Chip designer ARM Holdings (NASDAQ:ARMH) recently acquired Offspark, a Dutch specialist in security software, to expand its footprint in the Internet of Things, or IoT.

Offspark PolarSSL open-source technology is used to secure sensor modules, communication modules, and smartphones. The acquisition, which was made for an undisclosed amount, will boost the security of the IoT-focused mbed OS. PolarSSL will be rebranded as "mbed TLS" and become the backbone of the ARM mbed security platform.

This move mirrors recent decisions by networking giant Cisco and chip rival Intel (NASDAQ:INTC) in the IoT space. Read on to learn how expanding into the business of connected things will impact ARM and its industry peers in the near future.

Understanding the Internet of Things
Expectations for the growth of IoT-related businesses are high. Research firm IDC expects global spending on IoT tech and services to rise from $4.8 trillion in 2012 to $8.9 trillion in 2020.

There are two major areas IoT investors should focus on. First, chips will get smaller, trading raw processing power for power efficiency and portability. System on a chip (SoC) setups will integrate all of the components of a computer onto a single chip. ARM-licensed designs have an advantage over Intel-manufactured ones, here, since ARM previously dominated the smartphone and tablet markets with lower-powered processors and SoCs. However, Intel has been gaining ground with tiny SoCs like Quark, which is specifically designed for wearable devices.

Intel Galileo board, powered by Quark. Source: Wikimedia Commons, Regi51

The second area consists of security and analytics solutions. As more things get connected to the Internet, they become more vulnerable to attack. That is why many leading IoT companies already protect their devices with PolarSSL.

Integrating PolarSSL into mbed OS makes ARM chips more convenient all-in-one solutions for manufacturers. The OS also aggregates data for analytics, letting companies probe data collected from IoT devices. That is why Cisco recently launched its "Connected Analytics for the Internet of Everything" initiative, which integrates data analytics capabilities into existing network hardware.

What does this mean for Intel?
The Offspark deal is a response to earlier moves from Intel. Last December, Intel -- which bought McAfee in 2010 -- unveiled an IoT security platform to unify "gateway, connectivity, and security components" to streamline the deployment of IoT devices.

Intel lost the smartphone and tablet market to ARM for two reasons. First, it manufactured its own chips as ARM quickly licensed its designs to a large number of companies. Second, ARM designs had a reputation of being cheaper and consuming less power, which made them more popular among mobile manufacturers.

Intel does not plan on losing the IoT market in the same way to ARM and its partners, so it established a dedicated IoT group last July. Last year, revenue at that group rose 19% year-over-year to $2.14 billion, while operating income improved 12% to $616 million. That progress indicates that Intel is succeeding at leveraging its dominant presence in PCs and servers to expand into IoT devices.

Intel has an advantage over ARM
Since ARM has experience licensing designs for cheap, power-efficient chips and plenty of partners, it would seem well poised to profit from higher IoT spending. Unfortunately, the situation is not that simple.

ARM generates revenue mostly from licensing and royalty fees, which respectively accounted for 45% and 46% of its top line in fiscal 2014. For the full year, ARM licensing revenue rose 26% year-over-year, but royalty fees only inched up 1%. This means ARM is getting more upfront payments, but fewer chips are actually being installed. To make matters worse, demand for older, lower-royalty designs continues to outweigh demand for higher-royalty ones. Older ARM (7/9/11) designs still accounted for 36% of shipments during the year.

A Raspberry Pi micro-computer, powered by an ARM 11 processor from Broadcom. Source: Wikimedia Commons, Lucasbosch

Therefore, IoT expansion is a double-edged sword for the company. On the one hand, ARM will gain market share against Intel. But on the other hand, many of those lightweight designs will likely be lower-end products with lower royalties. Liberum Securities analyst Eoin Lambe estimates that ARM IoT chips will actually be 70% less profitable than the high-end ones found in Apple iPhones.

Meanwhile, Intel still holds a dominant position in PCs and servers, which require high-end processors. It is a market ARM has failed to touch because of an incompatible instruction set (x86) and its reputation for licensing cheaper designs with less horsepower.

The road ahead
The Offspark acquisition was a shrewd and necessary move. Looking a few years ahead, ARM designs could certainly account for a large portion of the IoT market. However, it might not be a very profitable one and gaining market share could actually weigh down its bottom line. Meanwhile, Intel does not need to go "all in" on IoT -- it just needs to gradually expand its existing PC and server businesses into the space.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.