Will Anyone Buy ARM Holdings?

British mobile processor designer ARM Holdings (Nasdaq: ARMH  ) is no stranger to speculative takeover rumors. The rumor mill is buzzing again, sending shares more than 9% higher yesterday.

The renewed chatter may be a result of Hewlett-Packard's (NYSE: HPQ  ) recent purchase of fellow Brit Autonomy for a hefty premium and all of the recent fuss over mobile-related IP. It's only natural that the market's attention would turn to ARM.

ARM's technology has become ubiquitous within mobile devices. Qualcomm's (Nasdaq: QCOM  ) popular Snapdragon processor is based on ARM architecture, and there's even been talk that Microsoft (Nasdaq: MSFT  ) will include ARM support in the next version of Windows.

Hypothetical suitors include Intel (Nasdaq: INTC  ) , Oracle (Nasdaq: ORCL  ) , and Apple (Nasdaq: AAPL  ) . Rumors of Apple acquiring ARM surfaced as early as April of last year, and those clearly haven't panned out. ARM CEO Warren East has promptly gotten in front of the recent round of rumors, dismissing the idea in an interview with British newspaper The Daily Telegraph. However, East's comments did little to quell the rumor-driven rally.

Too expensive, even for Apple
Sure, with $75 billion sitting around Apple could afford to simply cut a check, but should it? No.

With ARM's current market cap around roughly $10.9 billion and the presumption that any offer would be at a substantial premium, the final price tag could end up in the neighborhood of $15 billion to $17 billion. What would Apple be getting for all those zeroes?

ARM's most recent quarterly revenue was $190.2 million, which pales in comparison to Apple's $28.6 billion. Apple already has access to the technology through its licenses, and since many of them are perpetual and last forever, competitors that already hold those licenses would only be inconvenienced at most. Apple wouldn't be able to simply invalidate the existing perpetual licenses at its discretion, but it could theoretically block additional future licenses.

Since ARM's business model relies on licensing its technology to multiple semiconductor manufacturers and OEMs, a lot of the company's value is derived from its unique place within the supply chain and from its impartiality. It also generates royalty payments from every chip produced with ARM's architecture and, together with licensing revenue, is able to recover its R&D expenses and subsequently pump out fat margins.

If Apple were to corner ARM's technology with an acquisition to prevent future licenses to competitors, it would significantly and immediately hinder the value of what it just paid for. Besides, Apple's acquisitions are typically small names and highly specialized. In recent years, it already had two processor related purchases: P.A. Semi for $278 million and Intrinsity for $121 million.

As tempting as it is to jump to the conclusion that Apple should buy ARM because of its heavy usage in iPads, iPhones, and iPods, in addition to rumors of ARM-based MacBooks, the notion quickly loses plausibility when you look at the facts. Apple wouldn't be getting any bang for its buck, making it far too expensive.

ARM Inside (Intel)?
The case for Intel acquiring ARM has a little more substance albeit with its own hindrances. ARM is a glaring threat to Intel, and the company's prominence is even comparable to Intel's own past success in the PC market.

The company has expressed interest in expanding beyond its core PC market and into mobile, even considering acquisitions since Intel has been missing opportunities to meaningfully penetrate the mobile market organically with its Atom processor. Meanwhile, ARM-based tablets have been decimating Atom-powered netbook sales.

With both Microsoft and Apple considering putting ARM processors in laptops and desktops in addition to mobile devices, ARM will be encroaching on Intel's home turf. There are numerous compelling reasons why an acquisition by Intel would make sense, but there are other obstacles that would likely stand in its way.

With $11.5 billion in cash on the balance sheet and operating on the above estimate of an approximately $15 billion price tag, an all-cash offer doesn't seem likely unless the company is willing to take on some debt to do so or to include stock in the deal. Intel's recent quarterly revenue was $13 billion, which also dwarfs ARM's sales. With much more similar business operations, Intel would realize more value out of an acquisition through cost-saving synergies than Apple would.

The biggest hurdle for Intel would be scrutiny from antitrust regulators. The company is all too familiar with antitrust claims and probably isn't too anxious to revisit with regulators.

Strong ARM
ARM is well positioned in the growing mobile computing market. With an enviable gross margin of 94.8%, revenue growth of 27%, and more than 95% mobile market share, I'm going to be keeping an eye on the stock and will likely pick up shares in the near future. Even though there are impediments to the usual suspects acquiring the chip designer, the company has been doing just fine on its own and shows no signs of slowing down.

Fool contributor Evan Niu owns shares of Apple, but he holds no other position in any company mentioned. Click here to see his holdings and a short bio. The Motley Fool owns shares of Oracle, Microsoft, Qualcomm, and Apple. The Fool owns shares of and has bought calls on Intel. Motley Fool newsletter services have recommended buying shares of Intel, Apple, and Microsoft; creating a bull call spread position in Microsoft and Apple; and creating a diagonal call position in Intel. 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.


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Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On August 25, 2011, at 10:55 AM, yreuven wrote:

    you contradict yourself within your own article. you articulate how ARMH is not a takeover target because it is too expensive, yet you say that you're going to be buying shares? how do you justify paying 11BB dollars for a company that makes 600mm in sales? rather than finishing the article the way you did, i would have recommended you finish by saying that ARMH would be a perfect takeover target only if it were about 75% cheaper than it is now.

  • Report this Comment On August 25, 2011, at 11:30 AM, TMFNewCow wrote:

    yreuven, I can understand how it would seem contradictory, but the argument that it's too expensive was really only meant to apply in the context of Apple purchasing ARMH. Assuming Apple would pay a heavy premium to acquire the company, and how that would inherently reduce the value of the company since ARMH would no longer be a neutral chip designer.

    On the other hand, I think the current valuation is compelling from the standpoint of an individual investor that's not taking a control perspective and changing the company's strategy. As an individual investor, this is why I am considering a purchase at current prices instead of a big premium for the company as it operates now.

    Hope that adds some clarity!

    Evan

  • Report this Comment On August 25, 2011, at 1:41 PM, thenatural24 wrote:

    ARM's independence is much of its value. While I'd love a large takeover at a huge premium, much of that value would be deteriorated if its was taken over for defensive purposes.

    Evan - I think this is a great company that is unbelievably difficult to value. The company generates its revenue from license and royalty sales. Thse aren't unrelated however, as the licenses sold today will generate royalties in the future - the problem is that future is 4-5 years down the line. I didn't hear the percentage disclosed in the current quarter, but in Q1 they said something like 90-95% of royalty revenue was generated from licenses sold before 2007. And royalties are approx 2/3 of the business and one quarter in arrears.

    My point is - an investor can't just look at valuation as you would a company like Intel or McDonald's. Most people that completely dismiss ARM as too expensive are doing that (ie PE, EV/FCF etc). But I completely agree that it may be too expensive for these companies, but it's not for the average investor.

    Long ARMH

  • Report this Comment On August 26, 2011, at 12:25 PM, ibankingcrooks wrote:

    For those of you who do not, and have not for the last two years, understand ARMH's valuation I suggest your research two thing: microcontrollers and 802.15.4. If you think we have a lot of connected devices now... wait 10 years.

    ARM will not get bought. It would be a direct threat to their customers, and anyone making the acquisition would get this, and realize the immediate devaluation. ARM's price can be justified on earnings and growth potential alone. MIPS on the other hand - there is the acquisition target...

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