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By their nature, conservative investors usually limit the risk that they are willing to take when considering investments. Although lower-risk stocks tend to be associated with below-average total returns, there are relatively straightforward ways of enhancing their prospective performance using options that have attractive risk/reward parameters. Accordingly, this series of articles offers ideas relating to the sale of out-of-the-money options on stocks of companies that have excellent Financial Strength ratings, sound near-term earnings growth prospects, rising dividend payouts, and attractive current valuations.  In the case of Qualcomm (QCOM), a major player in the rapidly expanding smartphone business, this includes a likely continuation of the impressive share-earnings growth through 2017 at least, that it posted over the past four years. Also, based on our share-earnings estimate for the fiscal year ending September 28, 2014 of about $5.10, which would be a 13% increase, the P/E ratio of 14.6 appears quite reasonable and is meaningfully below the stock’s historic norm. Moreover, the debt-free balance sheet features cash assets of $15 billion, equivalent to $8.88 a share, at the close of fiscal 2013.

Overview

Qualcomm is the leader in the development and commercialization of a digital communication technology called CDMA (Code Division Multiple Access), and it owns considerable intellectual property, including patents, applicable to products that implement any version of CDMA. The mobile communications industry generally recognizes that any company seeking to manufacture products that use CDMA, one of the main technologies used in digital wireless networks, will require a patent license from Qualcomm. This is also true in reference to its commanding market share with regard to Orthogonal Frequency Division Multiple Access, which is more commonly referred to as LTE (long term evolution) and is the standard for 3G and 4G (third and fourth generation) handsets.

In fiscal 2013, revenues generated by the division that sells integrated circuits and system software, based primarily on the aforementioned technologies, increased 38%, to $16.7 billion (67% of the total). In addition to mobile phones, Qualcomm’s chip sets are key components of tablets, laptops, data modules, handheld wireless computers, and gaming devices. The company utilizes a fabless production model, which means that it does not own or operate facilities for the production of its silicon-based integrated circuits. This arrangement, along with economies of scale and the company’s technological advantages, enabled the division to realize a stellar gross margin of 42% (including depreciation charges) last year.

Meanwhile, licensing revenues advanced 18%, to $7.9 billion (30% of the total). These funds exceeded Qualcomm’s expanding research expenditures by about $3 billion. Indeed, R&D outlays jumped 66%, to almost $5 billion, since fiscal 2011. This, as well as its superb design skills and established client roster, suggests that the company can retain much of its 60% share of overall baseband processor sales for a while.

The Smartphone Boom

Management continues to see smartphone adoption grow at a rapid pace across the globe. Notably, about 225 million smartphones were shipped in the June 2013 quarter, representing a 47% year-over-year increase.  Much of this ramp up is occurring in emerging regions where demand is being driven by the migration from 2G to 3G technology. The largest transition is currently taking place in China. Looking forward, industry sources expect 1.7 billion smartphones to be shipped in 2017, which would be almost twice the recent annualized rate. Qualcomm has also benefitted lately from the launch of devices, based on its products, with expanded capacity, such as Ultra HD video and additional frequency bands for global roaming. Thus, it is likely that an anticipated downward trend in average selling prices (ASPs) for smartphones in the coming years will be quite moderate , and that  negative impact on Qualcomm’s licensing income will be far surpassed by benefits from increased volumes of these and other mobile devices.

Other Investment Considerations

Net of capital expenditures, Qualcomm generated $7.9 billion in fiscal 2013. This year, it intends to distribute about 75% of free cash flow to shareholders in the form of dividends and share repurchases. The company raised the dividend in the June quarter in each of the past four years, and healthy improvement may well be forthcoming in 2014 and 2015; the 2013 increase was $0.10 a share, to $0.35. The share count was reduced modestly in fiscal 2013, and larger reductions appear to be in the cards in the coming years. This scenario, coupled with estimated revenue and net profit gains of somewhat below and above 10%, respectively, are appealing, in our view. High scores for Price Stability and Earnings Predictability are other pluses.

Option Strategy

Qualcomm stock has traded between about $71 and $76.55 since November and is now near the high end of that range. Even at the current quotation, it offers good 3- to 5-year total return potential. In light of the foregoing factors, the potential yield from the sale of either a May, 2014 covered call with a strike price of $77.50 or the May 2014 cash-covered put with a strike price of $72.50 appears quite attractive. At press time, the bid price of the call was $1.94 (equivalent to $194 a call). In this case the call entitles the buyer to purchase the stock at $77.50 a share. Since the sale of a covered call implies that the seller owns 100 shares per call sold, the potential annualized yield of about 15% would be about 25%, if the share price of QCOM were at or above $77.50 on the April 19, 2014 expiration date.

Meanwhile, the sale of a cash-covered put at the $1.25 bid ($125 per put) is the more conservative strategy, given the lower breakeven point, which is $71.25 (6.4% below the current price). In a margin account, the prospective annualized yield of about 9%, assuming the likely case of QCOM trading above $72.50 on the May 17th expiration date, would be greatly enhanced.

At the time of this article’s writing, the author did not have positions in any of the stocks mentioned.