filings, Samsung supported the Federal Trade Commissions’ case against Qualcomm.
Samsung argued Qualcomm’s refusal to license standards-essential patents directly to competing chip makers discourages smartphone firms from buying modems from anyone but Qualcomm.
“This case presents a simple question: By excluding would-be competitors from making and selling licensed chipsets and cementing its market power by forcing downstream customers to accept onerous licensing terms, has Qualcomm harmed competition?” Samsung’s lawyers wrote. “As the complaint makes clear, the answer is yes.”
Samsung has been withholding partial patent royalties owed to Qualcomm for some time. The company is also believed to have cooperated with an investigation last year by South Korea’s anti-monopoly regulator, which fined Qualcomm more than $850 million. Qualcomm has appealed that decision.
The lawsuits and government investigations are all old news. Markets are discounting mechanisms which means they are forward looking. For investors, the question to answer when making buy and sell decisions is to understand what potentially lies ahead.
Analysts are, of course, lowering their earnings forecasts for QCOM. There are 21 analysts who have published forecasts for EPS for this year and 19 have posted forecasts for next year. The average for this year is $4.23 and for next year, the average is $3.71.
Given the uncertainty the company faces, it could be best to consider the most pessimistic forecast. For this year, the lowest estimate is for $4.07 and for next year, the pessimistic forecast is for EPS of $3.00.
Even at those levels of earnings, QCOM could continue to pay its dividend. The stock currently offers a yield of about 4.2%. The stock also offers value at its current price since valuation levels would not be excessive even if earnings collapse to the lowest forecast.
This indicates QCOM is likely to recover if it settles its legal disputes. However, if it doesn’t the stock could fall sharply. This might sound like a price forecast that is not tradable but there is an options strategy designed for this scenario.
The long condor is used when a trader is looking for a sharp move either up or down in the underlying stock during the life of the options. The risk and reward profile for this strategy, from The Options Industry Council, web site is shown below.
A long condor consists of buying a call and being short another call with a higher exercise price while also being long one put and short another put with a lower exercise price. Typically, the call exercise prices are above the market price of the stock and the put exercise prices are below the current price.
The distance between the call exercise prices should be equal to the distance between the put exercise prices. All four of the options must share the same expiration date.
For QCOM, we can expect a large move reasonably soon, before the next earnings report which should be released in October. There are options expiring October 20 that will work for a long condor. The specific options that can be used are:
- Sell one QCOM October 20 $57.50 call at about $1.05
- Buy one QCOM October 20 $55 call at about $1.90
- Buy one QCOM October 20 $52.50 put at about $2.05
- Sell one QCOM October 20 $50 put at about $1.20
The total cost of this trade will be $1.70. Since each contract covers 100 shares, the total cost of the trade will be about $170 before commissions which should be small if you are using a deep discount broker.
The maximum possible loss is equal to $170, the amount of money paid to open the trade. The maximum possible gain is $80, the difference between the exercise prices of the calls or puts ($250) and the cost of opening the trade ($170).
The advantage of this trade is its low risk. It costs just $170 to benefit from a move in QCOM, the cost of less than three shares of the stock. With three shares, even a 25% move in the stock would result in a gain of about $40.
Given the uncertainty associated with the company’s future, the risks of owning the stocks are equal to the potential gains on the trade since there is largely a 50/50 chance QCOM will go up or down. The direction of the move largely depends on a court battle that investors have limited insight to.
With so much uncertainty, the long condor could be the best strategy. The trade pays off whether the stock moves up or down. This position benefits from the likelihood of a price move and requires just a small amount of capital.
The potential profit is equal to about 47% of the amount of capital risked, an excellent return for a trade lasting just three months. This trade could allow small investors to benefit without having access to expensive research on court filings.