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Why Qualcomm Should Ring the Bell

By Ari Bensinger Telecom-equipment stocks skidded 61% in 2001, leaving the group the third-worst performer among all of S&P's sub-industries. Investors are still shunning the group, which has fallen 23.4%, vs. a 0.9% increase for the broad S&P 1500 index, year-to-date through Mar. 20 (see BW Online, 2/15/02, "Cell Phones and Investors: Disconnected").

Even though the telecommunications market continues to be plagued by tight capital spending and excess capacity issues, one former high-flyer in the equipment group is worth buying now: Qualcomm (QCOM). S&P likes this maker of chips and software for advanced wireless services for its solid long-term earnings potential.

Improving market conditions should help Qualcomm. The wireless-handset market is expected to rebound this year, after declining about 7% in 2001, to an estimated 380 million units. Higher market penetration rates, lower operating subsidies, excess inventory, and a slower replacement market have hurt handset shipments. Still, some 200 million new subscribers signed up in 2001, bringing the total near 900 million.

STRONG PROSPECTS. And in 2002, handset unit growth is expected to increase, to about 430 million units, as the introduction of phones with color screens and multimedia messaging should help spur a faster replacement cycle. For Qualcomm, investors should focus on strong prospects in its key markets: Korea and the U.S.

On the technology side, Qualcomm is the pioneer in the development of innovative digital wireless communications products and services based on code division multiple access technology (CDMA), with close to 2,000 patents issued and pending to date.

The two main technologies used in wireless phones are global systems for mobile communications (GSM) and CDMA. GSM is used to allocate a discrete amount of frequency bandwidth to each user in order to permit many simultaneous conversations. With CDMA, each telephone call is assigned a unique code that distinguishes it from the multitude of calls simultaneously transmitted over the same broadcast spectrum.

CDMA offers about 10 times the capacity of conventional analog and three times the capacity of GSM by more efficiently using wireless carriers' licensed spectrums. Other advantages of CDMA include enhanced voice quality, better call security, increased network capacity, fewer dropped calls, compatibility with Internet protocols, lower power and extended talk time, and lower infrastructure costs.

JOCKEYING FOR POSITION. CDMA currently represents roughly 20% of the total mobile handset market, with over 100 million subscribers worldwide, according to the CDMA Development group (CDG), an association of companies formed to lead the adoption and evolution of CDMA wireless systems. In North America, CDMA is the dominant technology, with a market share of over 40%. Latin America, which has more than 20 million subscribers, is the fastest growing CDMA market, with the number of subscribers almost doubling in 2001.

In the wait for Web-enabled, third generation (3G) cell-phone services, an intermediate technology called 2.5G is being rolled out. Two technologies are jockeying for market position in 2.5G: general packet radio services (GPRS), designed for the GSM standard, and CDMA2000 1X for the CDMA standard. These technologies use packet switching (Internet technology), rather than circuit switching (traditional phone technology), offering data speeds of greater than 100 kilobits per second (kbps). Both allow operators to upgrade existing base stations and core networks at a relatively modest expense compared with 3G.

Qualcomm believes its CDMA2000 1X technology provides voice capacity that is six to eight times greater than GSM-based networks. CDMA2000 1X initially provides peak data rates of 144 kbps, with up to 307 kbps planned, longer battery life, and position-location functionality that's in compliance with Federal Communications Commission mandates for emergency 911 calls.

3G ROYALTIES. Commercial deployment of CDMA2000 1X began in October, 2000, in South Korea, with approximately 2 million subscribers signed up as of November, 2001. CDMA2000 1X chips are shipping to more than 50 customers, with 12 million chips shipped in the December, 2001, quarter and over 20 million expected in the March, 2002, quarter. Carriers view the technology as a cost-effective voice-capacity solution that will enable them to offer increased data applications and in turn increase their average revenue per subscriber.

In the near future, 3G phones with Internet services will offer rates of up to 384 kbps in wide area applications and 2 megabytes per second in local areas, compared with 64 kbps for the fastest existing digital systems. Two primary standards are competing for 3G networks: Wideband CDMA (WCDMA) and CDMA2000. Qualcomm will receive royalty fees from both technologies, since they stem from the core CDMA technology it developed.

Given CDMA's superior technology, S&P believes it offers the fastest growth opportunity for mobile-equipment makers. Being the pioneer in the area, Qualcomm is best positioned to benefit through sales of CDMA handsets and infrastructure chip sets, as well as from licensing and royalty fees paid by third-party equipment manufacturers.

>ATTRACTIVE VALUATION. S&P expects Qualcomm's sales to advance in the low-teens in fiscal year 2002, driven by higher licensing fees and integrated chip shipments -- particularly for CDMA 2000 1X products. The company's predictable royalty revenue base has great appeal. S&P expects approximately 75 million CDMA phones to be sold in 2002, with a 10% annual decrease in average unit selling prices (on which royalties are calculated).

However, this market estimate could prove conservative if China quickly solves its current CDMA handset availability issues. S&P expects a significant increase of CDMA subscriber growth in China in the second half of 2002, as more handsets become available.

In addition, Qualcomm boasts strong net margins of 30%. Margins should continue to improve, reflecting an increased percentage of licensing fees (over 90% pretax margin) and a ramp-up of higher-margin mobile station modem integrated circuits. Overall, S&P sees operating earnings per share of $0.93 in fiscal year 2002 and $1.21 in fiscal year 2003. The company's balance sheet is strong, with no long-term debt and over $2.3 billion in cash.

Based on the tremendous CDMA market opportunity available, S&P believes Qualcomm can post earnings growth of at least 25% for the next several years. With the shares currently trading at a p-e to long-term growth ratio of 1.3 times S&P's 2003 EPS estimate, below its peers, Qualcomm shares are attractive. S&P's discounted cash flow analysis yields a fair value in the high $50s, above the current stock price of about $38. S&P recommends that investors buy the shares. Analyst Bensinger follows telecom equipment stocks for Standard & Poor's

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