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Summary

  • The fundamentals of the business are solid with ARM expected to win more business in enterprise.
  • At 18.7 times sales, ARM's valuation is stratospheric.
  • The technicals are bearish.

Investors have been selling the momentum stocks, as fears of higher interest rates weigh on investors' sentiment about the growth outlook for the high flyers. In some cases, the dumping of growth-stock shares is unwarranted, but that is not the case with ADRs of ARM Holdings PLC (NASDAQ:ARMH), which appear overvalued.

I think the overvaluation speaks to the strength of the underlying business, as the fundamentals of the company are excellent. ARM is the major player in its space in mobile technology and is gaining traction within the embedded space. The company could also experience significant success in the home and enterprise spaces. I think this combination of successes and potential successes has lead investors to irrationally bid the shares well above their intrinsic value.

Consequently, ARM is a short sale candidate with an unjustifiable price-sales ratio of 18.7. Based on my fundamentals estimates, I think the intrinsic value is $17 per ADR.

Recent Developments

  1. The momentum stocks are being dumped by investors, which could lead to undervaluation.
  2. An ARM-powered robot broke the world speed record for solving a Rubik's cube; the robot featured the same processors as the Samsung Galaxy S4.
  3. Bernstein upgraded ARM to Market Perform.
  4. Qualcomm's Snapdragon 810 will feature eight 64-bit ARM cores.

Analyst's Note

ARM designs the semiconductor intellectual property and enabling technology at the heart of the world's advanced digital products. Its energy efficient and scalable processors deliver the intelligence that is transforming society. The organization's solutions are used in smartphones and wearable devices, enterprise infrastructure and servers, and are embedded technology in automotive, industrial applications and the "Internet of Things."

The company's technology is used in almost every smartphone on the market. As a result, in 2013, 10 billion ARM-based chips shipped. ARM forecasts smartphone shipments to reach 1.3 billion in 2014 with growth being driven by entry-level and mid-range smartphones. Although the organization generates less revenue from entry-level and mid-range smartphones, ARM's royalty revenue from smartphones is expected to grow at a CAGR of 15-25% through 2018. Also, ARM had an estimated 5% share of the enterprise networking market, and revenue from servers should be accretive during 2014. Additionally, the company's embedded offerings are expected to be included in wearable technology, which is forecasted to grow from 10 million units in 2013 to more than 200 million units in 2018; but ARM reported more than 3 billion shipments of its embedded solutions during 2013, which means wearables would be a small fraction of the market for embedded solutions.

For the quarter ending (in millions of dollars, @ GBP 1.67, except per ADR data):

2012-03

2013-03

2014-03E

Revenues

222

284

336

Operating income

80

109

124

Net income

62

87

97

Diluted EPADR

0.13

0.18

0.20

For the first quarter, consolidated revenue is forecasted to increase 18%, which is below my full-year forecast of 20%. The difference in revenue growth is attributable to seasonality. The profitability margins are forecasted to be flat relative to the first quarter of 2012 and 2013. I expect diluted EPS to increase 9% to $0.20.

2011-12

2012-12

2013-12

2014-12E

2015-12E

Asset turnover

0.38

0.39

0.44

0.46

0.47

Debt-to-capital

0

0

0

0

0

Financial leverage

1.23

1.22

1.25

1.26

1.27

The balance sheet is solid. And the asset turnover ratio is improving, which suggests that sales are growing faster than assets. Also, the financial leverage ratio is outstanding. But Timothy Score, the CFO, needs to get Goldman Sachs on the phone and tap the B-O-N-D market.

For the year ending (in millions of dollars @ GBP 1.67):

2011-12

2012-12

2013-12

2014-12E

2015-12E

Cash provided by operations

324

436

526

630

725

Capex

20

33

23

25

27

FCFF

304

402

503

605

698

FCFE

304

402

501

605

698

Dividend paid

70

87

115

127

139

I'm projecting solid cash flows growth with continued moderate investment in fixed capital. Cash flow from operations is forecasted to increase 20% this year with free cash flow to equity topping $600 million. The free cash flow to equity coverage ratio is forecasted to be 4.77. The dividends paid are forecasted to increase just over 10%.

I view ARM as particularly well positioned within mobile and embedded. I think the company could continue to increase the percentage of sales generated from providing solutions in the enterprise space. The offerings geared toward home applications are relatively nascent. In conclusion, the product sales mix combined with the costs structure appears likely to generate an economic profit during fiscal 2014. But Intel's Atom chips, with reduced power consumption, are a credible threat to ARM in the mobile-chip market.

General Risks

  1. The share price is likely to remain volatile, and investors could lose a portion or all of their investment.
  2. Investors should judge the suitability of an investment in ARM in light of their own unique circumstances.
  3. A decline in the global economic growth rate and/or a decline in the pace of economic growth in the United States could adversely impact the results of operations and the share price.
  4. The technology industry is characterized by rapid technological change, which could materially adversely impact the results of operations.
  5. Competition in product development and pricing could adversely impact performance.
  6. Incorrect forecasts of customer demand could adversely impact the results of operations.
  7. Higher interest rates may reduce demand for ARM's offerings and negatively impact the results of operations and the share price.

This section does not discuss all risks related to an investment in ARM.

Portfolio & Valuation

(click to enlarge)

ARM is in a bear market of at least intermediate-term degree. The bear market could extend to a bear market of primary degree. For now, this is a sideways correction, which is different from a sharp correction. There is scope for a break below $40 per share. Simply stated, the technicals suggest at best a neutral stance.

Estimated intrinsic value

Forward price multiples based on base case scenario

Optimistic

$26.37

P/E: 20.60

Base case

$16.95

P/S: 5.56

Pessimistic

$11.30

P/BV: 3.22

P/CFO: 12.63

At 18 times trailing sales, ARM's valuation is exorbitant. I think the stock is priced for perfection with a valuation reflecting where the company could be several years in the future. I think the intrinsic value is closer to $17 per ADR, which is 5.56 times 2014's sales per ADR estimate. Simply stated, ADRs of ARM appear overvalued in the market.

Source: Irrational Exuberance Leaves ADRs Of ARM Overvalued