ARM Holdings: Great Business, But Estimates Seem Frothy

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ARM Holdings (NASDAQ: ARMH  ) is one of the world's most successful semiconductor IP vendors on the planet. The company -- which had spent many years as a $5-$10 stock -- got its big break when Apple (NASDAQ: AAPL  ) selected a Samsung system-on-chip powered by an ARM11 core for its iPhone, which kicked off the smartphone revolution.

Before long, ARM went from a company known for making relatively simple cores for embedded applications to the IP vendor of choice for just about every new area of computing -- smartphones, tablets, smart TVs, smart watches, and so on. While the company's story really is great, it's important for investors to mind the valuation.

ARM's growth has been fantastic
ARM's growth drivers are actually rather understated. Many appreciate the obvious headline growth drivers -- namely growth in chip shipments in phones/tablets, growth in micro-controllers, and even the beginnings of the ramp in networking. But the company also has been expanding its content share in each of these devices. Today, ARM provides CPU IP, graphics IP, and even physical IP to its licensees. This increase in IP per chip leads to higher royalty rates per chip -- a good thing for ARM, which derives a good chunk of its income from the upfront license fees for its IP.

To quantify this, note that beginning in 2006, a year before the iPhone launch, ARM's revenue sat at $400 million. Today, the company's top line is on track to punch past $1 billion for 2013 . If the analysts are right, it should see healthy growth to $1.33 billion at the end of next year – representing a cool 19% year-over-year growth. What's more interesting, though, is just how much leverage there is in the business model. Since ARM licenses IP and collects royalties on said IP, the company's robust top-line growth tends to far overshadow any increase in the company's operating expenses. It's a great model, indeed.

It's not all roses
While ARM's growth prospects do look attractive -- smartphone/tablet growth, networking and communications infrastructure, and micro-controllers -- it's not without rather significant risk here at $50/share. While the business does have solid operating leverage, it's important to understand that at current levels, the market is pricing in a lot of growth. Further, while the analysts expect the company to do $295 million in sales in the current quarter, it's important to realize that management only guided to $290 million. ARM has a pretty solid track record of beating its guidance, but note that Wall Street is now wise to this tactic and is baking it into estimates.

On top of that, Wall Street is still expecting some pretty phenomenal growth numbers  -- consensus sits at 18.7% revenue growth. This is probably achievable, particularly as the growth in low-end smartphones represents a royalty uplift from the lower-end feature phones, due to more expensive IP per chip and more of them. But there is very real risk that this growth doesn't come in as great as expected.

Competition in tablets and an aggressive defense in the micro-server space from Intel (NASDAQ: INTC  ) could serve as a meaningful headwind to the growth that many are modeling in. Further, meaningful share gains in tablets on Intel's part could also serve to hurt both estimates and sentiment, as a credible Intel push in mobile will have investors updating their models to account for the potential share loss in both tablets/phones.

Foolish bottom line
ARM is a great company that has done a wonderful job of getting its IP into all key markets for computing and has done an exceptional job of driving up content per chip in a bid to increase its royalty per chip. That being said, the company's valuation -- particularly ahead of a potentially much more competitive Intel in mobile -- makes this Fool queasy.

While ARM may be the world's leading semiconductor IP firm, and while ARM may also have many growth drivers ahead of it, shares would be much easier to own on a pullback. Today, there's just not a whole lot of room for error, making it not very compelling on a risk/reward basis at $50.

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