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Summary

  • ARMH makes money by selling licenses and earning recurring royalties.
  • Growth for ARMH would come from emerging economies and markets such as enterprise networking/servers and automotive solutions.
  • Current stock price implies 60% annual growth rate in earnings, for the next 10 years!

ARM Holdings (NASDAQ:ARMH) primarily "designs microprocessors, physical IP and related technology and software, and sells development tools" (20-F).

Customers

ARM sells/licenses its technology to electronic companies (such as Freescale, ST, NXP, Xilinx etc), which build the chip, to sell it to makers of system companies (Samsung, LG, HTC, Amazon!), that rule the high-volume markets such as mobile phones, tablets, digital TVs and more.

Revenue

By upfront license fee and ongoing royalties, which are typically based on a percentage of chip price. ARM's current royalty revenues are derived from licenses signed many years ago.

Revenue mix

Historically royalty revenues have been higher than licenses, by about 30% or so. Higher licensing revenue would mean that the company has gotten more first time customers, who in turn will be "repeat" customers too, adding to the royalty revenues down the line. Revenues also include other income, namely selling software and tools, and providing services such as support and training. This 'other' income contributes roughly about 10% to the topline.

Profitability

Operating margin has been close to 35% and should rise going forward as more royalty revenues pour in. This is assuming costs don't rise as fast as revenues! Return on Equity and Return on Invested Capital are around 15%.

Market saturation

Firstly, the market isn't saturated. Consider the emerging economies. Positive population growth and expanding middle class means they will look for aspirational goods. And moving from feature phones to smart phones/tab is aspirational. Further proof of that is a hitherto unknown mobile phone company called MicroMax hiring Hugh Jackman as a brand ambassador (Video). Whose processor does MicroMax use? ARM's of course!

Secondly, the growth in topline is expected to come from 'enterprise solution'. ARM currently occupies 90% of the mobile phone market share. In the 'enterprise solutions' segment, its less than 5%. This segment refers to an ensemble of mobile/wireless infrastructure, corporate networks, storage devices etc. So, a big opportunity there! However, this segment has entrenched players including Intel. It will be interesting to see how this plays out.

The growth in topline is also expected to come from 'Embedded solutions' segment. This segment caters to automotive, industrial control and others; provides anti-lock braking systems and smartcards. As of now, ARM occupies about 10% of the market. This provides ample room to grow.

Furthermore, the buzz around 'Internet of Things' and 'Wearables'. At this point in time, its hard to predict how big this market is going to be. Given the optimism, ARM should benefit from the growth in this market too!

Valuation

With zero-debt, the enterprise value is the same as market capitalization. And market cap of $23B seems pricey with p/e of 120! Assuming a discount rate of 10% (opportunity cost!), it works out that the earnings have to grow at 60% per annum for the next 10 years, (and nothing thereafter!), to account for the current share price of $47. How likely is that? Furthermore, this assumes that there will NOT be further dilution of equity via options or anything else!

For earnings to grow, either topline has to grow, or costs have to drop, or both. In this business, it is unlikely that costs will drop. The intellectual realm of semiconductor industry demands that engineers be paid well, else they would switch! Also, this brings us to the business of equity dilution. In 2010 Dec, the company had 1352M shares. By 2013 Dec, the company had 1411M shares. 5% equity has been diluted in 3 years. Should this trend continue, the implied growth rate of 60% would have be revised higher!

Will the stock price climb higher in future? Very likely! A bubble isn't burst until pricked!

Source: ARM: The Toll Booth On The 'Information Highway'