It's the company you don't know, but whose know-how drives the products you take for granted -- from wireless handsets to digital cameras to PDAs. Britain's ARM Holdings (NASDAQ:ARMHY), a designer of high-performance microprocessors and related technologies, disappointed with its Q2 results. There may be more than meets the eye.

Revenues -- consisting of license fees, royalties from products shipped containing ARM intellectual property (IP), development systems sold to developers, and services provided to partners -- were up a scant 1% sequentially and down 27% year over year. Adjusting for changes in exchange rates, I calculate a 5.6% increase and 7.3% decrease, respectively. At the same time, revenues have turned up notably the last two quarters after falling off a cliff in 2002's second half.

For the quarter, the company added 11 new licensees for a total of 118. But notice that royalties comprise an increasing percentage of overall revenues. This makes sense as products go from development to market and require semiconductors embedded with ARM IP. Here's how this breaks down over the last six quarters:

  
        Revs.   %        %    Royalty FCF**Quarter (mil) License Royalty Rate    (mil.)  Q2 2003 $51.9  40%      33%   $0.094 $16.4Q1 2003  49.1  39%      33%    0.091   7.3Q4 2002  39.4  65%      32%    0.099  19.3Q3 2002  42.6  66%      23%    0.079  14.9Q2 2002  55.9  70%      18%    0.104  13.7Q1 2002  50.9  66%      18%    0.083   1.9*Source: Company press releases.
**Excluding interest income.
 Amounts converted from British Pounds to US$
at rate in effect at company reporting.

You could argue that the stock is pricey at 44 times trailing-12-month (TTM) earnings; however, the company's free cash flow production less interest has outpaced EPS for those four quarters. Shares now trade at an enterprise value to TTM free cash flow multiple of 18. Not cheap, but not unreasonable for a company with plenty of cash, no debt, and more licensees shipping more royalty-producing products each quarter.

In the end, ARM is a bet not only that its IP continues to be adopted, but that both semiconductor production and prices increase. That won't likely happen soon -- management sees a flat second half. I've taken the ARM plunge with a long-term view. Whether it's right for you depends on your investment strategy and tolerance for risk.

For more on ARM, enjoy World Tech Domination? and our active ARM discussion board!

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