49% Jump in Royalty Revenue at Imagination Technologies Group

LONDON -- Imagination Technologies  (LSE: IMG  ) , the graphic processing-focused rival to ARM Holdings  (LSE: ARM  ) (NASDAQ: ARMH  ) , reported strong growth in the number of devices -- mobile phones, tablets, and smart TVs -- shipped containing the company's chip designs. Units jumped from 325 million to 535 million last year.

This progress puts the company well on its way to its (once seemingly audacious) goal of having 1 billion items with its intellectual property ship in a single year by 2016.

As a result, royalty revenue increased 49% to 89.5 million pounds and total revenue was up 19% to 151.5 million pounds. However, heavy investment in staff, facilities, and research into new technologies resulted in a dramatic increase in operating expenses and pulled operating profit down 13%.

What's a billion between friends?
The company's shares tumbled in early May after management revealed license revenue was going to be weaker than expected this year.

Similar to ARM, Imagination doesn't physically build chips. Its research and development teams design the chips and then license those designs to partners like AppleSamsungLG, and Intel (Intel and Apple own 15% and 9% of Imagination, respectively) to use in their products. Then Imagination gets paid every time one of those products is sold (currently about 17 pence per).

So license revenue is a bit of a look-ahead indicator for future revenue and if Imagination is having trouble signing new license agreements, achieving that 1 billion target could be tricky. With a price-to-earnings multiple of 41, it would appear the market is looking for some serious growth so missing that target would be painful.

Management thinks the drop in license revenue is temporary and the result of the weaker global economy and some short-term industry trends, but they would say that, wouldn't they?

New(ish) kid on the block
One reason to wonder if there is more to the drop in license revenue than management says is that ARM, which is known mainly for central processing units as opposed to Imagination's graphics processing units and dominates the mobile phone chip market, has been winning market share in the graphics market with its Mali chip.

While Apple's iPad uses Imagination chips, many cheaper Android tablets use the Mali chip which has given ARM a boost in the tablet game as more and more low-end tablets hit the market.

To answer this challenge, Imagination bought troubled CPU designer MIPS earlier this year in an attempt to boost the company's CPU development and hopefully gain access to some new clients and markets.

Virtual land grab
The world is becoming more connected and mobile computing (via smartphones, tablets, wearable devices) is growing rapidly. We're also approaching the age of the Internet of Things (where your refrigerator talks to your car to let you know you need to stop at the grocery store for milk and your thermostat tells the utility company you don't need as much power because you're on vacation), which means there is likely to be immense demand for the combination of powerful computing capability and low energy consumption that are hallmarks of the ARM and Imagination chip designs.

ARM won the first round with its dominance in mobile phones. Imagination notched a nice win with its presence in Apple devices. Where we go from here could be interesting -- for consumers and investors.

I don't pretend to know what the future holds, but I'm pretty certain Imagination investors are in for some exciting times.

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