Qualcomm's Mega Merger Is Dead: What Dividend Investors Need To Know

Qualcomm (QCOM) has had an eventful two years to say the least. 

The company's main cash cow, chip licensing for smartphone manufacturers, has faced a customer revolt with both Apple (AAPL) and China's Huawei deciding to not to make royalty payments as they challenge the company in court over what they claim is predatory licensing agreements (Apple continues withholding $1 billion in royalties). 

Meanwhile, a slew of regulators all over the world have levied billions in fines against the company which it continues to appeal. And of course, Qualcomm's planned $44 billion acquisition of Dutch chipmaker NXP Semiconductors (NXPI) was recently called off after a failed 21-month attempt to clear regulatory hurdles.

Let's take a look at why the NXP merger failed and what it means for Qualcomm's future dividend safety and growth prospects.

What Merger Failure Means For Qualcomm

Qualcomm wanted to buy NXP Semiconductor in an attempt to diversify its business model and reduce its dependence on its licensing business (about 20% of revenue but nearly 50% of profits due to 85% operating margins). 

The reason this division is so profitable for the company is because Qualcomm's 130,000 patents (mostly 3G and 4G wireless) allowed it to extract licensing terms where it would get royalties equal to 3% to 5% of a smartphone's wholesale price. 

Numerous companies and regulators have called these terms onerous and unfair. NXP's strong presence in automotive chips meant that it would have made Qualcomm a leader in the driverless car industry which is expected to grow exponentially starting in the 2020s. 

In fact, according to management, buying NXP would have increased Qualcomm's addressable market by 40% "across key growth opportunities in: automotive, Internet of Things, security, and networking."

While Qualcomm was eventually able to obtain regulatory and shareholder approval from in the EU and US, Chinese regulators dragged their feet largely due to the escalating trade conflict between the US and China. 

As a result, when the July 25 deadline to close the deal came with no sign of Chinese approval coming anytime soon, Qualcomm decided to call off the $44 billion deal. 

As a result, Qualcomm has to pay NXP a $2 billion breakup fee and misses out on the expected long-term diversification and growth benefits it was looking forward to.

However, while the failure of this merger is certainly a blow, there is some good news for dividend investors.

Qualcomm Plans To Continue Growing Its Dividend In The Future

A $44 billion merger is a game changer. The acquiring company loses significant financial flexibility to pay for the deal, integration challenges are common, corporate culture can clash, and management risks overpaying for expected synergies that don't fully pan out.

If the financial strain becomes great enough, the acquirer's dividend can either be frozen for several years or even reduced to improve the balance sheet. So from a pure income perspective, at least over the short term, the failed NXP deal bodes well for investors holding Qualcomm and banking on its dividend.

Instead of taking another big swing, management now plans to return more cash to shareholders and focus on internal projects, which are far more conservative uses of the firm's capital.

Specifically, Qualcomm's plans involve tapping its $36 billion cash position to buy back up to $30 billion worth of stock over the next year or so. That would potentially represent about a 30% reduction in its share count and provide nearly the same level of earnings per share growth that the NXP merger was expected to generate over the same time period. 

At the same time, the company believes it is on track for major cost cutting, including $1 billion in fiscal 2019 alone, enough to boost its free cash flow by nearly 20%.

Over the long term, Qualcomm remains focused on continued innovation in 5G technology, which is one of the key growth areas that have seen sales increase by over 70% in the past three years alone. 

Management expects that by 2020 5G will represent a $100 billion annual global market and thinks Qualcomm is well-positioned to compete aggressively for market share in areas like 5G smartphone chips, the Internet of Things, and driverless cars (even without NXP).

Meanwhile, Qualcomm's embattled chip licensing segment has recently seen some good news. First, the company cut an interim deal with Huawei, which is quickly becoming the largest smartphone maker in the world (by unit volume). 

Under this arrangement, Huawei would pay Qualcomm $500 million in back royalties. Qualcomm also recently cut a deal with Taiwanese regulators who in 2016 levied a $773 million fine against the company over its licensing agreements.

Taiwan's Fair Trade Commission agreed to drop that fine and merely keep the $93 million in fines Qualcomm has already paid it. In exchange, Qualcomm has agreed to invest $700 million into Taiwan's semiconductor industry over the next five years. 

Not only does this mean that Qualcomm is avoiding about $700 million in fines, but it will hopefully be able to earn attractive returns on its capital investments into Taiwan, which represents its third largest market. 

More importantly, Taiwan regulators have agreed to leave its existing licensing agreement in place. Remember those deals give Qualcomm 3% to 5% of a phone's wholesale price and are a key reason that Qualcomm remains an extremely profitable company. 

In fact, over the past 12 months Qualcomm's free cash flow margin exceeded 20% which allowed the company to generate nearly $6 billion in free cash flow (what pays the dividend). Qualcomm's free cash flow payout ratio over the past year sits near 60%, suggesting that its dividend remains at very low risk of a cut.

Combined with the potential 30% share count reduction that its $30 billion buyback represents, this means that Qualcomm's free cash flow per share is likely to soar in the coming years, allowing Qualcomm's safe dividend to continue growing. 

On the company's last earnings call in July 2018, management also reasserted its commitment to maintaining and growing the dividend over time. That will be backed up by rising free cash flow (fueled partially by cost cutting and improving margins), a strong balance sheet (investment grade credit rating), and the launch of its upcoming 5G chips.

Large Uncertainties Remain But Dividend Growth Thesis Remains Intact For Now

Qualcomm still faces major uncertainties about its future. For one thing, on its most recent conference call the company disclosed that rival Intel (INTC) has received all of Apple's contracts for providing model chips for this year's iPhones. 

In addition, the business is still battling with regulators in China, South Korea, and the US over its licensing practices. And going forward, more large phone makers like Apple, Samsung, and Huawei are looking to build their own smartphone chips in-house, which might make it harder for Qualcomm's non-licensed chip business to grow.

That being said, Qualcomm remains a large, highly profitable, and innovative company whose proven track record in research and development means that it has solid growth potential in the world of 5G. Combined with management's plans for ongoing cost cutting and increased buybacks, the company's dividend remains safe and likely to increase for at least the next few years. 

While the NXP merger failure is not a thesis-breaking event for dividend investors in Qualcomm, investors considering the company must get comfortable with the industry's complexities and the ongoing licensing battles Qualcomm faces, which could ultimately pressure its long-term profitability.

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