Better Buy: Qualcomm Inc or Texas Instruments Inc?

By Markets

Qualcomm (NASDAQ: QCOM) and Texas Instruments (NASDAQ: TXN) once competed against each other in mobile application processors and baseband modems. Qualcomm eventually won that battle, and TI quit both markets to produce cheaper analog and embedded chips for a wide variety of industries.

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The two chipmakers aren't direct competitors anymore, but both stocks have outperformed the Philadelphia Semiconductor Index's 25% gain this year. Qualcomm is up 34% for the year, while TI is up 26%. Let's see which chipmaker is a better long-term pick at current prices.

Image source: Getty Images.

How Qualcomm makes money

Qualcomm is the world's largest mobile chipmaker. Its Snapdragon SoCs (system on a chips) -- which unite application processors, modems, GPUs, and other features onto single chips for smartphones, tablets, and other devices -- generate most of its revenue. But most of its profits come from the higher-margin patent licensing business, which receives a 3% to 5% cut of the wholesale price of every smartphone sold worldwide.

Qualcomm's chipmaking (QCT) and licensing (QTL) businesses both posted robust growth in the early days of modern smartphones. But as the market became commoditized and margins fell, lower-cost chipmakers like MediaTek started stealing market share from Qualcomm. Leading OEMs like Samsung and Huawei also followed Apple's (NASDAQ: AAPL) example and created first-party chipsets to cut costs and maintain tighter control over their own supply chains.

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Meanwhile, OEMs facing paper-thin margins started demanding lower licensing fees. Chinese regulators fined Qualcomm and forced it tolower those fees last year, and other major markets like South Koreaand Taiwan could follow suit. This ongoing pressure on its QCT and QTL businesses has forced Qualcomm to expand into adjacent markets like wearables, drones, cars, and Internet of Things (IoT) devices. That's why the company acquired IoT chipmaker CSR for$2.4 billion last year, and why it might purchase chipmaker NXP Semiconductors (NASDAQ: NXPI) for over $30 billion.

How Texas Instruments makes money

TI generates most of its revenue from analog and embedded chips for connected cars, industrial machines, wireless infrastructure, consumer electronics, enterprise systems, and other devices. Analog chips convert real-world signals like voice, sound, pressure, and temperature into digital signals; while embedded chips perform specific tasks like processing digital signals. Both kinds of chips are much cheaper to produce than high-powered application processors.

Image source: Texas Instruments.

TI's diversified business model allows it to offset weaknesses in certain industries with strength in higher growth ones. For example, TI's growth in personal electronics and communications equipment wasweak last year, but that softness was offset by its strength in the industrial and automotive segments. TI also recently shifted its production from 200mm to 300mm wafers, which reduced the cost of chip production by about 40%.

TI's main weakness is its exposure to Apple, whose orders of IC chips, display drivers, and other components accounted for 11% of its sales last year. If sales of iPhones and iPads peak this year, TI's personal electronics revenue could slump. TI's automotive revenue could also be threatened by Qualcomm's purchase of NXP, which became the world's biggest automotive chips manufacturer after its acquisition of Freescale last year. That's why some analysts believe thatTI could also make a bid for NXP.

Growth and valuations

Qualcomm's revenue fell 5% in 2015, andanalysts expect another 8% decline this year due to the headwinds facing its QCT business. However, newer high-end chipsets and an expansion into adjacent markets might boost sales by an estimated 2% in 2017. TI's revenue fell0.4% in 2015 due to the challenges in personal electronics and communications, but is expected to improve 0.5% this year and 4% next year on the growth of its industrial and automotive segments.

Qualcomm's earnings fell 12% last year due to price declines in chips and licensing conflicts with OEMs and regulators. Its earnings are expected to fall another 8% this year before possibly rebounding 10% next year. TI's earnings rose 9% last year, and are expected to grow 12% this year and another 9% next year. Despite its weaker top- and bottom-line growth, Qualcomm currently trades at 20 times earnings -- which is lower than TI's P/E of 24 and the industry average of 22 for broad line semiconductor companies.

Looking ahead, analysts expect Qualcomm to post 10.5% annual earnings growth over the next five years, which gives it a 5-year PEG ratio of 1.5. While that isn't below the "undervalued" threshold of 1, it's lower than TI's PEG ratio of 2.3, which is based on an estimated annual growth rate of 10%. Both companies have raised their dividends annually for more than a decade, but Qualcomm's forward yield of 3.2% is beefier than TI's 2.2% yield.

The winner: Qualcomm

I think Qualcomm and Texas Instruments are both solid long-term investments, but I believe Qualcomm's lower valuation, higher dividend yield, and better growth potential into adjacent markets makes it a better buy at current prices. TI is still a great core holding for conservative portfolios, but I'd rather buy it at lower multiples.

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Leo Sun owns shares of QCOM. The Motley Fool owns shares of and recommends AAPL, NXPI, and QCOM. The Motley Fool has the following options: long January 2018 $90 calls on AAPL and short January 2018 $95 calls on AAPL. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.