PROF.

PETER DEMARZO
FINANCIAL VALUATION

THE NETPHONE PROJECT

INTRODUCTION

Qualcomm is considering the development of a cordless/cellular combo phone that would serve to
combine a cordless telephone and a full cellular mobile phone into a single device. The device
would combine existing cellular technology (CDMA) with standard wireless technology protocols
(WiFi).

Consumers could use this device in cellular mode when outside the home at regular connection
fees and rates (just like a standard cell phone). But when inside the home or office, the phone
would connect through the user’s WiFi router to the internet and the provider’s VoIP server to
route the call. This would allow the consumer to make calls at VoIP connection fees and rates,
which are typically much lower than cellular rates.

A 6-month, $250,000 feasibility study for the project has produced the following estimates:

Market size, timing and revenue projections

The target market for the NetPhone includes upscale residential and business users. Estimates
indicate a total potential market of approximately 100 million users worldwide with the
appropriate profile. Ultimate market penetration is expected to be 20% of the available market.
(There is a great deal of uncertainty surrounding this estimate, however, with a best case scenario
of 30% and a worst case of 7.5%.)

The product has a life expectancy of 4 years. After that the technology is likely to become obsolete.
Approximately 25% of the total anticipated sales are expected during each of the 4 years.

The projected retail price of the NetPhone is $70, with an average sales price of $62.50 after
allowing for typical end retailer / operator discounts and subsidies. Qualcomm will not
manufacture or sell the phone itself, but will only provide the core technology; as a result
Qualcomm will receive revenue equal to 20% of the average sales price for providing its chipset
and software.

If launched, the NetPhone is expected to displace sales of certain existing Qualcomm products.
Estimates are that, in the absence of the NetPhone, approximately 40% of the anticipated
Professor Peter M. DeMarzo, Mizuho Financial Group Professor of Finance prepared this case as the basis for class
discussion rather than to illustrate either effective or ineffective handling of an administrative situation. While based
on an actual case, the data has been simplified for expositional purposes.

Copyright © 2014 by the Board of Trustees of the Leland Stanford Junior University.
The NetPhone Project p. 2

customers would have purchased alternative Qualcomm devices with an average sales price (for
Qualcomm content) of $5 per unit and an average cost of goods sold of $3 per unit.

Development cost estimates

Developing the new hardware will be relatively expensive as it will involve engineering, testing,
and fabrication of combined technologies. Estimates for the required hardware R&D are
approximately $10 million. Overall, the hardware design and engineering is anticipated to take
nine months.

An additional $20 million will be spent on lab equipment to test the design and verify its
implementation and compatibility with existing wifi protocols. This equipment will be installed
after product development is completed, and straight line depreciated over the subsequent 4 years.

In addition to the hardware requirements, new software applications must be built for the
NetPhone. This software development project requires coordination with each of the service
providers and is expected to take a dedicated team of 50 software engineers a full year to develop.
The fully loaded cost of a software engineer is $250K per year (including options expenses).

Manufacturing cost estimates

Ultimate manufacturing of the product will be outsourced. The contract manufacturer has
estimated that the component costs and packaging are expected to be $6 per device.

Sales, General, and Administrative expenses

All aspects of the development of the NetPhone can be housed in existing Qualcomm facilities, so
no new facilities will be needed. Once the product is developed, 125 regional sales and support
personnel will be required to provide support for the product as an added responsibility. On
average, approximately 10% of their time will be devoted to the NetPhone product. Each full-time
headcount costs $200K per year.

In the year prior to the product’s launch, upfront training of involved personnel will be required.
In addition, Qualcomm plans an initial marketing campaign for the NetPhone. A total budget of
$500K has been allocated for initial training and marketing.

Other considerations

It is expected that the retailers/operators selling this device will demand more favorable terms than
usual. Thus, receivables are expected to be 16% of revenues (60 days). Furthermore, the contract
manufacturer has demanded stricter terms, so that payables will be about 10% of the cost of sales
(36 days). Incremental profits are subject to a 40% marginal corporate tax rate.

In order to benchmark to Qualcomm’s existing operations, attached are Qualcomm’s financial

statements from 2011.
The NetPhone Project p. 3

Key Questions

 What are the key costs and benefits of the NetPhone project?
 What NetPhone’s gross margin? How does it compare with Qualcomm overall?
 How would the NetPhone affect Qualcomm’s earnings each year?
 How would the NetPhone change Qualcomm’s available cash each year?
 Does the NetPhone justify the required investment of cash and other key resources?
 How would you determine the value of this opportunity? How will it affect
Qualcomm’s share price?
 Should Qualcomm develop the NetPhone now?
The NetPhone Project p. 4

Exhibit 1
Qualcomm Balance Sheet (December ’11) -- Amounts in $ millions

Assets Liabilities
Cash & ST Investments 11,540 Accounts Payable 974
Accounts Receivable 1,035 Accrued Comp & Exp 1,943
Inventory 714 Deferred Revenue 543
Other Current Assets 745 Other Current Liabilities 606
Short-Term Debt 928
Total Current Assets 14,034 Total Current Liabilities 4,994

Marketable Securities 10,438 Deferred Revenue (LT) 3,535

Prop/Plant/Equip. (Net) 2,607 Capital Leases 149
Intangible Assets (Net) 3,093 Other Liabilities 431
Goodwill 3,624
Other Long-Term Assets 3,810 Long-Term Debt 0
Total Assets 37,606 Total Liabilities 9,109

Total Stockholders' Equity 28,497

Total Liabilities & 37,606

Stockholders' Equity

Exhibit 2
Qualcomm Income Statement (FYE, Sep ’11) -- Amounts in $ millions

Income Statement 2004 2005 2006 2007 2008 2009 2010 2011
(FYE, in $ millions)
Total Sales 4,880 5,673 7,526 8,871 11,142 10,416 10,991 14,957
yoy growth 26.9% 16.3% 32.7% 17.9% 25.6% -6.5% 5.5% 36.1%
Cost of Sales -1,484 -1,645 -2,141 -2,642 -3,414 -3,181 -3,517 -4,670
Gross Profit 3,396 4,028 5,385 6,229 7,728 7,235 7,474 10,287
Gross Margin 70% 71% 72% 70% 69% 69% 68% 69%
Operating Expenses:
R&D -639 -911 -1,186 -1,417 -1,769 -1,837 -1,916 -2,068
Selling, General & Administrative -466 -531 -742 -1,054 -1,219 -976 -1,036 -1,043
Stock-Based Compensation -495 -493 -541 -543 -573 -816
Depreciation & Amortization -163 -200 -272 -383 -456 -635 -666 -1,061
Operating Income 2,129 2,386 2,690 2,883 3,744 3,245 3,283 5,300
Other Income/Loss -10 -14 -1,145 -569
EBIT 2,119 2,386 2,690 2,883 3,730 2,100 3,283 4,731
EBIT Margin 43.4% 42.1% 35.7% 32.5% 33.5% 20.2% 29.9% 31.6%
Interest Income/Expense 184 423 466 743 96 -24 751 661
Income Before Tax 2,303 2,809 3,156 3,626 3,826 2,076 4,034 5,392
Taxes -583 -666 -686 -323 -666 -484 -787 -1,132
Net Income 1,720 2,143 2,470 3,303 3,160 1,592 3,247 4,260
Net Profit Margin 35.2% 37.8% 32.8% 37.2% 28.4% 15.3% 29.5% 28.5%

Total Shares Outstanding 1,616 1,638 1,659 1,660 1,636 1,656 1,643 1,658
EPS 1.06 1.31 1.49 1.99 1.93 0.96 1.98 2.57
yoy growth 103.2% 22.9% 13.8% 33.6% -2.9% -50.2% 105.6% 30.0%