ARM Holdings (Nasdaq: ARMH) is in an enviable position that's only going to get better -- or so company president Tudor Brown says. In late May, he predicted ARM would grow its share of the market for mobile PC processors from 10% to 50% by 2015, and boost overall shipments of its ARM processor by 13% annually from now through 2020.
Talk about bold claims. Few executives outside of Oracle's Larry Ellison have ever been so forthcoming. And yet Brown may have a point. Due to its long-standing relationships with Apple (Nasdaq: AAPL) and NVIDIA (Nasdaq: NVDA), ARM is surging while rival MIPS Technologies (Nasdaq: MIPS) is still establishing a presence in the market for mobile device processors.
A history of dominance
ARM is to the mobile market what Intel (Nasdaq: INTC) has been to the PC market. At February's Mobile World Congress in Barcelona, the company released new data showing that 95% of the phones built for Long-Term Evolution would use an ARM processor. LTE is the natural successor to the 3G networks now accessed by most mobile users. Among the majors, only Sprint Nextel has opted for the opposing WiMAX standard in deploying its 4G network.
And that's just the latest victory. Just as Intel has long-standing relationships with Acer, Dell, Hewlett-Packard, and Lenovo, ARM's licensee list reads like a Who's Who of the world of mobile computing. Here's a sampling:
- NVIDIA
- Qualcomm (Nasdaq: QCOM)
- Samsung Electronics
- Texas Instruments (NYSE: TXN)
In all, more than 250 semiconductor licensees use some form of ARM technology.
What Steve Jobs can do
But some licensees matter more than others, and ARM's recent track record of outrageous growth maps nicely to the introduction and adoption of Apple's various iDevices, beginning with the U.S. launch of the iPhone 2G in June of 2007:
|
Growth Rates |
2010 |
2009 |
2008 |
|---|---|---|---|
| Revenue | 33.3% | 2% | 15.3% |
| Normalized net income | 96.8% | (14.3%) | 41% |
| Cash from operations | 83.2% | (4%) | 68% |
Source: Capital IQ, a division of Standard & Poor's.
While it's true that ARM's business hasn't improved symmetrically, the overall growth of its license revenue suggests the Apple relationship has borne significant fruit. Investors have certainly noticed: The stock has been a four-bagger since the summer of 2008.
Valuing outrageous growth
So there's a history of outperformance here. That's one of the six signs we look for in evaluating great growth stocks for our Motley Fool Rule Breakers service. But is there still room for the company to grow? I'd say so.
ARM isn't just licensing more cores. The company's technology is finding its way into ever more advanced chips such as NVIDIA's superpowered Tegra and Qualcomm's Snapdragon. More advanced chips generate more revenue, and usually at higher margins. (ARM's gross margin has improved 460 basis points since 2008.)
So we can expect ARM to keep growing. What sorts of returns will that lead to? The best way to answer that question is to dig into the numbers and assumptions that comprise a discounted cash flow analysis. In doing so, you'll get a better sense of what Mr. Market expects in terms of financial performance and the relative margin of safety you'd get from buying at current prices.
But if we're only looking at the next 10 years, we don't need a down-to-the-last nail DCF to get a grip on ARM's valuation. Comparing growth in unit shipments and normalized profits should tell us all we need to know:
|
Years |
Growth in Unit Shipments |
Growth in Normalized Profit |
|---|---|---|
| 2010 | 55% | 96.8% |
| 2009 | (2%) | (14.3%) |
| 2008 | 38% | 41% |
| 2007 | 18% | (9.1%) |
| 2006 | 47% | (13.7%) |
| 5-YEAR AVERAGE | 29.7% | 12% |
Source: Capital IQ, a division of Standard & Poor's. Averages are compounded rates.
Too bad the results are inconsistent. Even though recent volume gains have padded ARM's bottom line, it hasn't always been this way. Yet this is still a growth story. What I find interesting is that Brown expects unit growth to slow rather than accelerate -- from 29.7% annually over the past five years to 13% annually over the next 10.
The Foolish bottom line
How does that affect valuation? Since profit growth has traditionally lagged unit growth by more than half, I think it's fair to say Brown's predictions for 13% unit growth should result in less than 6% annualized profit growth over the next decade. Trouble is, even if profit growth accelerates relative to unit shipments in the coming years, the stock is currently trading for more than 100 times trailing normalized earnings and 50 times next year's consensus profit estimate -- so investors appear to be counting on a lot more.
Fortunately, there are plenty more opportunities in the chip space. One, identified in this Motley Fool special report, is an ARM partner. According to my Foolish colleague Eric Bleeker, the chip maker is on track to deliver market-crushing returns to investors. Click here to get a copy of the report -- it's 100% free.
