LONDON -- I've always balked at ARM Holding's (LSE: ARM ) (NASDAQ: ARMH ) 's massive price-to-earnings ratio. Even after a 10% fall from last month's high, the shares are trading at 46 times forecast earnings. Some say the pull-back is a buying opportunity.
For me there are two big questions:
- Just how good a company is ARM?
- How fast must it grow to justify its rating?
Sales growth of 24% per annum in the last three years is the result of ARM's monopoly position in a booming market.
The company is a research factory that licenses microchip designs to chip makers. License fees should broadly cover ARM's costs, leaving ongoing royalties on the sale of each device as pure profit.
By good judgement and some luck, ARM has cornered the market in low-powered chips ideal for the battery-hungry smartphone market. It enjoys an astonishing 95% global share of smartphones, and 80% of digital cameras. Having built an ecosystem around its designs and a library of intellectual property, it's replicating its lead in tablet computing.
ARM's fixed cost base gives it operational leverage, so higher revenues mean higher margins and much bigger bottom-line profit.
Growth will slow when the burgeoning smartphone and tablet markets mature. With the lead time on the introduction of new designs around seven years, ARM is widening its end-market into laptops (via Windows 8), servers and the "Internet of things," such as "smart" dishwashers.
That butts up against six-times-larger Intel, which dominates the market for PC and server chips but foolishly neglected the low-powered chip market. Now it's fighting back, with its lower-powered Atom chips in some smartphones. The ubiquity of ARM's designs means phone manufacturers are limited in how they can differentiate their products, and many must secretly wish the company would lose its stranglehold.
So threats to ARM's growth come from the risk of disruptive technology, be it from high-spending Intel, Chinese intellectual property theft, or backwards integration from chip makers.
Growing, but how fast, how long?
"Forecasts of royalty revenues tripling over the next five years are common," according to the Financial Times. That's equivalent to a growth rate of 30% a year.
Operational leverage means profits should grow faster but competition might drive down margins, so on a very broad brush basis let's assume earnings also grow at the same rate, tripling over five years. The prospective P/E would then be 15 (the current market average) in five years' time, if the share price remained unchanged.
That analysis suggests there's upside if the company can maintain above-average growth for more than five years. But it doesn't leave much room for disruption from a competitor. It's a close call.
If you're looking for a safer growth story to balance your portfolio, I suggest you look at the Motley Fool's top growth share for 2013. The company is no stranger to disruptive technology as its industry has been transformed by the Internet, but it has adapted and flourished.
It has strong cash generation, has increased or held its dividend every year since 1988, and there could be considerable value that isn't reflected in the share price. To discover the identity of the company, you can download a free in-depth report just by clicking here -- it's free.