ARM Holdings (NASDAQ:ARMH) is a processor IP company. This means that it develops processor designs and then licenses them to chip integrators that build a finished product around those ARM designs. The company has seen strong growth over the last several years as it its IP has dominated the mobile chip landscape. However, as the smartphone and tablet markets have seen a slowdown, ARM's results have been affected.
Understanding the role of licensing and royalties
ARM's business has two components: licensing and royalties. ARM receives licensing fees upfront from companies that plan to use ARM's processors and/or instruction set architecture; royalties represent a portion of the selling price of a chip using ARM IP.
From a business perspective, licensing strength is important because the larger the licensee base, the larger the potential opportunity for ARM to collect royalties down the road. However, royalties are generally more important as they indicate the broader health of ARM-based chip shipments (a bunch of licensees that don't sell much product aren't all that valuable to ARM in the long-run, but a few big licensees that drive a lot of volume are very valuable).
Licensing growth this quarter strong, but royalties weak
In the most recent quarter, ARM reported 42% year over year growth in licensing as more customers adopt the ARM architecture for various end markets for future products.
However, ARM also reported a paltry 2% year over year growth in processor royalties (and a 10% decline in royalties from physical IP, though this isn't a huge part of ARM's royalty business). ARM blames this on an inventory correction as handset vendors clear stock of 3G based phones to make way for 4G based phones, but expects a rebound once this correction plays out.
Transition to ARMv8 should be broad and drive meaningful royalty rate uplift
In its prepared slide deck, ARM gave some indications of how the transition to processor designs utilizing the company's ARMv8 architecture – ARM's 64-bit instruction set architecture – affects the royalty rate. Observe the following slide:
ARM claims that its average royalty rate would have increased by 25% if every Cortex A chip shipped utilized ARMv8. Note that only 19% of ARM's unit shipments are Cortex A class, though these units command higher selling prices and thus make up a larger portion of ARM's sales.
Can the iPhone 6 have a significant impact?
Later this year, Apple (NASDAQ:AAPL) is set to launch its next generation iPhone products. Apple ships ARMv8 chips only in the iPhone 5s today, but the A7 chip found in the iPhone 5s will move down the stack (either with the iPhone 5s or in a lower-cost equivalent), broadening Apple's use of ARMv8 chips, driving ARM's per-unit royalties from Apple up.
Further, since Apple will likely be moving to the more expensive 20-nanometer process for the iPhone 6's processor, ARM not only benefits from a higher blended royalty rate across Apple's products, but it could enjoy average selling price increases.
Qualcomm is rolling out ARMv8 based chips this year, too
Qualcomm (NASDAQ:QCOM) will also be transitioning the vast majority of its product stack to ARMv8 later this year. This process begins with the high volume Snapdragon 400 and 600 series, and will culminate with a transition to 6- and 8-core ARM big.LITTLE designs for the high end during the first half of 2015. Not only does ARM benefit from a move to 64-bit there, but it sees a core-count boost to boot. For the very high end 64-bit Qualcomm parts, the move to the 20-nanometer node should also drive high end chip selling prices up.
Foolish bottom line
The key takeaway for investors is that ARM needs to see a reacceleration of royalty rate growth during the back half of 2014 and across 2015 for the stock to make progress. ARM's content share gains in mobile chips with graphics and physical IP, coupled with the transition to ARMv8, are impressive and should represent tailwinds for the company into 2015 and beyond. However, from a longer-term perspective, ARM still needs to see a return to robust mobile apps processor unit growth for the story to continue to be an attractive one.
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Ashraf Eassa owns shares of ARM Holdings. The Motley Fool recommends Apple. The Motley Fool owns shares of Apple and Qualcomm. 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.