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Qualcomm's Vulnerable Valuation

A disappointing outlook from Qualcomm for the third quarter isn't sitting well with investors.

By Chris Bulkey, principal analyst at Technology Research Group


(QCOM) - Get Qualcomm Inc Report

shares are set to move lower as investors digest results for the second quarter of fiscal 2010.

Earnings quality irregularities don't appear to be a catalyst for thislatest round of volatility. Recall that declining operating leverage, liberal use ofasset impairments to stabilize expense levels, backlog reduction, and aggressivemanagement of valuation allowances were a few of the items criticized in previousreports (with commoditization of CDMA technology the underlying cause).

A disappointing outlook for the third quarter isn't sitting well with investors.Guidance suggests earnings will be flat to down slightly on a year-to-year basis in both GAAP and pro forma terms. A sustainable growth rate -- return on equity multipled by retention rate -- in the 6% range aggravates an already unfavorable risk/reward tradeoff.

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An unhealthy variance between pro forma and fully expensed earnings expectations adds fuel to the fire. Consensus GAAP EPS forecasts are roughly 19% and 14% below pro forma for fiscal 2010 and 2011, respectively. Estimates that aren't fully expensed overstate growth potential and understate corresponding valuation multiples.

Shares are down 9% year to date and valued at 32 times trailing GAAP earnings. Loose comparable



trades at 280 times due to depressed profitability. A multiple on trailing earnings more than five times above sustainable growth leaves Qualcomm's valuation vulnerable to a potentially sizeable correction.

We reiterate a sell rating and $36 price objective; target multiple goes to 16 times fiscal 2010 EPS estimate from 20 times.