I Concede Defeat On ARM Holdings

Oct.30.13 | About: ARM Holdings, (ARMH)

Yes, I'm shamelessly stealing the title of Paulo Santos' superb piece on Amazon (NASDAQ:AMZN), but it's become increasingly obvious to me (and has been obvious to longs of this particular name for years now) that ARM Holdings (NASDAQ:ARMH) simply cannot lose. That doesn't mean the stock is a particularly good buy (admittedly this is strictly a valuation call, not a structural one - and in this market, "valuation" simply doesn't matter as long as you've got a story), but what it does mean is that my short thesis is 100% completely broken. ARM Holdings is quite obviously here to stay and any threats it may (eventually) face in the low power mobile system-on-chip space are not immediate enough to warrant being bearish on the shares.

Few Immediate Mobile Share Threats, Increasing Mobile Chip Content

Despite being an ardent Intel (NASDAQ:INTC) bull, it seems likely to me that material share losses in mobile (i.e. something that could show up in a clear way on the P&L statement) are unlikely over the next year. While I do expect Intel to gain more share in tablets (it's at about 5% today, and I'm looking for 10-20% exiting 2014) and I am even optimistic about mid-tier phones next year as its "Merrifield" SoC + LTE modem ramp (likely ARM based modem, though), the very high volume low end (where ARM's A7 and soon A53 reign supreme, and plenty of ARM GPU IP and physical IP is utilized, driving up royalty as a percentage) belongs to the likes of Qualcomm (NASDAQ:QCOM), MediaTek, and Allwinner.

The high end of the market will also likely be safe, as Apple's (NASDAQ:AAPL) iPhone (which uses an royalty bearing, Apple-designed ARM compatible processor) - the most popular high end phone - will likely be tied to ARM indefinitely. Samsung, too, is likely to continue to pursue its own in-house chip designs and eventually displace Qualcomm as soon as it can, which means more sockets indefinitely tied to bespoke, ARM-royalty bearing processors.

While Intel could very well play in the very high volume low end markets (and try to win this on scale if it were to pursue a targeted design for low cost/low die area), and while I do believe it will eventually be able to service the higher end, non-Apple, non-Samsung markets, Qualcomm is proving to be a most capable leader in this space. Intel will have to build better products on a faster cadence if it wants to take sockets in the high end phones from HTC, LG, Nokia (NYSE:NOK), which means that the "threat" to ARM is at least a year out in this device category (although as an Intel bull, I'd be happy to be proven wrong).

But the bottom line is that ARM now provides best in class processor IP (Cortex A12 should "fix" the issue that the company had with A15 in phones for the midrange guys unable to do their own cores), best in class graphics IP with Mali, and top notch physical IP for the cost sensitive Asian vendors. ARM has done a truly remarkable job in grabbing more content share (leading to higher royalty rates) of the smartphone/tablet space.

Networking/Comms Dominance Imminent

Today, ARM does not play meaningfully in the high end networking chip space. This is dominated by chips designed around IBM's (NYSE:IBM) POWER architecture, Imagination Technologies' (OTCPK:IGNMF) MIPS, and Intel's X86 chips. In this market, traditionally MIPS vendors are now moving to ARM (Broadcom's (BRCM) high end networking chips are now going ARM), as are the POWER guys (like Freescale (NYSE:FSL) and IBM itself). X86 is gaining share rapidly, and it's clear that ARM will gain a lot of share, too. This isn't a huge market in terms of units, but ASPs are quite robust and the market itself is growing. Also, given that these chips can contain many cores (8+), ARM's royalty rate on these rather high ASP devices could be very healthy.

Valuation Is Still A Concern, But Who Cares?

If you're in the markets long enough, and if you're looking at tech in particular, you'll note that valuations don't mean as much as the "story" does. As long as a company keeps "beating" estimates (and ARM is a company that very much "manages" expectations, so the bar is always set just high enough by the sell-side for them to beat), and as long as the healthy revenue growth continues, it's really tough to be bearish. Analysts/investors can build whatever aggressive DCF that they'd like, and as long as the near-term story continues to look good, there's precisely zero reason for them to adjust these models down.

Now, there's the little snag of an only 14% Y/Y royalty rate increase in the current quarter (so the "beat" was driven largely by a swelling in one-time licenses) and share based compensation makes the IFRS results (that's basically like international GAAP) look not-so-great (it's actually really bad), but for a story like this, nobody except the one lone bearish sell-side guy who continually looks like a dork (the lowest PT published is $36) because he continues to be wrong (believe me, I'd know) will dare bring up any concerns. And, you know what? Why would they? ARM is in great shape and until it faces meaningful competition in its high volume areas, it's going to continue to be in great shape.

Does that mean it's a buy here? I wouldn't be a buyer right now, but I do know that I wouldn't dare be short. Not without a clear catalyst and not as long as it's clear that every dip (manufactured, or otherwise) continues to be bought. If you put a gun to my head and told me to either short or go long, I'd probably be long - but I'd ask real nice to be able to wait for a dip.

Disclosure: I am long INTC, BRCM. 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.