Can ARM Holdings Sustain Its Multiples?

| About: ARM Holdings, (ARMH)

ARM Holdings plc (NASDAQ:ARMH) single-handedly changed the computer processor landscape and broke Intel's (NASDAQ:INTC) hegemony in the sector. Defying the general lethargy in the semiconductor sector, the stock registered high double digit growth rate the previous year and the run continues unabated into the current year as well. However, it is time to take stock of the future prospects of the company.

ARM Holdings is still on its path to provide value to its investors as it declared 13 cents per share in dividend. For its fourth quarter, the company announced consensus-beating results. Its quarterly revenue surged 19 percent to $263 million, beating consensus of $241 million, while net profit showed 28 percent growth to $66.8 million. Similarly, full year revenue and net income also grew 17% and 43% respectively, indicating good times ahead. While the results are good, such optimistic numbers are already valued in the stock price.

ARM Holdings' arch nemesis Intel recently inked a new deal with Altera Corporation for manufacturing chips. While the contract is lucrative, Intel will also have to incur the costs of keeping its foundries operational. This is where ARM Holdings makes a score, as the company does not manufacture anything and rather derives its revenue by licensing its technology. The business model helps ARM Holdings in keeping its overall costs - and consequently prices - lower. ARM Holdings also boasts of a very high gross margin, which may provide extra cushion in case of any downfall in the business.

ARM Holdings' future mainly depends on the growth of smartphone and tablet markets. IDC expects the smartphone market to grow at the annual compound growth rate of 18.3 percent. Similarly, tablet market is expected to develop at the rate of 23.3 percent compounded annually. Since ARM Holdings maintains leadership position in this segment and its rival Intel is still languishing, the major chunk of the growing pie is likely to go to the British company.

Another positive catalyst for the company is going to be its push in the server market. ARM Holdings is aggressively pursuing the market. So far, it has managed to augment its market share significantly. The company also means business when it comes to innovation. ARM Holdings spends more than 25 percent of its revenue on R&D. It is also moving beyond mobile computing towards embedded technology, which entails embedding smart chips on to the daily-use objects like TVs, Cars and refrigerators, turning those hitherto dumb devices into smart ones. The market is expected to grow exponentially in the near future and the company is in the unique position to grab a major share.

However, like any other company, ARM Holdings is not immune to the vagaries of the fickle economic scenario and competition. The company was said to have won a major coup when Microsoft (NASDAQ:MSFT) announced its decision to use ARM chips for its smartphones and tablets. However, the deal failed to do much for ARM Holdings as the Microsoft tablets and smartphones are still struggling to gain any meaningful market share. Also, Intel-based Microsoft tablets have shown far better sales record than the ones with ARM Holdings chips. Intel is also slowly working to break ARM's control over Android market.

Late last year, the company CEO also issued a warning about possible slowdown in demand. While the company is still on a growth trajectory and announced strong quarterly results, the rate of its ascent seems to be cooling down. Its arch rival Intel's move to capture the lower end of the mobile segment may also hit ARM Holdings hard as these lower priced smartphones are popular in emerging markets and that's where the next smartphone boom is going to come from. ARM Holdings does not seem prepared for it.

The company valuation is another cause of concern. Though, generally traditional metrics fail to capture the scope of high growth companies, however, Price Earnings ratio of 84 is still too high to be ignored, especially when its rival Intel trades at a single digit P/E ratio. ARM Holdings has little competition and has a lion's share of the market. However, many other companies with equal risk profile are trading at considerably lower multiples. High valuation also indicates that the price already has most of the positive growth baked in it. The stock is also seeing high insider selling activity, which is generally not a good omen for any stock.

Despite all the concerns about competition and its future rate of growth, it is an undeniable fact that ARM Holdings is going to be around for a long time, offering good returns to its investors, though the returns may not remain as spectacular as they are now. The smartphone and tablet revolution is likely to continue with the advent of ultrabooks running on low-energy chips, keeping the demand side up for ARM Holdings. However, at the current price point, it would be wiser to wait for a considerable pullback to initiate a position with a long-term view.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.