Is ARM Holdings the Next Intel?

ARM Holdings (Nasdaq: ARMH  ) is in an enviable position that's only going to get better -- or so company president Tudor Brown says. In late May, he predicted ARM would grow its share of the market for mobile PC processors from 10% to 50% by 2015, and boost overall shipments of its ARM processor by 13% annually from now through 2020.

Talk about bold claims. Few executives outside of Oracle's Larry Ellison have ever been so forthcoming. And yet Brown may have a point. Due to its long-standing relationships with Apple (Nasdaq: AAPL  ) and NVIDIA (Nasdaq: NVDA  ) , ARM is surging while rival MIPS Technologies (Nasdaq: MIPS  ) is still establishing a presence in the market for mobile device processors.

A history of dominance
ARM is to the mobile market what Intel (Nasdaq: INTC  ) has been to the PC market. At February's Mobile World Congress in Barcelona, the company released new data showing that 95% of the phones built for Long-Term Evolution would use an ARM processor. LTE is the natural successor to the 3G networks now accessed by most mobile users. Among the majors, only Sprint Nextel has opted for the opposing WiMAX standard in deploying its 4G network.

And that's just the latest victory. Just as Intel has long-standing relationships with Acer, Dell, Hewlett-Packard, and Lenovo, ARM's licensee list reads like a Who's Who of the world of mobile computing. Here's a sampling:

  • NVIDIA
  • Qualcomm (Nasdaq: QCOM  )
  • Samsung Electronics
  • Texas Instruments (NYSE: TXN  )

In all, more than 250 semiconductor licensees use some form of ARM technology.

What Steve Jobs can do
But some licensees matter more than others, and ARM's recent track record of outrageous growth maps nicely to the introduction and adoption of Apple's various iDevices, beginning with the U.S. launch of the iPhone 2G in June of 2007:

Growth Rates

2010

2009

2008

Revenue 33.3% 2% 15.3%
Normalized net income 96.8% (14.3%) 41%
Cash from operations 83.2% (4%) 68%

Source: Capital IQ, a division of Standard & Poor's.

While it's true that ARM's business hasn't improved symmetrically, the overall growth of its license revenue suggests the Apple relationship has borne significant fruit. Investors have certainly noticed: The stock has been a four-bagger since the summer of 2008.

Valuing outrageous growth
So there's a history of outperformance here. That's one of the six signs we look for in evaluating great growth stocks for our Motley Fool Rule Breakers service. But is there still room for the company to grow? I'd say so.

ARM isn't just licensing more cores. The company's technology is finding its way into ever more advanced chips such as NVIDIA's superpowered Tegra and Qualcomm's Snapdragon. More advanced chips generate more revenue, and usually at higher margins. (ARM's gross margin has improved 460 basis points since 2008.)

So we can expect ARM to keep growing. What sorts of returns will that lead to? The best way to answer that question is to dig into the numbers and assumptions that comprise a discounted cash flow analysis. In doing so, you'll get a better sense of what Mr. Market expects in terms of financial performance and the relative margin of safety you'd get from buying at current prices.

But if we're only looking at the next 10 years, we don't need a down-to-the-last nail DCF to get a grip on ARM's valuation. Comparing growth in unit shipments and normalized profits should tell us all we need to know:

Years

Growth in Unit Shipments

Growth in Normalized Profit

2010 55% 96.8%
2009 (2%) (14.3%)
2008 38% 41%
2007 18% (9.1%)
2006 47% (13.7%)
5-YEAR AVERAGE 29.7% 12%

Source: Capital IQ, a division of Standard & Poor's. Averages are compounded rates.

Too bad the results are inconsistent. Even though recent volume gains have padded ARM's bottom line, it hasn't always been this way. Yet this is still a growth story. What I find interesting is that Brown expects unit growth to slow rather than accelerate -- from 29.7% annually over the past five years to 13% annually over the next 10.

The Foolish bottom line
How does that affect valuation? Since profit growth has traditionally lagged unit growth by more than half, I think it's fair to say Brown's predictions for 13% unit growth should result in less than 6% annualized profit growth over the next decade. Trouble is, even if profit growth accelerates relative to unit shipments in the coming years, the stock is currently trading for more than 100 times trailing normalized earnings and 50 times next year's consensus profit estimate -- so investors appear to be counting on a lot more.

Fortunately, there are plenty more opportunities in the chip space. One, identified in this Motley Fool special report, is an ARM partner. According to my Foolish colleague Eric Bleeker, the chip maker is on track to deliver market-crushing returns to investors. Click here to get a copy of the report -- it's 100% free.

The Motley Fool owns shares of Texas Instruments, Oracle, Apple, and QUALCOMM. The Fool owns shares of and has bought calls on Intel. Motley Fool newsletter services have recommended buying shares of NVIDIA, Intel, and Apple. Motley Fool newsletter services have recommended creating a bull call spread position in Apple. Motley Fool newsletter services have recommended creating a diagonal call position in Intel. Motley Fool newsletter services have recommended writing puts in NVIDIA. 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.

Fool contributor Tim Beyers is a member of the Motley Fool Rule Breakers stock-picking team. He owned shares of Apple and Oracle at the time of publication. Check out Tim's portfolio holdings and Foolish writings, or connect with him on Twitter as @milehighfool. You can also get his insights delivered directly to your RSS reader.


Read/Post Comments (4) | Recommend This Article (3)

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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 June 21, 2011, at 8:10 PM, techy46 wrote:

    ARMH licenses chip designs, for about .01-.02 er copy, to enterprise that want to make specialized chips with low power requirements; Apple, Nvida, Qualcomm, TI . Intel designs and manufactures chips for use in all devices except low power consumers. That's all about to change with Intel's Atom 3D SoC at 32 and 22nm. Buy Intel, forget AMD and ARMH.

  • Report this Comment On June 21, 2011, at 9:14 PM, bghouse wrote:

    As a holder of both ARMH and Intel, I really, really hope that ARM does not become the next Intel ... As of now ARMH is a multibagger for me and Intel is a looser but for dividends ...

  • Report this Comment On June 22, 2011, at 1:09 AM, russfischer1013 wrote:

    Tim,

    You can do better than this.

    ARMH is a wonderful success story, BUT....it has sales of about $650 mil and a market cap of $12.38 bill for a price to sales ratio of about 19. The company has a P/E of about 88.

    Apple will be using (or already is using) parts made by intel. Intel will first build the ARM part at 32nm, then for Apple to get their hands on 22nm fab they will have to redesign with the Intel Atom core.

    Since TSMC, by business model, cannot sell to end customers and Intel will not sell to their competitors like QCOM and NVDA, anyone who wants that 22nm 3D process will have to come directly to Intel....companies like HTC, RIMM (who cares), HP, DELL, etc. will switch to Atom cores simply to get on the 22nm 3D high performance bandwagon.

    When this starts to happen ARMH's growth will stop then shrink and the overpriced stock will crash to a very low number.

    ARMH is incredibly risky at these prices.

    Now retired from 35 years in the semiconductor industry, I have learned over the years that Intel is just a bitch to compete with.

    As for me, I'll let others make what might be left in ARMH....I'll bet on Intel and embedded flash based solid state drives....and, oh yeah, a few billion dollars worth of mobile chip business.

    Intel will triple their business through higher levels of integration in PC compute modules and probably tablet compute modules, including Apple.

  • Report this Comment On June 29, 2011, at 5:23 PM, shavanas wrote:

    Intel is at 8 watts in 35nm process with the Atom. A comparable device in ARM is 0.8 watts at 65nm. Intel and the x86 architecture will never catch up to ARM. You will see ARM product on a 22nm process from TSMC this year. The ARM A15 will start cutting into Intel’s i5 for the desktop and the XEON business for the servers next year. Server farms will be able to cut power usage and cooling by 100X using ARM.

    Apple is moving their laptops to ARM and over time it will move to the desktops. Windows 8 will have full support of ARM. Intel’s market share is dropping fast.

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