Why ARM Holdings Is a Difficult Short

ARM Holdings, despite an incredibly rich valuation, still remains a difficult short as it lacks a negative catalyst.

Mar 15, 2014 at 4:00PM

A common mistake that many retail/new investors make is to short richly valued stocks and to buy stocks that trade at a modest multiple. But the best analogy to illustrate why this isn't usually a winning strategy is, well, smartphones. Look at the Apple's (NASDAQ:AAPL) iPhone 5s. With a bill of materials of roughly $199, the cheapest model sells for $649, with $100 increases for each tier of additional NAND flash. Is Apple charging a huge markup? Absolutely. Is that premium worth it? Judging by the sales numbers, apparently so.

In contrast, take a look at something like a Nexus 5. It comes with a top-notch processor, more RAM than the iPhone 5s, a bigger screen, faster cellular/connectivity, and so on -- and it sells for just $349. The bill of materials is likely meaningfully higher than that of the iPhone 5s and yet it doesn't sell for nearly as much and the demand isn't close to as robust. Why are people willing to pay so much more for the iPhone 5s than they are for the Nexus 5?

It's a combination of factors
Anybody following the smartphone sector knows that the iPhone 5s is regarded as one of the highest quality phones on the market today from both a hardware and a software perspective. The Nexus 5 ticks all of the hardware checkboxes, but there are real limitations to a stock Android-based device versus a highly polished, ecosystem-integrated iOS device. There's also the value in the iPhone brand that users simply value more than they do the "Nexus" brand. This argument largely works if you replace "Apple iPhone" with "Samsung Galaxy."

And so is the case with ARM Holdings (NASDAQ:ARMH). Yes, it's trading at 90 times trailing 12 month IFRS earnings (this is like international GAAP), but on a non-IFRS basis (i.e., excluding share-based comp and special charges), the stock is trading at 40x the current year's earnings and 31.8x the consensus 2015 earnings. By all means, this is still richly valued, but think about what investors perceive to be getting for their money with ARM:

  • A nearly impenetrable monopoly on CPU IP that goes into mobiles, IoT/embedded, and the beginnings of a strong networking story.
  • A potential server growth story (although to be frank, Intel (NASDAQ:INTC) is probably going to defend its share extremely well making this difficult for ARM to realize long term).
  • An ongoing content-share gain story in handsets, particularly as ARM continues to offer/refine its physical IP, graphics IP, and so on.
  • A transition to ARMv8 (i.e., 64-bit) that should lead to increased royalties per unit in mobiles.

Now, the good news for ARM investors is that these are pretty legitimate reasons to drive a "rich" valuation, particularly given the very long tail and relative security there is to an IP/royalty-based model. The bad news is that if one of these tenets were to be proven false and the revenue growth slowed as a result, then the stock would see a pretty substantial downward repricing.

Does such a catalyst loom?
The only reason to short an individual stock is if you have a fairly near-term catalyst in mind that you want to exploit. For a good long while, the big fear for ARM has been a potential Intel incursion into mobile. Indeed, the decline during 2013 from ~$50 to ~$33 was probably driven largely by the fact that Intel had won the Samsung Galaxy Tab 3, setting the stage for future high-volume ARM socket losses. But as soon as this wasn't actually followed up with a pipeline of Intel-powered Samsung products, the market's sentiment reversed -- again.

If Intel were to show some traction in smartphones and tablets at major players, then this would serve as a fairly negative catalyst for ARM (although to be perfectly fair, ARM's financials would probably take far less of a hit than the sentiment around the stock would). But it would take more than just one marquee design win at this point, and it'd need to be across a variety of partners that have probably never used Intel mobile chips before. Dell doing an Intel-based tablet means something entirely different than Intel winning a line of designs from Samsung.

Foolish bottom line
It's typically a bad idea to short companies with improving fundamentals, so at this time ARM remains a short with a fairly unfavorable risk/reward profile, especially given how reactive it can be to news flow. Until the news turns negative and until ARM starts "missing" quarterly estimates, it will remain a difficult short barring a broad market meltdown. The best shorts are weak companies getting weaker -- not strong companies getting stronger.

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Ashraf Eassa owns shares of Intel. The Motley Fool recommends Apple and Intel. The Motley Fool owns shares of Apple and 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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