Should You Buy ARM Holdings PLC?

Let's look at the risks and opportunities for ARM Holdings.

Jul 10, 2014 at 12:00PM

Shares of processor IP vendor ARM Holdings (NASDAQ:ARMH) closed at $45.35 in the July 9 trading session, nearly 18% below its 52-week high of $55.26 set in late 2013. Though the shares look expensive at approximately 109 times trailing 12 month earnings, it's worth taking a deeper look into whether the shares are worth buying on this pullback.

Broad strokes, please?
ARM Holdings produces CPU and graphics processor designs, which are then licensed to third parties for incorporation into a larger chip design. ARM also -- implicit in the design of processors -- develops an instruction set architecture ("ISA"). Think of the ISA as the commands that a chip can understand and the processor as a machine that can execute those commands.

At any rate, the ARM architecture -- either in the form of custom processors built around ARM's ISAs or processor cores designed by ARM itself -- is extremely prevalent in mobile computing. Just about every smartphone or tablet has several chips containing ARM processor IP. The sale of these chips generates royalty payments for ARM.

Why own it?
Here are a number of reasons to be bullish on ARM's stock:

  1. New instruction set generates greater royalties. ARM launched a new version of its ARM instruction set known as ARMv8. It is a 64-bit instruction set and, more importantly, chips based on it command a higher royalty rate per core. So, as the industry (particularly high volume mobile processor vendors) naturally progresses to ARMv8, ARM should see an immediate boost to its bottom line.
  2. Greater content per chip. ARM appears to be gaining graphics content share in system-on-chip products. But rival graphics IP vendor Imagination Technologies (NASDAQOTH:IGNMF) is fighting quite vigorously to limit that share gain (and perhaps even reverse it), so this is something worth watching closely. Additionally, adoption of big.LITTLE is driving more cores per chip, which increases ARM's royalty rate per chip.
  3. Networking opportunity. ARM believes that its licensees can capture about $6 billion worth of networking-oriented processor sales by 2018 (and many top network chip vendors have announced support for ARM in future processors). If ARM's royalty rate per chip can work out to 2.5-3% on these, this represents $150-$180 million in incremental revenue (with most -- if not all -- of it flowing right to the bottom line).

That's the good -- what's the downside here?

Potential negatives
The risks to ARM's share price, which commands a rather high earnings multiple (about 30 times projected non-IFRS 2015 earnings) are the following:

  1. Intel traction in phones/tablets. If Intel (NASDAQ:INTC) can gain meaningful traction in smartphones and tablets -- and in particular, the low end of the market where ARM CPU, GPU, and physical IP content is prevalent -- then this could stunt ARM's longer-term growth rate.
  2. Broad phone/tablet slowdown. If the broader smartphone/tablet market simply slows down (the high end is already showing signs of saturation), then ARM's financials -- which are highly levered to these markets -- could suffer.
  3. Imagination could fight back. Imagination not only licenses graphics IP that competes with ARM's, but it also licenses CPU cores based on the MIPS instruction set. While traction in mobile apps processors is unlikely for MIPS, networking is big for MIPS and Imagination could fight back quite aggressively there.

Foolish bottom line
At the end of the day, ARM is an interesting -- if a bit expensive -- stock that has a lot going for it. That said, given the valuation that it trades at, there's definitely a lot of optimism baked into the company's future earnings expectations. If the company can live up to those expectations, then the stock should continue to move up nicely. If it fails to do so, then there is probably quite a bit of downside to be had.

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Ashraf Eassa owns shares of ARM Holdings and 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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