Should ARM Thank Apple Inc. For This Earnings Pop?

Apple's 64-bit A7 chip. Source: Apple.

Positioned at the heart of the mobile revolution, ARM Holdings (NASDAQ: ARMH  ) has a unique perspective on where computing is headed. The British company just reported a strong second quarter and shares are enjoying healthy gains today. It's possible that Apple (NASDAQ: AAPL  ) had a little something to do with driving ARM's quarter.

Let's dig in.

Starting at the top
Revenue came in at $309.6 million, a 17% jump from a year ago. Importantly, materially all of that growth came from licensing revenue. Total royalty revenue was essentially flat at $135.5 million. Within that total, royalties on shipped processors was up a modest 2% year over year, echoing some of the smartphone deceleration that investors have seen from major players such as Samsung and Apple.

Revenue

Q2 2013

Q2 2014

Total licensing

$102.6 million

$146.1 million

Total royalty

$135.3 million

$135.5 million

Software, tools, and services

$26.4 million

$28 million

Total revenue

$264.3 million

$309.6 million

Source: ARM.

Inking new licenses is key to ARM's future success, as it builds a pipeline and backlog of royalty streams that pay off for years. ARM scored 41 new processor licenses during the quarter, bringing its cumulative total to over 1,100.

Let's talk royalties
Royalty-bearing chips shipped during the quarter rose 11% to 2.7 billion. Mobile and embedded continue to be the dominant market segments in which ARM chips are being used. Average royalty per chip fell to $0.046.

Royalty revenue was stagnant for several reasons. Not only did seasonal trends related to broader consumer trends (80% of ARM's royalty value comes from consumer markets) affect growth, but China's broader transition from 3G to 4G also adversely impacted results. Wireless carriers are working to clear out existing inventory of 3G handsets in preparation for inventory buildup of 4G devices. That means OEMs are holding off on using the latest chips (which earn higher royalty rates) for the sake of their own inventory management.

Let's talk licensing (and Apple)
ARM signed seven new ARMv8 licenses during the quarter, bringing its year-to-date total to 13. This is the important part and where Apple comes into the equation. ARMv8 represents the transition to 64-bit chip architecture that is just now beginning. That's the same transition that Apple officially kicked off in the mobile space last year with the iPhone 5s and its A7 processor.

The shift to 64-bit has been years in the making. ARM began licensing ARMv8 back in 2009, but it takes years to develop chips and bring them to market.

Source: ARM.

ARMv8 licensing activity has dramatically accelerated over the past 18 months, and the company now has 50 total licenses. Apple took the industry off guard when it announced A7 last year, and competitors have scrambled to catch up in the 64-bit race. In December, a Qualcomm (NASDAQ: QCOM  ) employee conceded that the A7 "hit us in the gut" and that the company was "stunned" and "unprepared."

Samsung quickly confirmed that it would release a 64-bit chip in 2014, and Qualcomm has also been filling out its 64-bit lineup. While Qualcomm likes to tout its high-performance custom cores, its 64-bit offerings all use standard ARM cores. Custom cores take longer to develop, and this was likely a shortcut to accelerate the timeline. The important thing to note here is that Qualcomm obviously feels rushed and wants to catch up posthaste.

While neither Qualcomm nor Samsung would be included in this quarter's list of new ARMv8 licensees, the broader theme is that Apple has catalyzed 64-bit adoption in a big way and is accelerating the transition through competition, which is leading to more licensing activity for ARM.

It's the time of the season
As investors head into the tail end of 2014, ARM should see seasonal upside in its consumer end markets. That will include the iPhone 6 launch and its expected A8 processor, along with many other mobile devices. ARM expects full-year revenue to be "in line with market expectations," which is approximately $1.3 billion. Trading at 16 times sales, ARM is rather pricey. But it could be worth it.

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