ARM's Dire Headlines Misleading?
Board: ARM Holdings plc

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By Scollag
March 8, 2007

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Well, it was a classic reporting season for ARM. Sterling revenue for 2006 was up by 13.26% over 2005, but ARM's operating profit increased by 41.93%, actual profit increased 63.89%, and EPS increased by 66.5%.

So, with these stellar achievements available for discussion, what did the trade press report?

ARM's Profit Plunges on Currency Adjustment Woes
By Colleen Taylor - Electronic News, 2/6/2007

Licensing company ARM Holdings plc felt the fallout from foreign currency adjustments in 2006. The Cambridge, England-based company posted a loss for its Q4 and 2006, due to a weakening of the dollar against the British pound.

Complete rubbish. Fact: ARM posted a spectacularly increased profit.

Apparently Ms Taylor even got the direction of exchange movement wrong in the original version of the article, citing weakening of sterling against the dollar (this was subsequently corrected).

Over at EETimes, Peter Clarke continued to distinguish himself thus:

ARM's Trading Profit Hit by Foreign Currency Adjustment
Peter Clarke - EE Times Europe (02/06/2007 7:58 AM EST)

LONDON -- ARM Holdings plc, a licensor of processor designs and related intellectual property, reported a comprehensive loss for its fourth quarter and its full year ended Dec. 31, 2006, entirely due to the effect of foreign currency adjustments.

Utter cobblers. Fact: ARM's trading profit was not affected by the foreign currency adjustments Mr. Clarke cites, and EETimes is flirting with legal danger in making this claim.

Even TMF UK was not, alas, immune. Keith McMahon (KeithJamesMc) crafted a reasonably balanced article on the results: To ARM or Not?

Keith included this paragraph:

Exchange rate issues also make it very hard to understand the ARM financial results. For example, a �79m negative movement in Capital & Reserves under IFRS more than wiped out profit for the year of �49m.

Well, I certainly take Keith's point that exchange rate issues do complicate interpretation of the results. But I do not accept for a moment that the "�79m negative movement" wiped out profit for the year.

What is really going on?

Readers may recall that a similar controversy arose here two or three years ago, when the late Cordob challenged ARM's reported EPS because he thought "Total comprehensive income" should be used in the EPS calculation, rather than Net Income. I disagreed, and pointed out that ARM had been consistent in disregarding other comprehensive income when reporting their trading profit. I explained that the negative value he was worried about was the result of a change in the value of dollars held by the company due to a decline in the value of the dollar, which had nothing to do with the operations of the company. At that time, the discrepancy was less than �2M, I think. I believe I pointed out that the value had to appear as it represented a change in the balance sheet, though one over which ARM had no operational control.

So, what are Colleen Taylor and Peter Clarke missing? Like Cordob, they have noticed that ARM's US GAAP Income Statement includes some items under other comprehensive income, and have IMHO fundamentally misinterpreted these data. In this case, though, the figures look more substantial: -�25.6M for Q4/06 (cf. +�16.5M for Q4/05), and -�68.1M for FY06 (cf. +�58.6M). Perhaps it is mere coincidence that neither Ms. Taylor nor Mr. Clarke bothered to report the massive positive effect on ARM's earnings, according to their reasoning, last year?

There are two obvious questions:

1. Does the same reasoning apply in this case as with Cor's objection?

Yes, abso-cotton-pickin'-lutely. These are balance sheet adjustments necessitated by the decline of the dollar, and have zero effect on ARM's operational performance or achievements, which is why it is downright misleading, and possibly even libelous, to refer to any effect on ARM's trading profit.

2. Why, in any case, has the apparent disparity grown from �2M to �68M?

I think when I responded to Cor I referred to a change in the value of ARM's cash held as dollars. As I now realize, this is only part of the story, since of course ARM must have other assets denominated in US$, considering they have had US operations at least since 1998. But this does not explain the difference in scale, which it would be too easy to blame on the scale of the decline in the US$.

On the TMF UK ARM board, the excellent Gengulphus has pointed out that the �68M relates to revaluation of ARM's $-denominated assets. He is absolutely correct, though he omits to mention the nature of such assets, which obviously must be rather more valuable than Artisan's office furniture alone.

In fact, ARM's main US$-denominated assets may surprise some readers. The biggest itemized asset, by far, on ARM's balance sheet is Goodwill. Guess what? Under US GAAP, "The foreign exchange difference arises as goodwill on Artisan, Axys and KSI is denominated in US dollars and thus is subject to revaluation at the period-end rates." [AR 2005, p.101]

Now, I cannot tell at present if revaluation of goodwill alone is sufficient to account for the entire �68M, but I am pretty sure it accounts for most of it, with some PPE, Other Intangibles and cash held as $ making up the bulk of the remainder.

So, the great scandal of the dropped �68M is nothing more than the revaluation in � terms of ... well, the excess over book value that ARM paid for Artisan, Axys, and KSI. It is important to note that this does NOT represent an impairment of those assets, which are tested annually for that purpose, but simply a change in the � value that they represent since they are denominated in a currency that has declined in value over the reporting period, relative to ARM's base currency.

In my opinion, these revaluations due to the movement of the dollar have little to do with ARM's operational performance, and should certainly not be considered as part of trading profit. ARM cannot be held accountable for the decline in the value of the US$ against sterling. ARM's results already include the dismal effect of the plummeting dollar, which is precisely why, for example, ARM's Q4 � revenue rose by 8% though $ revenue rose by 20%.

It is regrettable that both Electronic News and EETimes saw fit to publish their analyses with such dire headlines. I consider both those articles to be weak and misleading.

As for Keith McMahon's Fool piece, I confess I had some trouble identifying his �79M negative movement, but I think he is looking at the Cumulative translation adjustment under Capital and Reserves on the IFRS Balance Sheet: as at 31 Dec 2005, this figure was �68.012M, and at 31 Dec 2006, -�11.347M.

Again, I think this movement is derived from exchange rate fluctuations applied to dollar-denominated assets. At least, "As intangible assets and goodwill arising on overseas acquisitions are treated as foreign currency assets of the acquired entities under IFRS (but not under the Group's UK GAAP accounting policies), related foreign exchange movements have been recorded in reserves." [AR 2005, p.73], which I believe explains most or all of this movement. I don't think it is appropriate to regard this currency revaluation as wiping out or negating ARM's considerable and growing profit. Of course there is an effect seen in the balance sheet, under both US GAAP and IFRS, but it is ephemeral, reversible, and mainly confined to a nebulous concept that has no tangible value in the real world.

Sometimes, faced with increasingly complex sets of figures, it may be preferable to find a few simple data to track. Net Cash from Operating Activities is a good candidate: up 51.7% for the year, despite the detrimental effect of the declining dollar.

Well done, ARM.


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