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Paying an ARM and a Leg

By Rich Smith – Updated Nov 16, 2016 at 4:49PM

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ARM gets slapped for making a pricey buy.

Shares of Motley Fool Stock Advisor recommendation ARM Holdings (NASDAQ:ARMHY) tumbled 19% on Monday in response to the company's buyout offer initially valued at $913 million in cash and stock, for fellow chip designer Artisan (NASDAQ:ARTI). Meanwhile, Artisan's own shares surged 16%. (Trivia: The decline in value of ARM's shares on the deal's announcement may mean that the price of the deal will also fall -- to about $780 million.)

ARM is already catching a lot of flak on Wall Street, which thinks that ARM is seriously overpaying for Artisan. Why? Well, right now, ARM is itself valued at 6 times its own sales (before the hit it took on Monday, ARM was valued at 7.5 times sales). Either way, when you consider that ARM wants to pay 11 times Artisan's sales to acquire the company, you have to wonder whether Artisan is really half again as good a company as ARM (and if it is, then why isn't it Artisan that is buying ARM?).

Sure, ARM's earnings growth forms anything but a "beautiful line," whereas Artisan has grown rapidly for three years now. But the idea is to buy growth at a reasonable price, guys.

Here are a few more numbers to consider:

ARMHY ARTI
Profit margin 13.3 20.8
Return on equity 9.7 9.8
Trailing revenues $251 million $83 million
Trailing profits $33.4 million $17 million
Free cash flow $60 million $8 million


Okay, so Artisan has a bigger profit margin than does ARM. Whoop-de-doo. Sears (NYSE:S) has a bigger profit margin than Wal-Mart (NYSE:WMT) -- but that doesn't make Sears, which is bleeding free cash flow, a better company than free-cash-generating Wal-Mart.

Note also that ARM turns 23.9% of its revenue into free cash flow, whereas Artisan's 9.6% "real cash" profitability is less than half as good. What's more, even on a GAAP basis, ARM works just about as efficiently as does Artisan, judging from their almost identical returns on equity.

Finally, consider the view of the market's short sellers -- investors who face unlimited losses if they place a wrong bet and thus have great incentive to be right. As of last month, 14.8% of Artisan's shares were sold short, indicating that a lot of people already thought the company was overvalued -- before ARM up and offered to pay a 40% premium for Artisan's shares.

Put it all together and, in this Fool's opinion, the market is calling this one right. ARM's circuit was fried when it negotiated this deal.

David Gardner picked ARM Holdings in Motley Fool Stock Advsior last November. So far, ARM has let him down, but in total his picks have outpaced the S&P 500 by 25% since April 2002. Find out what he'll pick next by trying Stock Advisor risk-free for six months.

Fool contributor Rich Smith owns no interest in any of the companies mentioned in this article.

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