I’m a contrarian investor by nature, meaning I’m more than willing to buy what I consider to be quality companies with safe dividends and bright futures just when the market hates them most.
In fact, my EDDGE 3.0 real money portfolio is stacked to the rafters with companies I bought at 52-week lows, including:
So I’d like to point out two more beaten down companies that I consider to be great contrarian value investments, Qualcomm (QCOM) and Kroger (KR).
Let’s take a closer look at why Wall Street hates these stocks. More importantly, why those fears are likely overblown, and these companies represent potentially excellent additions to your diversified dividend growth portfolio in this extremely frothy market.
Why Wall Street Hates Qualcomm
It’s been a rough few years for Qualcomm, with a rash of bad news that has soured the market on the company’s growth prospects.
For one thing it faces growing competition on the low end from low-cost manufacturers such as Mediatek, and on the high end from phone makers such as Samsung (OTC:SSNLF), Apple (AAPL), Xiaomi, and Huawei going in house.
However, by far the biggest cause of Qualcomm’s recent woes is the licensing disputes it’s facing.
QTL Getting Hammered
Qualcomm’s huge number of telecom patents makes its QTL licensing division its main profit driver, thanks to 73% operating margins compared to just 14% for its chip business.
The way it works is that Qualcomm licenses its patented tech to phone makers for a fixed percentage of the phone’s wholesale price, generally 3% to 5%.
In recent years, numerous companies have cried foul, claiming that this is outrageous because it allows QCOM to benefit from all value added propositions the phone maker brings to the unit that have nothing to do with QCOM’s tech.
For example, if Apple licenses Qualcomm’s modem technology, and then releases a new phone, such as the iPhone X for a 20% higher price, then why should Qualcomm’s royalty be 20% greater for the same exact chip?
In April of 2017, Apple suspended all royalty payments to QCOM claiming its licensing model was “illegal” which resulted in a 42% decline in QTL (licensing) revenue compared to Q2 2016.
Sources: Earnings Releases, Motley Fool
Now analysts are worried that this legal challenge, in which Apple claims that the licensing fees paid to a percentage of total phone sales are too high, could be triggering other phone makers to also refuse to pay until the legal challenges are resolved.
In fact, on August 18th, Evan Chesler, chief legal counsel for QCOM, admitted that a large phone maker has stopped paying royalties (possibly Huawei) as well.
This is far from the company’s only legal issue. The Seoul High Court recently ruled against QCOM’s appeal of an earlier $ 913 million fine over its licensing practices.
China also fined the company to the tune of $ 975 million in 2015, and regulators in Europe, Taiwan, and the US have launched antitrust probes against the company.
The basis of those claims is from the likes of Intel (INTC) which claims that Qualcomm refuses to license to direct competitors, while phone makers such as Samsung have claimed that Qualcomm threatens to charge more for certain licenses if you try to go to a competitor for certain chips.
Understandably all these setbacks to the high margin QTL licensing business have Wall Street running scared, with management guiding for QTL revenue in fiscal Q4 to decline by 31% to 47%. This has caused analysts to predict the company’s full-year sales and earnings to decline by 2% and 6% respectively.
This is also why Qualcomm is attempting to buy NXP Semiconductors (NXPI) for $ 47 billion to allow it to diversify away from its troubled QTL segment.
However, here too the company has recently run into trouble.
Growth Plans Hit A Wall
Qualcomm’s management expects the NXP deal to close by the end of the year; however, there are two snags it’s currently facing.
First, EU regulators are now holding up the deal on antitrust concerns, implying that QCOM might use NXP’s market share in auto computer chips (it’s the world’s largest supplier) and NXP’s rich patent portfolio to gouge suppliers and raise prices.
In addition, Elliott Management, an activist investor in NXP, has said that the $ 110 per share tender offer QCOM is willing to pay for NXP shares is way too low.
Susquehanna, an analyst firm, has reported that “some investors believe that Qualcomm should pay up to $ 130 per share for NXP.” That would mean that QCOM might end up having to pay 18% more, or $ 55.5 billion.
In other words, there is now significant doubt about whether or not the NXP deal can close at all, which adds to the company’s numerous other problems to suppress the share price.
Here’s Why I See Value In Qualcomm
First, while true that big phone makers have been shifting to in-house SOC chip designs, Qualcomm’s QCT (chip business) continues to generate solid top line growth (5% in the most recent quarter), but more importantly shows continued strong operating earnings growth.
I’m confident that Qualcomm’s continued drive to innovate and branch out into new Snapdragon lines, including drones, cameras, wearables, and cars, should allow this business segment to drive solid double-digit bottom-line growth for years to come.
Now, as for the well founded concerns about QTL, there too we have some good news.
While the Apple litigation could drag on for years, ultimately Qualcomm is likely to win simply because Apple spent five years licensing the company’s patented tech under a contract that it voluntarily signed.
Thus, Apple now deciding years later that this contract was unfair, or even illegal, and to withhold payment isn’t likely to fly in court.
Now we may see a judge rule, such as in China in 2015, that the licensing terms were too high, but the point is that Qualcomm is likely to get some large catch payments from Apple (and Huawei) in the next year or two.
In fact, speaking of China, where a judge ruled in 2015 that Qualcomm needed to pay a large fine and reduce its royalty terms, we can’t forget that Qualcomm’s QTL segment is thriving in China, where it still enjoys 3% to 5% royalties on 65% of wholesale phone prices.
Source: Qualcomm Investor Presentation
And lest we forget Qualcomm has a rich patent portfolio that applies to pretty much all aspects of wireless telecom technology.
That number, which stands at nearly 47,000 granted patents, is steadily climbing over time and should ensure that the QTL segment is able to continue growing in the long term, monetizing the growth of smartphones for the next 10 to 20 years at least, though the royalty rate may be smaller than it is today.
Next, while it may take longer than expected, and potentially cost more than anticipated, I fully expect the NXP deal to close, and when it does, Qualcomm is going to see a nice boost to its struggling top and bottom lines.
|Company||TTM Sales||TTM Earnings||TTM FCF||EPS||FCF/Share|
|Qualcomm Today||$ 22.6 billion||$ 3.9 billion||$ 3.78 billion||$ 2.61||$ 2.54|
|QCOM + NXP||$ 31.9 billion||$ 5.9 billion||$ 5.74 billion||$ 3.93||$ 3.85|
In fact, thanks to the NXP deal being all cash and debt (non dilutive), the EPS and FCF/share accretion for the acquisition is 51% and 52%, respectively.
In other words, assuming the deal closes, as I and several other analysts expect, Qualcomm will immediately face a strong price recovery.
Of course, that’s in the short-term, but my concern is with the long-term growth prospects of the company, and there too the situation is far less bleak than the market currently anticipates.
In fact, I think that all of Qualcomm’s recent legal troubles have caused the market to lose the big picture, which is that the company is one of the best positioned in the world to take advantage of several major megatrends that will dominate the next century.
Specifically, QCOM isn’t just a chip maker, but a great, long-term investment into the future of computer expansion into all aspects of our lives including the internet of things, autonomous cars, 5G, data centers, and cybersecurity.
That in turn should allow Qualcomm to continue richly rewarding dividend growth investors as it has for the past 14 years.
Why Kroger Has Been Gutted…
KR data by YCharts
Kroger has had a terrible few years, with shares now down over 50% from their all-time highs.
This is understandable given market concerns about increasing competition in the grocery space, not just from traditional rivals such as Wal-Mart (WMT), and Target (TGT), but also now from Amazon (AMZN), whose $ 14 billion purchase of Whole Foods is its largest single acquisition in that company’s history.
After all, recently Kroger broke an impressive 13-year streak of comps growth, and with low cost grocers such as Aldi and Lidl making a bigger play for the American market, Kroger has had to slash food prices and invest more heavily into technology in order to compete in a notoriously low margin industry.
|Company||Operating Margin||Net Margin||FCF Margin||ROA||ROE||ROIC|
Sources: Morningstar, GuruFocus
That means worse short-term earnings performance, and management’s recent decision to stop issuing long-term forward guidance certainly adds to the market’s uncertainty about its future growth prospects.
However, here’s why I bought Kroger anyway, despite all the fears, uncertainty and doubt.
…And Why It Will Likely Thrive In The Future
Source: Business Insider
The $ 800 billion US grocery market is highly fragmented, but Kroger currently has just over 10% market share, and is the largest grocery-only national chain.
Source: 2016 Factbook
Currently Kroger operates:
- 2,793 full grocery stores in 35 states
- 783 convenience stores in 19 states
- 307 premium jewelry stores under the Fred Meyer Jewelers and Littman Jewelers brands
- 38 manufacturing facilities for its own private label (higher margin) foods
- 1,472 fuel centers
- 2,258 pharmacies
Thanks to well executed acquisitions over the years, Kroger is today a food empire that serves 8.5 million customers daily, but more importantly, has managed to increase its market share for 12 consecutive years (through 2016).
This has allowed the company to become the number one or two sales leader in 98 of 120 markets in the US and number one in 46 of 51 major markets.
The reason that matters is because it allows Kroger to leverage its fixed costs (distribution system) better and not just win and protect market share, but achieve better bottom line growth.
This accomplishment isn’t just done through acquisitions of other brands and grocery chains but through two main competitive advantages that few other grocers have.
The first is that Kroger is very strong at private label foods (26% of total sales vs. 18% industry average) such as its Simple Truth organic foods. And since it manufactures its 40% of the private label brands it sells, Kroger benefits from higher margins (about 10% better gross margins) on these products.
Second, few grocers have been as effective at data mining its customers, courtesy of the company’s in-house 84.51 degrees analytics firm (fed by over 25 million digital accounts), which provides Kroger with deep insights into customer preferences and regional ordering patterns.
This has helped make Kroger a leader in online ordering and curbside pickup via its Clicklist and ExpressLane locations, which it now offers at 640 locations with plans to double that. In fact, this increased focus on omni-channel sales should allow Kroger’s e-commerce sales to grow at about 20% a year through 2021.
Source: Quarterly Filings, Motley Fool
In fact, thanks to online ordering, which more than doubled year over year, Kroger’s comps growth came in at 0.7% in the last quarter, and management expects 0.5% to 1% growth in the second of the year.
And while true that about 0.75% comps growth in the second half of the year would be a pale imitation of the kind of strong comps growth enjoyed in recent years, the fact is that it’s still moving in the right direction.
This indicates that management is capable of adapting to very challenging industry conditions. In addition, analysts expect Kroger’s long-term comps to return to 2.5%, which I believe is a potentially conservative estimate.
Let’s also not forget the company’s relentless focus on cost cutting via supply chain optimization and closing underperforming stores that has allowed sales per square foot to grow steadily over time and that can make a huge difference in earnings growth in the future.
In fact, at $ 650 in revenue per square foot, Kroger is the second best retailer in this industry, behind only to Costco (NASDAQ:COST) at $ 1,100.
All these reasons are why I as a contrarian investor like Kroger. Because the essence of what I do is to look at a historical winner, one trading at beaten down valuations (and preferably at 52-week low), and determine whether or not “this time is different”.
The simple fact is that the challenges facing Kroger right now, while different in specifics, are not meaningfully different than the kind of brutal competition it’s faced for decades from the likes of dividend aristocrat Wal-Mart and dividend king Target.
KR Revenue (Annual) data by YCharts
And as you can see, Kroger has done fine, growing sales, FCF/share, and EPS at 6.7%, 5.3%, and 10.0% CAGR respectively over the past 27 years.
KR Total Return Price data by YCharts
In fact, Kroger has historically been a solid market beater, even after accounting for the recent 50% crash.
This tells me that this is a company that I’m more than comfortable owning for the long term, given management’s track record and its future growth plans.
Dividend Profiles Point To Market-Beating Returns
|Company||Yield||TTM FCF Payout Ratio||10 Year Projected Dividend Growth||10 Year Expected Annual Total Return|
|Qualcomm||4.3%||84.4%||9% to 10%||13.3% to 14.3%|
|Kroger||2.4%||32.2%||7% to 8%||9.4% to 10.4%|
Sources: GuruFocus, Morningstar, Multpl.com, CSImarketing.com
Ultimately as a dividend growth investor I’m counting on a combination of generous, secure, and growing dividends to generate market-beating total returns.
In this case both Qualcomm and Kroger offer far better yields than the market today, and despite QCOM’s temporarily elevated payout ratio (will come way down once the license dispute is resolved and or the NXP deal closes), I’m confident in the strong security of both dividends.
More importantly, I think that they will continue to grow at moderately strong rates that will allow for double-digit total return potential that should result in far superior total returns in the coming decade than what the overheated S&P 500 will generate.
Of course, those long-term dividend growth projections could end up being lumpy, meaning that short-term struggles to grow the top and bottom line might mean that payout growth might be slower in the next few years, but likely catch up later on.
Valuation Is Highly Attractive On Both
QCOM Total Return Price data by YCharts
Both Qualcomm and Kroger have had a terrible year, which is exactly what I love to see, because it means the valuations are now at historically excellent levels.
|Company||Forward PE||Historical PE||Yield||Historical Yield||Yield Percentile|
|Kroger||10.3||16.0||2.4%||1.5%||All Time High|
Source: F.A.S.T. Graphs, Multpl.com, Jeff Miller, GuruFocus, Yieldchart.com
For example, on a forward PE ratio basis, both companies are way below the market’s overheated levels, as well as significantly below their historical norms.
More importantly for dividend investors, the yield for QCOM and KR is sky-high. For example, Kroger’s yield is near its all-time high while Qualcomm’s yield has only been higher 1% of the time.
|Company||TTM FCF/Share||10 Year FCF/Share||Fair Value Estimate||Growth Baked Into Current Share Price||Margin Of Safety|
|Qualcomm||$ 2.54||10.9%||$ 65.65||6.6%||20%|
|Kroger||$ 1.49||6.3%||$ 24.25||3.6%||15%|
Sources: Morningstar, GuruFocus, F.A.S.T. Graphs
Another thing I like to look at is the longer-term, 20-year outlook using a discounted free cash flow model, using a 9.0% discount rate (the post expense ratio historical return on an S&P 500 index ETF, i.e. the opportunity cost of money), and a conservative 4% 10-year terminal growth rate.
This allows us to get a rough estimate for the intrinsic fair value of a company, and in this case, we can see that Wall Street is being overly pessimistic about the future growth rates of both stocks, resulting in strong margins of safety.
Normally I like to buy quality DGI stocks at a 15% or higher discount to fair value, which makes both Qualcomm and Kroger some of the few undervalued names you can buy in today’s frothy market.
Bottom Line: Qualcomm and Kroger Will Likely Turn Things Around Presenting A Potentially Great Opportunity For Higher-Risk Investors
Don’t get me wrong, contrarian value investing isn’t for everyone. You need to be comfortable taking a VERY long-term, big-picture view and dealing with plenty of fear, uncertainty, and doubt in the short to medium term. It also means potentially experiencing a lot of volatility, which is something most investors would rather avoid.
Then again, it can also be an exceedingly profitable endeavor, and if you have a long enough time horizon and a high enough risk-tolerance, both Qualcomm and Kroger could prove excellent, contrarian income growth investments.
That’s because, based on the excellent track records of both companies to navigate their respective, challenging industry conditions over past decades, as well as the long-term growth potential, I’m confident that both QCOM and KR will once more rise like a Phoenix from the current short-term ashes (Amazon can’t dominate every industry).
Which is why I’m more than happy to lock in their highest yields in over a decade (or ever) and patiently wait for their likely turnarounds to play out and their share prices to recover nicely.
Disclosure: I am/we are long QCOM, KR.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.