ARM Holdings
Q2 - First Look

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By Scollag
July 19, 2005

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OK, one thing I dislike is that these results are getting increasingly difficult to disentangle, but this seems to be a consequence of ARM placing increased emphasis on dollar revenues, which is perfectly reasonable, just at the time when the comparable figures are becoming difficult enough to work out.

I propose to review each of the individual former companies' revenue results separately, then the combined group results. Unfortunately, the individual analyses cannot extend to the level of detail that we formerly used, since R&D and other operating costs are not allocated between the two former companies, but let's see what we can do. First, the original ARM business.

One of the disadvantages of having to cite headline results in $ terms is that other good news can be pushed into the background, and that has happened today. ARM have actually failed to disclose one of the most telling figures, that of ARM's total revenue in � for the quarter. Instead, I have had to add together ARM's � license revenue, � royalty revenue, and the � figures for services and development systems (I think the PIPD contribution to these is negligible), to obtain what I think is possibly the most significant point of the entire quarter.

ARM's revenue from the original business reached record levels in Q2.

I make the total �44.76 million, which finally surpasses the figure from 2Q02, immediately before ARM's fall from grace, of �43.17 million.

Royalty revenue was, of course, at record levels, thanks in part to the strengthening of the $, though shipment numbers were actually down. This quarter's figures, of course, covers shipments in the March quarter, so perhaps some seasonality can account for the very slight sequential drop over the gadget-laden holiday season.

It is in ARM's licensing that I find most encouragement today. The figure of �18.1 million is the best since 2Q02, and in fact there were only ever five boom quarters that exceeded the present level. YoY growth of 24% and sequential growth of 11% looks pretty healthy, especially considering the stagnation in the semiconductor industry overall. This strongly suggests to me that ARM is increasing its share of the semiconductor design pie, which will realise more shipments and more royalties for the future.

To summarise, then, I think the original ARM business performed well, and the weakness in royalty growth can be attributed to the prevailing flatness in the semiconductor market.

Let's look now at PIPD's revenue, compared to Artisan's.

Overall, the level still looks surprisingly weak, with a slight sequential drop. This looks worrisome, since the record level immediately prior to the Dec quarter in which the takeover took place was preceded by healthy sequential growth. My first reaction is that if that famous backlog bulge is still tucked away in a drawer somewhere, I'd be interested to know why it hasn't been brought into play already.

On the licensing side, however, PIPD has performed well in this quarter, exceeding the previous record for license revenue by a considerable margin. Sequential growth was 10.5%, and YoY 26%.

The royalty side is much the weaker of the two PIPD revenue streams. There was a nasty sequential drop which is starting to look like a trend down. I have some theories about this, but for now my only comment is that the situation is really not helped by PIPD citing "underlying" levels of royalties, as this just fudges the situation. It might be more helpful to return to reporting net and gross royalty figures, but I would prefer to see a much tighter collections regime than these "adjustments" for underlying figures.

Of course, we should certainly expect that if the former ARM royalties are flat, then so should PIPD's be, but there is something more going on here that I would prefer to know more about. It may be nothing, or it may be a strategic matter that ARM already have well in hand, but I think we should be told rather more about it. That's what I'll be listening for, above all, in the CC.

So, overall how did the ARM group perform?

Interestingly, today's Guardian carried an article, "ARM's expansion into US hits snags", which seemed full of doom and gloom inspired by Virage's warning and by some caution expressed by analysts.

"Overall, analysts are expecting second-quarter revenues of �56.2 million with profit before exceptional items and financial charges of �18.8 million".

Actual revenue reported was �57.8 million, and IBIT plus exceptionals came to �19.6 million.

Digging deeper, however, we are hit by the lack of comparables, because Artisan's previous quarters are all in dollars, and ARM's in �.

Based on the gross margins, and assuming Artisan makes no significant contribution to service revenues, I think we can allocate out the cost of product revenue, �3.5M to PIPD and �1.01 to ARM's core business. That latter figure represents an absolute decline over the previous year, which is impressive considering license and devsys revenues both rose.

Looking over OpEx, R&D seems to have grown rather less than Sales and Marketing, so I'd certainly like to know why S&M has grown so much. R&D is now around 27.2% of gross revenue, which seems reasonably consistent with the long-term objective, but if royalty revenue had been a little stronger then this proportion would have been lower, which might start to ring some alarm bells. Compared to ARM's independent operating expenses for last year, R&D is up 27.8%, S&M up 41.2%, and G&A up 28.5, all in the context of gross revenue up 56.5%.

It's those cotton-pickin' exceptionals that spoil the fun: Deferred stock-based compensation and Amortization of intangibles total �6.7 million, excluding which, according to ARM, operating margin is a healthy 31.8%, though this is down slightly on Q1. Contributing to that 31.8% were 32.1% from ARM and 30.9% from PIPD, though how the heck they can determine those figures beats me.

Since it is the exceptionals that cause the trouble, it is worth looking at the cashflow. ARM has not provided a US GAAP version this time, but there is an IFRS version attached for the six-month period. This shows that, even after a massive hike in accounts receivable (which also jumps out from the balance sheet), cash generated by operations is up well over 50%, both before and after tax. No wonder ARM have increased the divi and instigated a buyback programme.

Here, then, are my concerns:

� PIPD royalties fell more sharply, even on an underlying basis, than ARM original business, and I'd like to know why there was such a difference.

� I need to know why S&M seems to be ballooning for the group, faster even than R&D investment.

� If there is a benign explanation for A/R increasing, I'd like to hear it; otherwise I want to see improved collections for the rest of the year.

� I'm still trying to get my head around the increased value in goodwill under US GAAP, which may not be unrelated to another curious observation, the purchase of subsidiaries under investing activities on the cashflow.

Overall, then, I am favourably impressed by what I see. Obviously there was some weakness in the semi market in the March quarter, but I gather foundry utilization rates improved in the most recent quarter, so we should see some improvement next time in royalties. For the key areas of activity under ARM's control, licensing looks very healthy indeed, and even development systems seems to have reached a new record level.


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