LONDON -- As the designer of the tiny silicon microchips and processors powering some of the world's coolest and most popular smartphones, computers, and other electronic devices, ARM Holdings (ARM) (ARMH) is a business with very definite attractions. A 10.5-billion-pound FTSE 100 constituent, last year the company earned a pre-tax profit of 157 million pounds on revenues of 492 million pounds.
And with margins like that, it's no wonder that this hi-tech powerhouse is popular with many investors -- especially those with an eye to growth, rather than income. For today, with its shares changing hands at 758 pence, the company is rated on an impressive prospective price-to-earnings ratio of 42, with its forecast 5.2 pence per share dividend placing it on a prospective dividend yield of just 0.7%.
But how safe is that share price? And -- of vital importance to income investors -- how safe is that dividend? In short, how could an investment in ARM adversely impact investors' wealth?
In this series, I set out to help investors answer just these questions. My starting point: ARM's latest annual report, where the company's directors are obliged to address the issue of risk.
Risk management
One immediate thing that I'm looking for is an acknowledgement that risks do exist, and that they need managing.
The good news? As you'd expect from a business of ARM's size and caliber, the company has in place a risk management policy, a system of regular reviews, and a number of high-level committees tasked with monitoring the risks that the business has identified.
But what, precisely, are those risks that the company faces?
Read the small print, and ARM identifies just five risks as being material enough to have a significant prospective impact on the company's financial performance -- not many, to be sure, but bear in mind that ARM is in the business of designing chips rather than manufacturing them, and is essentially a business selling and licensing intellectual property to some of the world's largest electronics and computer businesses.
So let's take a look at three of the biggest risks ARM reckons it faces.
Slowing growth in the semiconductor industry
Today's mobile phone and desktop computer markets are very different from those of -- say -- a decade ago. Taking phones as an example, names such as Nokia and Motorola are on the wane, and names such as Apple, Samsung, and HTC are the preeminent suppliers. And typically, during such shifts, a period of consolidation ensues. As ARM puts it:
About half of ARM's revenue comes from direct licence sales to semiconductor companies. If there are fewer semiconductor companies, then ARM may have fewer customers to sell to. ARM is exposed to a range of markets including wireless handsets and microcontrollers. Consolidation in these parts of the industry could represent a loss to ARM's future licensing business.
As ARM points out, the risk is a very real one. In 2011, for instance, its customer base witnessed Qualcomm's acquisition of Atheros, and Broadcom's acquisition of Netlogic.
What can ARM do about this? Not a lot. But, as it points out, it does strive to make sure that customers get the message that ARM's technology is an opportunity to reduce costs as companies work to combine their businesses into one. As ARM notes: "In consolidating companies, ARM technology is often a standard that both companies can integrate around."
Convergence of smartphones and laptops
Today's consumers want portable products that keep them connected to their social and business networks, have an all-day battery life, and are simple to use. So in response, smartphones are getting smarter, and laptops are getting smaller and more portable, and the market is seeing new "crossover" mobile computing products introduced.
And to be sure, this is providing an opportunity for smartphone technology to cross over into laptops -- but more worryingly for ARM's shareholders, it's also providing an opportunity for the reverse. As ARM puts it:
The main processor in a laptop is typically based on the x86 architecture. Smaller and lower power x86‑based chips are being developed that will be suitable for the main processor in a smartphone. They are capable of reducing ARM's market share in smartphone application processors, and hindering any market share gains that might be made by ARM licensees in mobile computing.
The risk is real, to be sure. But ARM's technology strategists reckon that it's also an opportunity for the company, pointing to the fact that ARM processor‑based chips for mobile computing are lower cost and lower power than traditional computer "x86‑based" products. And certainly, ARM's licensees have announced chips that are suitable for mobile computers, including tablets, e‑book readers and laptops.
What's more, ARM has raised the stakes, announcing its new "big.LITTLE" micro-architecture in 2011, which combines a higher performance with a long battery life. Smartphones containing this new technology will reach mainstream consumer markets during 2013, say analysts.
Competing in microcontrollers
In 2011, ARM had just 15% market share of the 8 billion unit microcontroller market -- although that share has of late been growing strongly.
This market is characterised, says ARM, by a large number of proprietary processor architectures being developed by a great many semiconductor companies, who then sell very low cost chips into a highly fragmented end-market. In other words, it's a very different market from ARM's traditional markets. And, as ARM puts it:
It could be difficult for ARM to be successful in the microcontroller market. ARM will need to displace many established in-house processor designs. ARM has invested a lot of effort and cost to achieve modest penetration to date. [What's more] as the microcontroller chips are low-cost, the royalty revenue per device is also lower than in other markets.
That said, ARM believes that it can capture a significant proportion of the microcontroller market. Its Cortex‑M processor family was developed specifically for this market and, by the end of 2011, had been licensed more than 120 times, helping the company to almost double its market share.
The result: more OEMs have chosen ARM processor-based chips for their products, and more semiconductor companies have chosen to sell ARM processor-based chips for the first time. Indeed, says ARM, during 2011 such semiconductor companies as Cypress, Freescale, Fujitsu and Toshiba started shipping ARM microcontrollers for the first time. All of which sounds to me as if the battle is finally going ARM's way.
Risk vs. reward
Two superstar investors who are well-used to weighing risks are Neil Woodford and Warren Buffett.
On a dividend re‑invested basis over the 15 years to Dec. 31, 2011, Neil Woodford delivered a return of 347%, versus the FTSE All‑Share's distinctly more modest 42% performance. Warren Buffett, for his part, has delivered returns of over 20% per annum since 1965, transforming himself into the world's third-wealthiest person.
Each, as it happens, are the subject of two special reports prepared by Motley Fool analysts. And they're yours to freely download, without any obligation.
So click here to download this free special report profiling the investment logic behind eight of Woodford's largest and most successful current picks.
And click here to discover which beaten-down British share Warren Buffett has been buying of late -- and why he bought it, and the price he paid.
