VOLUME IV: ISSUE II

OCTOBER 2013

Letter from the vice preSident

Kevin Goldfarb
Dear WUFC members, The Financial Analysis Committee, as part of the Wharton Undergraduate Finance Club, has been hard at work drafting our newsletters for the semester. We are in the process of expanding our output to include both a blog and a daily market report. Our Daily Market Report will be accessible on Twitter, and Facebook. Our blog and will give you a run-down of everything that happened in the days market as well as what is expected to happen. The purpose of our committee is to assist students preparing for interviews answer market related questions, inform individuals about important or interesting market events, and relay information about events that the club is hosting. We hope that you enjoy another year of our newsletters and welcome the new additions we are making. As the Vice President of Financial Analysis, I am pleased to announce that this issue will explore many topics of interest to our community, ranging from stock pitches to technical and market analysis. I would also like to belatedly welcome everyone back from Summer Break and wish everyone a great Fall semester. I hope that all readers enjoy this issue and find value in our work. As the Vice President and editor, I appreciate any feedback or suggestions related to this publication. Best Regards, Kevin Goldfarb

Spin-offS:
Roni Luo

A niche market of high returns

Why consider investing in spin-offs? First off, why should you consider investing in spin-offs? After all, these divestitures havent proven their ability to operate profitably as independent companies, and you can find much more robust data available for analysis on existing companies in the market. The simple reason is that spinoffs tend to perform better than their parents and the overall market. According to a Credit Suisse study, spin-offs from 1995 through 2012 yielded returns that exceeded the S&P 500 returns by an average of 13% per year. If you need evidence from more recent data, on a year-to-date basis, Guggenheims spin-off ETF is outperforming the S&P 500 index by 12.47%. However, beware of rushing into spin-offs the moment they become publicly traded studies have found that the typical spinoff actually underperforms the S&P 500 over its first 27 days of trading, with a trough being reached within its first week. Trading Patterns Imagine that you are a fund manager at a large asset management firm, and that your funds mandate is to invest in software companies. Your fund currently holds Epazz, Inc. (EPAZ), a leading provider of cloud based business software solutions. Epazz has been working on a new mobile power device, which lies outside its core software business. However, as long as Epazzs main line of business remains software, it is eligible for your fund. Now, lets say that Epazz divested this hardware division (which it did in fact announce). As a shareholder, you will receive shares of the spin-off company, but now you face a problem: the new company that your fund owns no longer fits the funds mandate. So what do you do? Naturally, you dump these spin-off

Story continued on page 4, Spin-offs quALcomm (qcom): smARtphone wAve

ryan chen

quAntitAtive eAsinG expLAined

Kevin Lai

INSIDE THIS ISSUE

Wharton underGraduate finance cLuB

octoBer 2013

QuaLcomm (nYSe: Qcom)

surfing the smartphone wave
By Ryan chen
In the second quarter of 2013, smartphone sales reached 237.9 million units, surpassing feature phone (non-smartphone) sales for the first time. The smartphone market has been growing at a rapid pace and shows no signs of slowing down. In fact, according to IDC, the market grew at a year-over-year rate of 52.3%, the highest in five quarters. However, in the six years since the release of the iPhone in 2007, competitors have rushed into the smartphone market to grab their share of the rapid growth. With the massive influx of players, including heavyweights such as Microsoft and Googles Motorola Mobility division, competition has become heated and margins have been whittled down. Thinking beyond the well-publicized smartphone vendors, you should consider Qualcomm (QCOM), a supplier of integrated circuits for mobile devices. As the leading chip supplier to the biggest smartphone vendors, Qualcomm provides an excellent opportunity to gain exposure to the growing smartphone market without being exposed to the risk of shifting consumer tastes between specific smartphone brands. Qualcomm is an attractive investment for three reasons: its market leadership position in the mobile chip market, its differentiated high-margin business model of licensing its enormous patent portfolio, and its shareholder-friendly policies are manifest in the companys dividend growth and aggressive stock buyback programs. Company Overview Qualcomm develops and supplies integrated circuits and system software based on CDMA (Code Division Multiple Access), OFDMA and other technologies for use in voice and data communications, networking, application processing, multimedia and global positioning system products. The Company had an outstanding third quarter in 2013, increasing revenues 35% to $6.24 billion, increasing operating income 18% to $2.04 billion, and beating the consensus EPS with a result of $0.92. Its main revenue driver is its Snapdragon line of microprocessor chips for mobile devices, a well-established product integrated into the iPhone, iPad, Samsungs line of Galaxy devices, HTC devices, and recently Googles Nexus 7 tablet. Market Leader As the pioneer of CDMA, Qualcomm enjoyed the first mover advantage when smartphone usage skyrocketed with the introduction of 3G. Over the years, Qualcomm has capitalized on its successful bet on mobile chips by becoming the number one provider of mobile processors. Today, Qualcomm holds a 50% market share in the $7.9 billion smartphone application processor market and a 86% market share in the newer LTE cellphone modems. While rivals like Nvidia, Intel, and Broadcom are developing their own LTE chips and are a major threat to Qualcomm, adoption among smartphone vendors have been slow, with Google recently choosing to switch from Nvidias Tegra microprocessor to Qualcomms Snapdragon for its Nexus 7 tablet. Qualcomm has been able to protect its market share through the close channel partnerships it has built downstream with companies like Apple, Samsung and HTC. These strong relationships show no sign of weakening. In fact, Qualcomm recently entered into a partnership with China Mobile, the worlds largest carrier with 670 million subscribers, to develop a chip compatible with China Mobiles proprietary TD-SCDMA technology. With less than 20% 3G penetration, Qualcomm will be able to capitalize on the future wave of 3G growth in the emerging markets. High-Margin Business Model Qualcomm not only has a dominant position in market share, it generates very high margins from every chip it sells. Its 60% gross margin is higher than any of its major competitors and customers, including Apple. The reason it is able to generate such high margins is its unique licensing business model. Qualcomm holds over 13,000 patents, the majority in mobile patent applications, so the company collects royalties on nearly every smartphone sold. For example, every Apple iPhone 4S contains $23.54 worth of Qualcomm parts. Moreover, the company cuts costs through a fabless strategy outsourcing the manufacturing of its chips to third-party contractors. According to Qualcomm CEO Paul E. Jacobs, what happens when you run a fab is you end up worrying all of the time about what you are doing to fill the fab. Qualcomms fabless strategy allows it to focus solely on its competitive strength of chip design and development. With its high R&D spending (in 2012, it spent $3 billion on R&D, over 20% of revenues), Qualcomm is well positioned to preserve that competitive advantage. Shareholder Friendly Since Qualcomm started issuing dividends in 2003, the companys dividends have grown steadily, from $.09 /share to $.93 /share, which results in a forward annual dividend yield of 2.10%. Management has also been increasing share buybacks at an aggressive pace. In the third quarter of 2013, Qualcomm repurchased $3.2 billion worth of shares, much larger than the $1 billion repurchase in the previous quarter. The large size of the repurchase eclipsed analyst estimates and indicates managements confidence in the companys mid-term fundamentals. Qualcomm is well-positioned to capitalize on the growth in the smartphone market, especially as adoption increases in the emerging markets. If you are looking for a dividend stock that also has upside potential, consider buying Qualcomm.
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octoBer 2013

Wharton underGraduate finance cLuB

What You need to KnoW:

quantitative easing
By Kevin Lai
After Chairman of the Federal Reserve Ben Bernanke announced tapering earlier this year, interest rates were expected to rise as the central bank weaned off quantitative easing (QE). However, Bernanke reneged on his earlier comments in the third week of September, indicating there would be no tapering of existing QE. Brief Background on Quantitative Easing Anemic growth and record unemployment levels following the 2008 crisis prompted the Fed to implement the QE program to reinvigorate spending and reduce excess capacity. The Fed issued money to buy back bonds and other financial assets from banks. The idea was that, in turn, banks would use the cash available to make loans and finance projects that created jobs and stimulated organic economic recovery. By buying up the outstanding bond supply, the Fed propped up bond prices and yields dropped, effectively decreasing borrowing costs. The program was expanded from $600 billion in late 2008, and later to an indefinite $85 billion/month bond buyback in late 2012. Recent M&A Environment Before Bernankes announcement, analysts expected the monthly bond purchases to decrease to $65 billion by the end of this year. In the past 5 months, rising interest rates have threatened to make financing for M&A transactions increasingly expensive. While the threat of more expensive financing provides an incentive for buyers to get deals done, it also creates an impediment to negotiations by intensifying valuation disagreements. What is interesting about the current environment is that conditions that generally favor M&A have existed for quite a while. We are in a period of historically low interest rates and there are low organic growth opportunities for firms who are holding record cash balances on their balance sheets. Despite all of this, recovery in M&A activity has been slow. Likely, the repeated macro shocks the Fiscal Cliff, Euro Zone Crisis, slowing growth in the Chinese economy, heightened antitrust scrutiny, instability in the Middle East have fostered a strong risk aversion among corporate leaders. Corporations have generally scaled back on capital expenditures. Similarly, exports to China and Europe have largely slowed down. This air of caution is reflected in rising reverse termination fees. The paper 2012 Transaction Termination Fee study released in June by Houlihan Lokey reveals that the median reverse breakup fees as a percentage of transaction value increased from 3.5% in 2008 to 4.7% in 2009, to over 5% in 2012. These
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fees are paid by the buyer to the target if the deal does not close, typically due to insufficient committed financing. Naturally, its the sellers who request the amount of the reverse termination fee, and they will push this amount up on the buyer if they think there is more risk that the transaction will not go through. The increase in these fees reflects heightened cautiousness toward M&A from business leaders. According to an interview with Gregg Lemaku, Head of Global M&A at Goldman Sachs, the M&A environment of the past 3 to 4 years has been characterized by take-private transactions from financial sponsors and divestitures from companies looking to focus more on core competencies. There have been fewer large strategic transactions. However, this trend is gradually reversing, as companies have demonstrated renewed receptivity to strategic deals. In 2012, strategic add-on transactions accounted for the majority of US M&A deals, driven by the energy sector, where companies sought to increase geographic scale and reduce costs. Corporate boards still seem to be unreceptive to transformative deals. Are rising interest rates a credible catalyst to M&A activity? A comparison of M&A activity before and after Bernankes tapering comments shows an increase in both the number and average value of deals announced. The rate of increase during these periods is greater than the historical increase in deal growth. From this data, it seems that the threat of paying higher rates on deal financing might serve as a credible catalyst for getting deals done. The increases in M&A activity in the periods shown had significant fundamental drivers. The period from 1981 to 1988 saw the breakup of huge underperforming corporate conglomerates that had formed in the mid-1960s to early 1970s. This decade also saw the popularization of LBOs and increased use of junk bonds to finance transactions. Both developments created sizable deal flow during this era. There was also a wave of activity from 1992 to 2000, driven by sector focused activity arising from deregulation of banks and rapid technological innovation. Consequently, this was a period of many large strategic mergers. 2003-2007 saw more cross border and horizontal mergers. Transactions during this period were driven more so by the appeal of low interest rates within an economic bubble. Thus, in all periods where M&A increased in line with rising interest rates, there were other, more substantial fundamental drivers. Perhaps instead, the threat of rising interest rates only serves as a credible catalyst under certain circumstances. Logically, higher valued deals and transactions with buyers with high existing debt ratios would be more sensitive to interest rate fluctuations.

Wharton underGraduate finance cLuB Spin-offs, story continued from front page
shares as soon as possible, regardless of whether you believe them to be a good investment. With many asset managers acting similarly, its easy to see how the supply generated by fund restrictions can contribute to a dip in price for spin-offs in their initial days of trading. On the demand side, buyers are more cautious due to the greater uncertainty involved in investing in spin-offs, and analysts dont tend to focus on spin-offs immediately much more attention is paid to the larger parent companies. Benefits of investing in spin-offs Apart from the obvious reason of higher long-run average returns, there are several benefits to considering spin-offs as potential investments. Spin-offs, which are typically in a single line of business, are much simpler to analyze and value than complex businesses. In fact, simpler businesses tend to trade at higher P/E ratios than complex businesses. The implied downside of this, of course, is that simpler businesses are less frequently undervalued. Spin-offs also tend to be smaller firms, which are typically valued at higher earnings ratios than giant conglomerates due to the greater growth potential of smaller firms. Risks of investing in spin-offs Spinoffs are not an exception to the investment rule that

octoBer 2013
higher returns imply greater risk. Spin-offs are, on average, much more volatile than the market indexes that they outperform. In 2008, the Guggenheim Spin-Off ETF plunged 55.2%, 17% worse than the S&P 500. The standard deviation of returns for 12month-old spin-offs is 82%, according to the Credit Suisse study mentioned above. For highly risk-averse investors, building a portfolio of spinoffs may not be a good idea. However, I urge those with more risk tolerance to consider investing in spin-offs in the higher-yield portion of your portfolios. How to invest in spin-offs Good places to begin your search are www.stockspinoffs.com and www.spinoffresearch.com, where you can find updated spinoff announcements across industries. The next step is to analyze and value the spin-offs of your choice. Given that spin-offs were previously only divisions of a larger parent company, you might be wondering how to obtain financial results for a spin-off. More data is available than you may expect. Financial results for spin-offs are often provided as part of SEC spin-off filings on a pro forma basis, which shows the hypothetical results of the spin-off had it been a standalone company immediately prior to being divested. Even if you are confident in your valuation of the spin-off, it is wise to observe the stock for a bit and wait for signs of confirmation from the market before purchasing.

Kevin Goldfarb Editor-in-Chief

Vice President of Financial Analysis

Shruti Shah
Senior Managing Editor

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Jenny Qian
Managing Editor

Jasmine azizi, alejandro villero & ese uwhuba

Copy Editors

Questions or comments? please send your suggestions to Wufcfa@gmail.com

Guilherme Baiardi, tony murphy, matt parmett & teddy Xiong

Senior Financial Analysts

charles Bagley, JeonKang, Karan parekh, matt evans, Kevin Lai, roni Luo &ryan chen
Financial Analysts

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