ARM Holdings (NASDAQ:ARMH) and Texas Instruments (NASDAQ:TXN) might interest investors who are looking to add a major chipmaking stock to their portfolios. ARM licenses its low-power chip designs to a wide variety of mobile chipmakers, while Texas Instruments generates most of its revenue from sales of analog and embedded chips for mobile devices, personal electronics, cars, industrial machinery, and wireless infrastructure. Let's compare and contrast these two companies to see which is the better buy at current prices.
ARM generates revenue from two main sources: licensing fees from signing new chipmakers and recurring royalties from existing ones. When a new manufacturing process is introduced, licensing revenues rise faster. But when OEMs are waiting for a new process -- like the current lull before the launch of new 10nm/7nm licenses -- royalty revenues grow more rapidly. That's what happened last quarter, when licensing revenue only inched up 2% annually to $158.5 million as royalty revenues rose 31% to $217 million. Total sales rose 14.1% to $408 million, beating expectations by $10 million. Analysts currently expect ARM to grow its annual sales about 16.8% this year and 11% in 2017. Slowing sales of smartphones, which Gartner expects to rise just 7% this year, are expected to impact ARM's top-line growth.
Texas Instruments sells chips for industrial machinery, connected cars, personal electronics, communications systems, enterprise systems, and "other" devices. Sales of TI's personal electronic chips were soft last year, due to slowing sales of mobile devices. Sales of enterprise device chips dipped due to weak demand for projectors, while sales of communication systems chips fell 20% during the year, due to major telcos delaying infrastructure upgrades. Industrial chip sales remained flat, while automotive chip sales grew by the "mid teens." TI's total sales slipped 2.4% annually to $3.19 billion last quarter, missing estimates by $10 million. That trend is expected to continue, slipping another 1.6% this year before rebounding 4.4% in 2017.
ARM offers five types of licenses -- classic ARM (older chipsets), Cortex-A (application processors), Cortex-R (real-time processors), Cortex-M (micro-controller/Internet of Things processors), and Mali GPUs. The 64-bit Cortex-A designs, which are used in high-end smartphones, low-power servers, and smart TVs, have the highest margins. The classic ARM designs, which are mainly used in low-end mobile devices, have the lowest ones. Only 18% of ARM's cumulative licenses have been for Cortex-A designs, while 38% have been for classic ARM designs.
Nonetheless, an increase in new Cortex-A and Cortex-M licenses boosted ARM's gross margin 60 basis points annually to 96.5% for the fourth quarter. ARM's earnings rose 14% to $0.37 per share during the quarter, but that growth missed estimates by a penny due to the lower licensing fees offsetting improved shipments of 64-bit and multi-core chips.
Texas Instruments once competed against Qualcomm (NASDAQ:QCOM) in the mobile application processor and baseband modem market, but it left both markets several years ago to focus on higher-margin analog and embedded chips. TI also recently switched from 200mm to 300mm wafers, which reduced its chip production cost by around 40%. Those two strategies boosted its gross margin to a record high of 58.5% last quarter. Adjusted earnings rose 5% annually to $0.80 per share, topping estimates by $0.11, but that beat was notably inflated by a $0.09 boost from tax benefits and asset sales.
Valuations and dividends
Looking ahead, analysts expect ARM to grow its annual earnings by 13.6% over the next five years, which gives it a 5-year PEG ratio of 2.2. TI is expected to post 10% earnings growth during that period, which gives it a PEG ratio of 2. While neither stock comes close to dropping below the "undervalued" PEG threshold of 1, TI looks slightly cheaper than ARM relative to its earnings growth potential.
ARM has raised its dividend annually over the past five years, and it currently pays a forward annual yield of 1.1%. TI has raised its dividend for 12 consecutive years, and pays a forward yield of 2.6%. ARM spent 32% of its earnings on dividends over the past year, while TI spent 50% -- meaning that both companies will likely continue to raise their payouts.
The better buy: Texas Instruments
ARM is posting stronger sales and earnings growth than Texas Instruments, but TI's lower forward valuation and higher dividend make it a better buy at current prices. However, I still don't consider TI an ideal chipmaking play yet, since widespread softness in the mobile, enterprise, industrial, and wireless sectors will all likely weigh down TI's growth over the next few quarters. Other chipmakers also offer better dividends than TI, so income investors might want to check out those stocks first for stable dividends.
Leo Sun owns shares of Qualcomm. The Motley Fool owns shares of and recommends Qualcomm. The Motley Fool recommends Gartner. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.