ARM Holdings' Royalty Growth Slows to a Crawl

ARM Holdings (NASDAQ: ARMH  ) is the world's leading processor IP vendor. It designs a bevy of processor cores from extremely tiny cores intended for embedded systems like the Cortex M0 to ultra-fast speed demons like the Cortex A57, which will be found in next-generation high-end mobile processors like the Qualcomm (NASDAQ: QCOM  ) Snapdragon 810. While this company has been on a veritable tear over the last five years, it seems that the growth story has slowed to a crawl.

Licensing up but royalty growth down significantly
In the most recent quarter, the company reported processor licensing growth (licensing is the initial, up-front fee to use the given processor IP) was a robust 38% year over year -- although it is important to keep in mind that this business is extremely lumpy. More importantly, and perhaps more troublingly, is that processor royalty revenues were up just 8% year over year. Royalties are collected on chips sold containing ARM IP and are key to ARM's business model.

ARM attributes this to an inventory correction in the mobile supply chain, so the implication is that the growth rate should reaccelerate given that TSMC (NYSE: TSM  ) reported that demand picked up pretty significantly in Q1 relative to its expectations (this would affect ARM's Q2 results). That said, it does appear that ARM's growth has slowed significantly, largely in concert with the maturation of the smartphone and tablet markets.

There is still content share gain to be had and other markets to pursue, but is it material?
ARM's royalty growth story has been one of both content share gain (i.e., more/pricier CPU IP, GPU IP, physical IP) as well as raw unit growth. It seems that most of the mass-market smartphone/tablet chip vendors have already adopted quite a bit of ARM's IP, so the room for content share gain in those markets seems fairly limited. And, of course, with smartphones/tablets maturing, the opportunity for the explosive royalty-bearing unit growth is quickly going away.

There are also continued claims that the micro-server/networking/communications infrastructure markets will be fairly significant growth driver here, but given that Intel's (NASDAQ: INTC  ) product offerings are exceptionally competitive in the larger compute-oriented data-center chips, the opportunity here really seems to be limited to the communications infrastructure market. This is one where both MIPS and PowerPC are dominant and in which both Intel and ARM licensees are set to gain share, but the opportunity is nowhere near as large as the smartphone/tablet opportunity.

Share loss to Intel? Probably not until 2015
The good news, though, is that ARM is probably not going to experience material share loss to Intel (NASDAQ: INTC  ) until at the very least 2015 when Intel rolls out its "SoFIA" integrated apps processor/baseband chip. Note that ARM will still receive royalties on these chips as the integrated baseband and Wi-Fi contain ARM IP, but the "heavy hitters" for ARM are the Cortex A-class IP and the Mali GPU -- both of which will not be present in Intel's offerings and thus every unit sold from Intel takes away meaningful content from ARM.

It is also worth mentioning, though, that much of the mobile apps processor market for ARM is safe for now, as Apple continues to use ARM, and Samsung appears to have no intentions of using Intel silicon in its mobile products at this time. The vulnerability is principally in the whitebox players in Asia as well as from any of Intel's more traditional PC partners.

Foolish bottom line
ARM's shares are expensive so, as a result, any hiccups in the growth rate of the business is likely to spell bad things for the share price. Indeed, no stock trading at roughly 128 times trailing-12-month earnings can say that it will report results "in line" with market expectations (predicated on an uptick in the back half of the year that may not materialize) without getting punished. If processor royalty growth doesn't return to double-digit year-over-year growth, then the stock may see a dramatic repricing to the downside. 

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