Last year, over 1 billion smartphones were sold from hundreds of manufacturers around the world. By 2018, that run rate is expected to nearly double to almost 2 billion units per year. As an investor, what would you do if you knew a single company collects revenue from roughly 95% of those smartphones?
Because that's exactly the case with ARM Holdings (ARMH +0.00%), a $21.5 billion business whose Cortex-A family of processors is used in nearly every smartphone and tablet computer on the planet.
ARM's Cortex-A15 is used in high-end devices like the Samsung Galaxy Note 3, Credit: ARM Holdings.
Here's how ARM does it
Specifically, ARM is the world's leading semiconductor intellectual property supplier, which means it designs scalable, energy-efficient processors and related tech and licenses the products to other companies. Those companies, in turn, build their own devices around ARM's technology. But it doesn't stop there: ARM also collects royalties on all ARM-based chips, which has meant 50 billion chips (and counting) from more than 1,100 licenses with over 300 companies since it was founded in 1990.
That lineup ranges from ARM's minuscule Cortex-A5, which powers some entry-level smartphones costing as little as $35, and goes all the way up to its Cortex-A15, whose monster performance drives higher-end devices such as the Samsung Galaxy Note 3 and Hewlett-Packard Chromebook.
That goes to show ARM isn't simply resting on its laurels by licensing archaic tech. In fact, ARM last year received its first royalties for products based on its latest ARMv8-A architecture, which notably introduced support for 64-bit computing. And less than two weeks ago, ARM celebrated its 50th licensing agreement between 27 companies for ARMv8-A -- including all of the top 10 companies that sell application processors for smartphones, nine of the top 10 for tablets, four of the top five for other consumer electronics (like digital TV and set-top boxes), and eight silicon vendors in greater China.
There's a catch ...
There is a downside to ARM's approach: the business bears an outsized reliance on consumer products, where it holds a greater than 95% market share in application processors for smart mobile devices like smartphones, tablets, and laptops. As a result, though its licensing business might remain healthy, those lucrative recurring royalties are subject to the whims of the consumer mobile electronics market.
During the first half of 2014, for example, while ARM's total technology licensing revenue climbed 40% year over year to $276 million, royalties rose just 2% to $280 million. ARM blamed the sluggish royalty growth on a combination of seasonal trends and inventory corrections, primarily as handset makers cleared out old 3G smartphone inventory to make way for the next generation of 4G devices.
... but plenty opportunity
At the same time, this volatility is hardly an indicator of a broader problem with ARM's business over the long term. Management recently highlighted a "healthy pipeline of opportunities" to drive licensing revenue higher, as well as market data indicating improving semiconductor industry conditions, which should accelerate royalty revenue growth in the second half of this year.
To be sure, that seems fair considering that Apple and Samsung -- whose flagship products each consistently incorporate ARM's designs -- are both set for significant new product launches in the coming weeks (the iPhone 6 and Galaxy Note 4, respectively). What's more, noting that all major shippers of ARM-based apps processors have licensed ARMv8, ARM also enjoys higher royalty rates from ARMv8-A given its greater core counts than previous architectures.
Finally, ARM isn't only a mobile application specialist. Last quarter, it grew embedded intelligence chips -- which cover microcontrollers and nonmobile connectivity -- by 40% to 900 million. That should go a long way toward improving the 22% market share it held in the $14 billion market last year. ARM is also building on a 5% market share in 2013 in the $13 billion server and enterprise infrastructure industry, where it recently saw its first OEM design wins with new products from AMD, AppliedMicro, and Cavium. By 2018, both of these target markets are expected to grow into $20 billion industries, so ARM stands to reap huge benefits if it can continue bolstering its presence there.
Foolish takeaway
That's not to say ARM shares look "cheap" based on traditional metrics. To the contrary, despite shares having fallen more than 15% so far this year, the stock does look pricey on the surface in trading around 113 and 18 times trailing 12-month earnings and sales, respectively. But it also seems much more attractive at roughly 31 times next year's expected earnings, and investors who own ARM stock today can enjoy a nice little 0.7% dividend yield while they wait.
Besides, we're still talking about a company whose technology is integral to billions of devices around the world, and should only continue to grow from here. In the end, that's why I think ARM Holdings stock is worth a serious look.
