ARM Holdings Gets Whacked

It's worth prefacing this article by complimenting the management team of ARM Holdings (NASDAQ: ARMH  ) , the premier vendor of microprocessor IP for a wide variety of applications. While the company spent most of its life pre-iPhone developing very low-power, low-performance CPUs for embedded applications, the company has truly come a long way since the ARM architecture became the de facto instruction set in mobile computing.

Not only has ARM worked with its numerous partners (including Qualcomm, Samsung, NVIDIA, and Apple) to provide as much (or as little) support as necessary to bring these low-power/high-performance SoCs to life by providing either processor or architecture licenses (that allow the customers to design their own CPU designs to life), but it has become a one-stop shop for all semiconductor IP.

ARM does a lot more than processors
Yes, ARM is well-known for its "Cortex" line of processor designs for low-, mid-, and high-end smartphones/tablets, but it's also worth noting that the company is really pushing hard with its own graphics IP (known as "Mali"). While ARM's IP isn't quite up to snuff with the IP that rival, Imagination Technologies (LSE: IMG  ) , offers, the company is getting better with each generation.

Further, ARM continues to expand its content share across its licensees by offering a broad range of physical IP (i.e. what is required to do the physical layout of system-on-chip products). While the bigger players such as Apple or Samsung typically do their own physical IP, the weaker/smaller players such as MediaTek and Allwinner are more than happy to use ARM's IP.

ARM is still super expensive
Despite all of the good that ARM's management has done to really build shareholder value (it's a ten-bagger from 2009), the stock is pretty richly valued at nearly 100 times trailing-12-month earnings. Now, while an IP company with a wide moat like ARM certainly deserves a richer multiple than most, trees don't grow to the sky and – once competition from Intel (NASDAQ: INTC  ) and perhaps Imagination via MIPS – comes in from the CPU IP side, the multiple may further contract.

Now, what's interesting is that while MIPS CPU IP (from Imagination) is quite good, the biggest barrier to entry there is on the software side of things. Today's Android applications are mostly architecture agnostic, but there are still come native applications that need to be recompiled. Intel has the sheer financial might to pay developers to port their software (which in some cases is as simple as a recompile but in others requires more nuanced work), and it has a need to really succeed in the smartphone/tablet space (since the core PC business has largely flat-lined), so it's pretty likely that it will succeed in "breaking in" (eventually). 

Imagination, on the other hand, doesn't necessarily need to attack ARM in its core mobile processor markets as MIPS is well accepted in other segments such as networking and micro-controllers (although mobile share would be lovely and would help defend its graphics share). While ARM is making inroads here, MIPS under Imagination, has been better at keeping ARM at bay than MIPS was as a stand-alone entity. 

At any rate, if Intel and/or Imagination (MIPS) are able to gain meaningful processor share, then ARM may see a significant downward repricing as what is perceived to be an impenetrable moat starts to look not-so-impenetrable. One may argue that ARM is trying to move into traditional Intel/MIPS markets, but considering ARM dominates processor volume share shipments, it has much more to lose than to gain.

Foolish bottom line
While ARM is a fantastic company that is likely to continue to succeed in the future, it's hard to get excited about the shares anywhere close to $50. A discounted cash flow suggests that ARM would need to grow FCF in excess of 30% compounded over the next 10 years simply to justify the current price, let alone any meaningful appreciation. When/if the shares pull back dramatically, it may be time to buy once more. But for now, the sidelines-as Deutsche Bank's downgrade to "hold" implies-look like the place to be. 

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  • Report this Comment On January 12, 2014, at 12:13 PM, tempest669 wrote:

    Ashraf, does MIPS allow Imagination to have a better grasp of the future cloud technologies on servers? As an IGNMF investor, I think part of the markets hesitancy is trying to understand not just what MIPS has been, but what MIPS can do in the future. Thanks!

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