ARM: High-End Smartphone Growth Is Tapped Out for Now

ARM Holdings (NASDAQ: ARMH  ) announced earnings that missed both revenue and EPS estimates. Revenue of $116.3 million and EPS of $0.03 were slightly below consensus $118.6 million and $0.04. The source of the weakness was royalty revenue, which was up only 6% year-over-year, compared to licensing revenue, which was up 28% year-over-year. Overall, revenue grew at a healthy 15% rate, just below what investors were used to seeing from the company that acts as the arms supplier to all combatants in the smartphone wars.

Weakness in royalties was primarily in processors, which slowed from 16% in the third quarter to 6% in the fourth quarter. The smaller physical intellectual property royalty business was in line with prior quarters in mid-single digits. This is very disappointing because it seemed to catch both management and investors off guard in a business that recognizes revenue one quarter in arrears.

Insight from smartphone vendors
Apple's  (NASDAQ: AAPL  )  recent weakness underscores the slowing growth at the high end of the market that will flow through to ARM next quarter. In the most recent quarter, Apple shipped 51 million iPhones, which is a good number, but is up only 6.7% year-over-year. Comparing this with the September quarter shows a dramatic decrease from the 25.6% in the prior quarter.  

It's important to remember the handset vendors lead ARM, not the other way around.  Royalty payments are recognized one quarter in arrears, and if Apple has a mid-year product release with compelling features that drive a major upgrade, this upside will flow through to ARM. If, for example, Apple released an updated iPhone in the June quarter, the 31.2 million units shipped last year could represent an easy comp that would benefit both ARM and Apple. There are often speculative rumors about Apple's upcoming products. But this year, with data points coming from China about live iPhone 6 testing units and Apple funding a manufacturing build out for a partner, a substantial release could be six months out.  

Another leg down for ARM?
For an investor, six months can be a long time. For the full year, ARM's processor royalty grew faster than the overall semiconductor industry by 18 points, according to management. That's a fantastic accomplishment, but can it last? Over 1 billion smartphones shipped in 2013.  Ninety-five percent of them had an ARM Cortex processor, and 70% had an integrated modem. The company is highly regarded, but unless there is an increase in pricing, the smartphone opportunity may be nearly tapped out. This came across in the company's guidance as well, which calls for 2014 revenue in line with market expectations, but with this disclaimer added: "assuming outlook for the semiconductor industry improves." This doesn't inspire much confidence. On the call, management said that 2014 is likely to be a back-end loaded year, which doesn't inspire confidence either .

Future growth is outside of handsets
There are several developing and emerging technologies that ARM is tapping into. The company isn't just a play on handsets, even though that has been the main source of strength over the last three years. Mobile computing, in general, plays into ARM's strengths. Growth in tablets and laptops has room to run, with the company at 50% market share today. The potentially greater opportunity, though, is in wearable computing. If this becomes a trend in 2014, it would represent a new source of growth.

One area that could be a closet growth area could be the automotive industry. Currently, ARM has only 10% of the market, but as personal devices such as media players and smartphones become more integrated with sound systems and networking, this has the potential to increase dramatically. 

Overall, ARM is a market-leading company that has tapped out its near term potential. Over the next 180 days, there could be another leg down for the stock, as recent weakness with handset vendors flows through the company's financials. Later, ARM's growth story could return through developments in wearable computing, market share gains in servers, networking, or automotive. But, near term, it seems to be dead money at best.

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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 February 05, 2014, at 1:35 PM, nofoolingforme wrote:

    Funny, I know alot of people who are about to trade in for a new high end mobile for or trade up to one.

    The conference call was low key in parts but also very very encouraging, in others.

    Maybe you didn't hear the parts that were good and only choose to focus on what you see from a narrow perspective.

    6 percent growth sounds good to me. The share price will rebound, so, it is definitely not dead money.

  • Report this Comment On February 13, 2014, at 6:29 PM, dpelleratgmail wrote:

    Thanks for your comment nofoolingforme I appreciate your perspective and see opportunity as well farther down the road.

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David Eller

I started contributing to the Motley Fool in 2013. I have held research positions at two investment banks and two hedge funds before trying more entrepreneurial ventures. I'm passionate about helping people find freedom in financial independence. Feel free to add comments and start a discussion. I hope to use these articles as forums to learn from you as well as share my opinion.

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