Intel (NASDAQ: INTC) has signaled its intent to supply chips for roughly 40 million tablets next year. Now, while Intel is employing some pretty aggressive short-term tactics to gain substantial market share in the tablet market by shoehorning a high-end part into mid-range and low-end products (and subsidizing the platform bill-of-material costs to enable this). While Intel won't see much (if any) net revenue from these actions, the more interesting question is how this affects ARM Holdings (NASDAQ: ARMH).
The impact to ARM's financials
ARM licenses semiconductor IP to its customers who then take that IP, design chips around said IP, and then sell them to device vendors (or, in some cases, the device vendors are ARM's customers). From the sale of each chip, ARM collects a royalty on the order of 1%-2% of the chip's selling price (depending on just how much ARM content is in the chip). Just about every tablet and smartphone today contains ARM's IP for its applications processor.
So, the question that ARM investors need to ask themselves is just how material Intel wins in the tablet space (on the order of 40 million-60 million units during 2014) will be to the firm's top and bottom lines. It is worth exploring this from two perspectives: a licensing perspective and a royalty rate perspective.
Licensing revenues: unlikely to be a material impact
The first revenue stream that ARM enjoys is from processor/architecture licenses. These are one-time, potentially recurring, fees that are paid up-front for the rights to either use ARM's processor designs (such as the Cortex A CPUs or the Mali GPUs) or an architectural license with which the licensee can design its own processor core that is compatible with the ARM instruction set.
It doesn't seem likely that ARM's licensing revenues will be materially affected by Intel gaining a sizable chunk of the tablet market in the short-term, since the licensing fees are largely unit-volume agnostic. The longer term problem on the licensing side of things would be if smaller ARM competitors in the mobile space were simply driven out and no longer licensed ARM IP. This seems like a long-term inevitability as the mobile chip space is exceptionally crowded.
Royalties – let's do some math
ARM saw 2.5 billion processor shipments in Q3 2013 and royalty revenue of $122 million, implying an average royalty per chip of $0.04. Now, what's interesting is that the majority of these volumes are very low cost micro-controllers. Assuming that a mobile SoC costs $20 and assuming that ARM's royalty rate is between 1.5% and 2% of the chip's selling price, the financial impact could look something like the following.
Take 40-60 million units, multiply by $20, and then multiply by 0.015 – 0.02. This yields a potential royalty rate loss in 2014 of anywhere between $12 million and $24 million dollars for the full year. This suggests that from a near-term financial perspective, the market share loss to Intel is much more of a "sentiment" problem for ARM than it is a financial problem. The "sentiment," however, could turn ugly if investors start to extrapolate further share gains from Intel in tablets and meaningful headway across the board in smartphones.
The offset here, though, is that the tablet market is still growing. Indeed, even with the share loss next year, ARM will still see growth by virtue of end-market growth. However, that growth will be significantly diminished as a result of the share loss. It will get worse as the market begins to mature.
The sentiment thing
The reason that sentiment for a stock like ARM is so important is that the company trades at ~100x trailing-twelve-month IFRS (this is similar to GAAP) earnings. Clearly, there is a lot of positivity baked into the stock which means that the company is highly susceptible to news flow. If it starts becoming apparent that Intel is a long-term threat to ARM's financials (and large share in tablets and phones would do it), then the stock will see a pretty significant repricing downward on the multiple since the financial impact would eventually follow.
Foolish bottom line
ARM still has another really good year (financially) to itself as Intel probably won't take large quantities of the smartphone market until late 2014/early 2015 with the launches of SoFIA and Moorefield/Broxton. The question, though, is just how Intel's tablet push will affect longer-term sentiment in both tablets and smartphones. Wall Street is very forward looking and any signs that Intel's push is building significant momentum could be very bad news for this very expensive stock.
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