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Should You Buy ARM Holdings PLC?

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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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 July 10, 2014, at 12:55 PM, jpanspac wrote:

    big.LITTLE is a stupid idea. ARM licensees will probably realize that before going too far down that road, so I wouldn't count on any extra revenue from it.

  • Report this Comment On July 10, 2014, at 1:29 PM, tempest669 wrote:

    Little leery of ARMH. Great company, but looks to me like the market is shifting. Android L provides compiling support that remedies many of the MIPS and x86 compiling problems. That could potentially open doors for competitors. Intel is attempting to erode ARMH's tablet stronghold first. MIPS seems to be targeting China through deals with Allwinner and Realtek.

    ARMH's Mali graphics have not taken a very big hold of the mobile graphics market. And Mali appears to be stuck in the mid- to lower market where the royalties are smaller than Imagination gets on their PowerVR GPU's. And Imagination has broadened their Rogue line GPU's to create broader market availability. Unless ARMH has something up their sleeve, the Imagination Wizard series will further cover the market.

    Network oriented processors is already a pretty saturated market. What's the "in" for ARMH to make a foothold there? I cannot see one.

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Ashraf Eassa

Ashraf Eassa is a technology specialist with The Motley Fool. He writes mostly about technology stocks, but is especially interested in anything related to chips -- the semiconductor kind, that is. Follow him on Twitter:

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