Seeking Alpha
We cover over 5K calls/quarter
Profile| Send Message|
( followers)

ARM Holdings, Plc (NASDAQ:ARMH)

Q2 2014 Earnings Conference Call

July 22, 2014 4:30 AM ET

Executives

Simon Segars – CEO

Tim Score – CFO

Analysts

Achal Sultania – Credit Suisse

Adithya Metuku – Bank of America Merrill Lynch

Janardan Menon – Liberum

Sandeep Deshpande – JPMorgan

Brett Simpson – Arete Research

Sumant Wahi – Redburn Partners

Amit Harchandani – Citigroup

Nick James – Numis

Andrew Gardiner – Barclays

Gareth Jenkins – UBS

Simon Segars

Good morning, everyone. And welcome to the ARM’s Q2 and H1 Results. Thank you for joining us this morning. Hopefully you’ve had a chance to read the press release and primed with some questions. We’ll come onto questions later I’m going to give a bit of an overview of the business first. I’ll then hand over to Tim, who will talk through some of the numbers, and then we’ll do Q&A up here in the chairs.

So, before we get going, I’ll just refer you to the usual cautionary statements. I think you’re all very familiar with this and we’ll take it as right.

So, let me start by giving a bit of an update into what’s going on across the business. As you’ve seen from the release, our revenues in dollar terms were up 17% year-on-year. And now in this period, the dollar-sterling exchange rate moved against us. And so in U.K. terms, in sterling terms our revenues were up 9%.

The performance of our business was driven very heavily by very strong licensing, up 42% year-on-year. And royalty in this period was up 2%. And I’ll come back to that later.

In terms of licensing, this has been one of our strongest quarters ever with 41 licenses signed across a very broad range of technology including two licenses for products we haven’t actually announced yet. I’ll on to that a bit later on.

Now, despite the exchange rate headwind, our earnings per share, was up 11%, and we declared today the interim dividend up 20% year-on-year. Now let me come back to royalty.

As you have seen our royalty grew 2% year-on-year and that’s lower than we’d experienced in recent quarter. And that’s been driven by a number of factors, many of which have been anticipated. There has been seasonality in our numbers Q2 is ordinarily a weaker quarter.

There has been some industry cyclicality and actually a tough comp year-on-year, 12 months ago we had a very strong quarter in royalty performance.

Now, industry cycles do happen especially in consumer markets. When I talk about consumer I mean, phones, TVs, DVD players, digital cameras and the like. And when we look at the composition of ARM’s royalties, about 80% of the royalty value comes from these consumer driven markets. And so, when there is a cycle there, our royalty revenues are disproportionately impacted by that.

And you can see that cycles are nothing new to ARM. We’re showing here on the slide in the mobile sector alone, some of the peaks and values that we’ve experienced over the last few years. And you can see that some of the peaks the higher and some of the values are in fact lower.

And over the years, as we’ve been through these cycles, there’ve been a number of factors that drive the industry up and down. We’ve seen different product mixes, we’ve seen technical discontinuities come along, we’ve seen the anticipation of new devices that drive the markets up and drive the markets down.

And there have been a number of these kinds of factors that’s gone on over the last few quarters. In the last quarter, one such example is in China, where the operators are using subsidies to heavily drive the sell-through of 3G handsets in anticipation of moving to 4G later on. What that means is there is a delay in the uptake of the most advanced chips from our customers by the OEMs and that is one of the factors that read through into our royalties. So there are number of things going on.

But the real question, I guess is, are we at the deal, are we at the proximity (ph) valley or are we still on a downward trend.

And from what we see looking into the industry, talking to our customers, looking at overall trends, we believe that our licensees have already experienced the stronger Q2 for them that would result in stronger Q3 royalties for ARM. And that there is a momentum building that we’re carrying to Q4 and beyond. So, we think we are at or certainly near the bottom of this cycle.

Now, one factor that gives us confidence and underpins our belief in further strong royalty growth for ARM is the strength of licensing of our advanced technology, our Version 8 architecture products.

We’ve now licensed Version 8 products 50 times to 28 different companies. And when we look at some of the key segments for ARM, we see that all of the top-10 chip companies, the built chips for smartphones have licensed Version 8. Nine out of 10 of the companies that build applications processes for tablet have licensed v8.

In consumer electronics, TVs, DVD players, set-top boxes, it’s four out of five. And in enterprise networking, where we’re growing market share, again, four out of the five of the top guys who sell into this market have licensed Version 8 of the ARM architecture.

Version 8 as you know, commands a higher royalty rate than its predecessors. And as these devices come to market, as they end up in OEM products and deployed into datacenters, this would drive high royalties for ARM.

And in Q2, as I mentioned, we started licensing new technology roadmap products that we haven’t actually announced yet. And with two products that have been licensed. And today these go by the code names of Maya and Artemis.

Now, we’re not going to give a lot of detail about those products today, so bit of a teaser. I’ll talk about that more openly later on. In the meantime if you want to know how to spell Maya come see Ian afterwards and we’ll give you that, so more on those products, another time.

Now, Artemis and Maya are result fruits of the investment that we’ve made in R&D over the years. If you look at our headcount over the last 12 months, we’ve increased by about 500. And most of the people that we’ve hired are engineers working on our next generation of technology.

They’re working on multiple products, Artemis and Maya are just two of the things that are coming out now. But we have many investments going on in many different product lines to help us drive the business forward.

The products that they’re creating are going to help us sustain market share in markets where we’re traditionally strong. In mobile, we see huge growth ahead of us. And we believe that the products that we’re building will enable ARM to maintain a very high market share there.

It’s going to help us gain share in some of our non-traditional markets like automotive, like the datacenter as Cloud develops. And in the networking, as I said, we’re starting to grow share. And it’s also going to help us capture a lot of share in new and emerging markets in, the internet-of-things.

These are new markets which have much growth ahead of them we believe, many changes ahead of them. We believe the products that we’re building will allow us to take a very large share there. So this investment, this continued investment in R&D is really important to us.

Now, if we turn to our Analyst Day in May, you will see in this slide, and just to give a recap here. All of those different technology areas we group broadly into three different pillars, mobile application processes, enterprise, infrastructure and embedded intelligence. And I’ll just touch now on the progress in all three.

When we look at our progress in mobile, 12 months ago I stood here outlining how we see the mobile market, the smartphone market evolving over the next five years. How the different categories of smartphone will experience different growth rates over the next five years.

And how the kind of different semi-conductor devices our partners are building will power those devices. 12 months ago, we talked about our expectations for the adoption of Version 8 of the ARM architecture for the adoption of our graphics technology and our video technology. And the progress that we’ve seen in the last 12 months really does underpin our belief in the growth in the model that we spelt out leading to somewhere between; 15% to 25% CAGR in our royalty revenue stream from mobile.

And in the last quarter, the very strong licensing further gives us confidence in that model. So I’m more confident about that today than I was 90 days ago and that was 12 months ago.

Our Version 8 licensing as said has been very strong where we’re expecting to see many new devices based upon silicon build on v8 later this year and into next year.

When we look at progress on service and in enterprise infrastructure, the last quarter has been really interesting and really positive thing I believe for ARM powered server chips. We’ve seen three of our licensees, AMD, AppliedMicro and Cavium, all do some fairly major announcements about what they’re doing and the products that they’re building.

Earlier in the quarter, AMD demoed their first product and they talked about their roadmap using their architecture license from ARM. And they talked about devices which are pin compatible enabling an accelerating migration to ARM based servers.

At Computech, we saw Cavium launch a range of devices that tailored for different workloads and delivering very, very high performance with multiple very high core count devices.

And most recently, we saw AppliedMicro launch their products tailored at high performance computing but in a very low power envelop. So, we’ve seen a lot of silicon devices and we expect those to ship in real servers towards the end of this year as those devices start to get delivered to our customer’s customer. So it’s been a very strong quarter for progress in the enterprise.

In embedded intelligence, half, nearly half the licensees that we signed in Q2 were for our M-Class processes. These are the products that we’ve designed specifically to target a microcontrollers and very strong and very power efficient systems on chip that will be in variable devices, internet-of-things devices and in embedded products everywhere.

Now, those licenses, with on that 20 licenses for Cortex-M then we expect to come through into Silicon over the next few years and contribute to the strong growth we’re seeing in unit shipments of Cortex-M. It’s about 900 million units in Q2 or Cortex M-Class ARM based microcontrollers.

As well as, on the silicon side, we’ve seen some evolution in the ecosystem around the embedded space as well in the quarter. You might not be familiar with it but the board in the middle is now Adreno, Adreno is a development platform with a very large ecosystem around it, which is historically been based on very simple 8-bit microcontrollers.

In the last quarter, we saw new products from Adreno based on 32-bit ARM processors, helping that develop a community move over to a higher performance devices. And similarly Atmel, who have been a big driver behind Adreno as well are evolving very consistent with Atmel SMART to make it easier for their customers to move from very simple devices to more sophisticated more, higher performance 32-bit ARM based devices.

So the silicon side is evolving. Lots of customers coming to us looking to innovate in this space as we all see, many of us see the growth of embedded as a real driver for the semiconductor industry.

So, in summary, we’ve made great strategic progress in the last 90 days, a strong licensing performance, developments, in our ecosystem really to underpin the long-term growth opportunity for ARM.

Licensing is a pretty personal to royalty. Licensees we’ve signed today will come through in volume, typically in a two to three year time person. And the 41 licenses signed in the quarter is really significant, one of our best licensing performances ever. And that does access a very strong precursor for the future royalty growth.

Royalty in the short-term has been impacted by various market conditions. But when I look at the activity that is going on, ARM and our licensees have not lost market share anywhere. This is about the dynamics of the end market. It isn’t about market share changes. We’re continuing to see as is evidenced by the 41 licenses. Strong uptake of our newest technology and that will drive us into the future.

And based on the conditions we can see today, based on what is going on in the market, we do expect better royalty performance in Q3 and that moment to accelerate into Q4.

So, with that, let me hand over to Tim to talk through some of the numbers. And then we’ll get back into Q&A.

Tim Score

Thanks, Simon. Good morning everybody. So, I think Simon has given us a sort of good overview of the licensing and royalty dynamics that have impacted both Q2 and what we should expect down the road in terms of royalty growth.

So, this morning, I’ll keep it fairly brief and just focus in on a bit more color on the P&L, some comments and reminders about sort of balance sheet, cash capital structure. So, to revisit a little bit the backlog dynamics, because obviously it’s an interesting licensing quarter in terms of the number of licenses, the movement in the backlog, the outlook for the rest of the year. So, we’ll give a little bit of color on that. And then, just sort of reiterate the outlook, how we see the balance of the year.

So, Simon said 17% dollar growth, quite a tough headwind at the moment with regards to the currency. The Q2 effective translation rate was 1.65 in 2014 compared with 1.54 last year, that’s relatively painful move. So that translated as Simon said into 9% sterling revenue growth.

PBT, therefore more closely aligned with that, again up 9%. Now that is after another headwind from currency of the mark-to-market when we revalue our balance sheet, revalue our forward contracts at the quarter end.

The FX actually moves from about 1.66 in some at the end of Q1 to 1.71 at the end of Q2. And that typically would result in us having a mark-to-market charge in that environment when the dollar strengthens quarter-on-quarter you tend to get a credit. So, yes, in most quarters, it’s plus or minus a million quid. In this particular quarter with quite a significant weakening through Q2 of the dollar, it’s £3 million.

So, on an underlying basis, OpEx £85 million in Q2 compares to our previous guidance and consensus of about £87 million, so running a little bit under on an underlying basis. You’ll see there the guidance for the third quarter, little bit higher in the sort of £90 million to £92 million range. We have been continuing as Simon said to hire, to invest in the R&D opportunity.

We’re also investing in if you like, the back office, the infrastructure, the IT all of the things underpinned the future growth of this business. And Q3 also carries some costs that don’t necessarily appear in all quarters. We have our big Annual Partner Meeting in the third quarter probably our biggest single marketing event, that gets charged in the third quarter.

We also closed a sort of Bolton acquisition at the end of May called Geology (ph) referred to in the back of the release, relatively small acquisition but 60 plus people. The cost of those people will also be reflected in the Q3 numbers. So, somewhere in the sort of early 90s we would expect as a base case at current exchange rates.

That then, just driven a normalized EPS up 11%, the items in between there I think as we all know we’re all getting less return on our cash at the moment. There are one or two bankers in the room who are looking a bit sheepish in terms of how much yield given on that cash. But that stuff a little bit.

But on the other side of the equation, the tax rate in – is running at about 18% just over compared to just over 20% last year. And this is the dual benefit of the ongoing implementation of Patent Box, which is as most of you know is being implemented over five years. And also the U.K. Corporation tax rate continues to be legislated down. So, the tax tailwind continues earnings up 11%.

Also in Q2, and not only are we investing in our new R&D capability and innovation, we’ve also been reviewing as we look forward, the mix of sort of skill and capability generally that we need in ARM as we grow. So it’s not all about going out and identifying the new rules or looking at the ramp in the mix that we have. And that has given rise to around about 130 people leaving ARM in Q2.

Net headcount obviously up about – on a continuous basis if you like reviewing the skills mix, and this was a particularly focused exercise around doing that. So there is a restructuring charge statement in the quarter.

Moving on to the sort of the cash and the balance sheet. Strong quarter, cash generation, £87 million, you can see on the right there, the sort of cash journey that we’ve been on without sort of boring with ancient history. The way ARM has managed its cash is we were cash collectors until 2003, ‘04.

We then managed cash down as you can see there down to about £50 million just before the world went into meltdown going into 2008. And we did that via a three and half year rolling buyback where bought back about 16% of the share capital during that period.

But when we went into the downturn, we sort of deliberately let the cash ride up. And as you can see, have broadly continued to do so such that we find ourselves now with £750 million net. So I think with that cash balance, we have a lot of opportunity to invest. We have opportunity to do further M&A if we need to. And we have opportunity to continue to return cash to shareholders, probably on increasing basis as we look forward.

I mean, you can see the graph in the middle on the share count, looking back again over sort of 9-year view, the share count has been flat. And as we said at the beginning of this year that we continued, we continue to maintain a share count that will mean from here is a limited buyback.

Current numbers, probably about 10 million shares in a year. We did a little bit of adding Q2 1.4 million shares, 12 million quid. And you can expect to see more of that as we maintain that flat share count.

And on the dividend front, since we introduced the dividend back in ‘04, we doubled it at the beginning and of then have consistently grown in the sort of 20% area, some years plus, some years minus, spending most going in the market. And today we’re saying 20% in the context of earnings up 11%, consensus earnings with the full year up about 15%. And our future outlook up we think in here around those numbers at least, we’re increasing interim dividend by 20%.

So, as I say, backlog I think as we’re spending a little bit of time on because lots of moving parts on license revenue. And here is a quarter where we’ve beaten expectations by about $15 million.

We’ve signed as Simon says, 41 licenses, I think that’s the second time we’ve been through 40 licenses. And since yet the backlog down 10% sequentially, it was down about 5% sequentially last quarter. So, what should we be reading into all that, I think is what seek to address.

So I think it’s worth reminding ourselves over the last five years, backlog has grown broadly 5X. What’s been driving that and even though it’s been down the last couple of quarters, you can see it’s just high it’s pretty close to its historic high levels.

And I guess the key drivers, from the launch of Version 8 of the architecture, a combination of things that really drive the backlog up. Architecture licenses subscription licenses, subscription license just to remind those is not fresh in the mind.

It’s a license, a multi-year license, often three years, sometimes five years let’s say, that a company that uses ARM widely across multiple divisions and targeting multiple end-markets, often finds it attractive to take us with a corporate-wide license to a defined suite of our technology. So they don’t have to be negotiating individual licensees or individual processes all the time.

The way the accounting works for those licenses, because they incorporate technology to be developed during the period of the subscription, you can’t recognize revenue in the normal percentage of completion way. You have to recognize the on a linear rate of basis.

And so, when you sign a subscription license, you get five years worth or three years worth of contract value and the backlog on day one. And that backlog pertaining to that particular license will reduce on a quarterly basis through the end of that license.

In most cases, as subscription licensees will then renew at the end of that subscription, most of them stay with that model once they’ve embarked on it. And therefore after three or five years, the backlog will shoot back up again as they renew that subscription. And then it will wind down again. So that’s been quite a powerful dynamic in that growth.

Also the other key components of backlog is when you sign licensees with customers before you’re in a position to deliver all the things that they’re signing up for. Clearly you can’t recognize revenue before you deliver products or you still have cost to incur to complete those products.

And when you’re in early or a lead licensee, which is a model we have used throughout ARM’s history, the value of the license will go into backlog. And it will be transitioned from backlog to revenue as engineering master and unmet contract deliverables are made.

Therefore, inevitably you go through a period of as I say recognizing ratable from the subscription. And then, and it just happens that in the last couple of quarters, engineering milestones relating to the initial processes from the Version 8 architecture have been met multiple licensees, multiple deliverables. Obviously money goes from backlog into revenue and as that occurs.

And then you look forward, you look at the new subscription you look at the subscription renewals. And in the sense the cycle then begins again as we introduce new technology, Simon has just touched on a couple of the next wave of Version 8 processes that’s going to be coming to the market in due course.

Lead licensees are already beginning to engage, that’s driving out the backlog. So, what we say in the release is that we expect looking into the crystal ball of licensing in the second half. If you look at the mix of licenses between licenses that generate revenue in the short-term, licenses that generate backlog. And we expect the backlog to be rising in the second half from where we are. Which, I think we’ll – by the time we get to ending year, I think would be a strong support for target license revenue next year.

I mean, you’ve heard me many times that we don’t expect to be growing license revenue 40% or 30%, deep into the future. I draw to you that this accelerated growth is lasting longer and actually higher than I have been signaling. This is very good news. But don’t be disappointed if in Q3 or Q4, we’re not growing licensing in 40%.

If you look at the comparisons, in the same way that Simon said that the royalty compares in Q1 and Q2 have been tough. The licensing compares have been easier. And you remember Q3 last year we jumped through $100 million of license revenue for the first time, therefore in Q3 and Q4, license revenue compares will get tougher. So, we see a world of accelerating royalty revenue growth year-on-year but license revenue growth will be slower relative to the 42.

Anyway, these are the dynamics backlog will go up some quarters. It will go down in others. But we are very confident it is supportive of the licensing outlook which is out there in the market in 2015 and beyond.

So, reiterating the outlook, licensing prospects in the second half look good, they look good for turns business as we call it, that yields revenue in the short term. And we also see the pipeline of opportunities generating up with pressure on the backlog.

Simon’s touched on royalty industry data, guidance from our biggest shippers, looks positive for a pick-up, which we would expect the benefit from in Q3 and Q4 in Q1 because obviously we are one-quarter in arrears. And so, putting all that together, we see the – we see after dollar revenues being in line with market expectations which are in the sort of £1.295 billion area at the moment, £1.295 billion.

So, with that, we’ll go to Q&A.

Question-and-Answer Session

Simon Segars

So, perhaps I could ask in the Q&A, as we have been doing of late. If you’d ask one question, so we can get around the room and perhaps state your name and affiliation.

Achal Sultania – Credit Suisse

Thanks. Achal Sultania from Credit Suisse. Simon, you mentioned about 15% to 25% growth in your smartphone royalties long-term. And then, have you looked at that chart which you showed about mobile, like the impact from mobile inventory correction.

Shouldn’t we expect a significant – like a significant rebound like we’ve seen in the past, again this year in your royalty revenue growth when this inventory correction, when you come out of this inventory correction in the second half of this year. Because 15% to 25% growth is what you expect from smartphones.

And then you’ve got additional share gains in enterprise and networking. I’m just trying to understand why can’t your royalty revenues grow like 25% to 30% in the next few years going forward?

Simon Segars

Yes, I mean, there may well be a strong rebound. I mean, that 15% to 25% is a five-year CAGR for just mobile, just for smartphones. As you say, when you layer on other things, potentially there is much higher royalty growth to come from that.

That’s all going to come down to the timing of when products come out that they’re on – when you look at a server or networking equipment driven by very different market dynamics, very different timeframes and consumer devices. So, adding it all up, they’re all layers of royalty which contribute the long-term growth. The point I was making was specifically around long-term for smartphones.

Tim Score

I think one thing to bear in mind on that is that is one of the assumptions in that 15% to 25% is that by the end of that period, all smartphones, entry, mid and premium are incorporating Version 8 of our technology. And that, as Simon said is the one that yields the high royalties.

And actually today, that’s a minimal contribution. So yes, today we’re not really seeing the benefit, we’re just starting to but not really seeing the benefit yet of the Version 8 being designed into smartphones. So that is a longer term comment on that one sector.

Achal Sultania – Credit Suisse

So, would it be fair to say that you can outgrow the semi-market by more than 15% which is in your guidance long-term. Is that where that’s coming from?

Simon Segars

Actually, we have in the past. And I think yes, we’ve been developing a strategy for broader market penetration, broader adoption of ARM technology, which potentially can lead to those kinds of levels of out-performance in the future. We’ll see. Next question the gentleman behind you.

Adithya Metuku – Bank of America Merrill Lynch

Hi, Adithya Metuku from Bank of America Merrill Lynch. Simon, your guidance basically seems to imply 10% royalty growth for this year. When do you see your out-performance going back to the 15 percentage points that you’ve talked about. Can we see that in the 2015 considering your comps eventually easier this year?

And secondly, do you see your year-over-year be the royalty growth rate accelerating into the first quarter of next year, considering this, your fourth quarter this year seems to have been affected by some of the push-outs in the 4G space?

Simon Segars

So, the question is about royalty growth. Yes, certainly, I think the re-acceleration isn’t something that just aims on December 31. I think there is, as we work through the inventory, it feels one would expect to get back to something more normal. But at the same time, I would expect the regular seasonality, you can see from the shape of that graph these cycles do come and go on 18-month to two year kind of cadence.

So, at some point in the future, I’m sure would be impacted by some of that again. But the key for me is long-term, are we delivering the right technology into these markets. Are we continuing to maintain share, very high share markets and growing new share, and all of that is happening. So I think that supports the kind of long-term model that we’ve outlined in the past.

Adithya Metuku – Bank of America Merrill Lynch

Thank you.

Simon Segars

Just behind you.

Janardan Menon – Liberum

Hi, it’s Janardan Menon from Liberum. I’m just trying to paint a picture of your royalty rate, your percentage of royalty. As you’ve transitioned out of ARM 11, so ARM 11 is now fallen 50% rest lease on down to 3%. And that’s taken over by the Cortex A-Class. And that’s going to start transitioning to the v8 architecture going forward.

So, if you would paint a picture of royalty rate going from say 1.1% when this journey sort of started and rising to somewhere in the 2% to 3% range. Is this transition now the ARM 11, finishing and the v8 starting off? Is that an upward inflection moment in that graph or is it a steady state you’re sort of ticking on 1.2%, 1.3%, 1.4%, I mean, whatever the number is today. And just, if you could just give us a qualitative description of how you would see those transitions on your royalty rate?

Simon Segars

I think in the mobile space and the smartphone space, I wouldn’t necessarily inflection point because I think whilst we talk about v8 being pervasive, yes, it is going to transition in. But I think it will be faster than the very, I mean, I think there are two things. There is the smartphone and mobile space and then there is the overall blended.

Tim Score

I think it’s more on the smartphone.

Simon Segars

I think in the smartphone, I think and it will obviously depend very closely on the sort of v8 ramp. But I think it’s going to actually be quite noticeable within the mobile space. Then, when you look at the overall ARM royalties, it gets a little bit more submerged under the volumes and microcontrollers and IIT type stuff. But I actually think it will become quite noticeable in the mobile space as we move to v8.

Janardan Menon – Liberum

So, you’re saying that whatever the trajectory of growth you’re seeing in smartphones over the last say two or three years in the ARM 11 to Cortex A transition, you will probably see slightly more accelerated rate of growth going forward.

Simon Segars

I think what you’re going to see is, where ARM 11 is used as in kind of feature phones right now. Feature phones are being replaced by very local smartphones based on single-core, Cortex A5, Cortex A9. So it isn’t moving to the AV, I think there is a generation maybe or two of the – or maybe more actually of very low cost devices based on Version 7 architecture, where there is a less marked delta in the royalty rate.

And maybe they moved to multi-core over a couple of generations before going Version 8. But that is ultra cost sensitive market to make the whole smartphone unsubsidized for $30. You really got to work on that.

So, it’s – it will be a while before all the latest, greatest and all is put down, probably is going to happen over time. But I think the first transition in that feature phone space is from ARM 11 based feature phones to Cortex A5, Cortex A9 based single-core smartphones. And maybe, we’ll keep working back through that way.

Sandeep Deshpande – JPMorgan

Hi, Sandeep Deshpande from JPMorgan, just coming back to this royalty cycles that you’ve shown in the graph. Historically your royalty cycles tended to go along with what happened in the industry, where is the semiconductor industry.

If you’ve noticed from the first quarter has had a very, I mean, in fact, except maybe Q3 last year, there has been a fairly strong performance in the semiconductor space. So, why has ARM performance been slightly deviating from the semiconductor industry?

And following on from the earlier question, overall if you do 10% royalty growth this year, I mean, you’re not guiding to that number but I mean, 10% to 12%. You’re going to be in single digit out-performance versus the industry which hasn’t been the case for the last five, seven, eight years as such. So why is this year so different from past years?

Simon Segars

I think when you look at the semiconductor industry as a whole, all of it, through this year, with the retirement of Windows XP that has driven more recently a bit of a resurgence in PC adversely, which obviously we’re much less exposed to.

Yes, but certainly when I talk to CEOs of semiconductor companies, no one is exactly hi-fifing about the growth rate of the semiconductor industry for them over the last year or in fact, multiple years. It is slow growth and share is being moved around between companies. There is a lot of consolidation going on.

So, there have definitely been some bright spots there. But for the markets we’re exposed to, as I said earlier, we haven’t been losing share. Therefore this is about an unit shift, which is just a pull-through for us.

Now we’re not in control of that, anything we cannot go on these, the rates at which we’re licensing new technology and the adoption of it into the market and the build of the ecosystem to make that easier over the time which is where our focus has been.

Sandeep Deshpande – JPMorgan

You’re not saying this is because of this trend of the slowdown in the high-end, mid-end, handset market versus the low end. So since you can actually see where the royalty growth is coming for or lack of royalty growth within that mix.

Can you say that because the low-end has been growing very fast and you’re very highly exposed in that segment of the market whereas some of the high-end players have been much slower? So, are you seeing that trend impacting this?

Simon Segars

Well, as you say, we’re in all of those devices. So we move with that market. And there is no magic that this connects us from those end-market trends to our royalties that’s highly correlated. Now we’re in such a high market share position. Brett?

Brett Simpson – Arete Research

Thanks, Brett Simpson, Arete Research. Just a quick question for Simon. There has been a big debate in the industry over the last year or so about sort of Moor’s Law no longer given the sort of economics at one stead. And I guess, if I look at 20 nanometer which is coming up for ramp-up fairly soon.

The wafer price increases, we’re hearing is pretty dramatic. And I just wanted to get a sense because the dice sizes we’re seeing at 20-nanometer are pretty similar to 28 IK, which would mean there is going to be cost pressures for ship makers.

What does this really mean for ARM’s business and royalties, particularly from mobile chip prices? Do you think we’re going to go through a period of inflation for high-end mobile chips as we go into 20-nanometer and in other nodes beyond that?

Simon Segars

Yes, I mean, there are some fundamental economics here, right. It is 20 nanometers more complex process, there are more process steps. The scaling, the 20 nanometers achieved isn’t what the historic trends have been. And therefore the price per transistor hasn’t been on the same curve that we’ve enjoyed for decades. There is no getting away from that.

And somewhere along the supply chain, someone was going to pay for it. Now the equipments that the fabs put in more and more expensive, the R&D cost of the chip, more and more expensive. It’s got to be funded somehow.

I think this is a new news, I mean, people have been talking about this for a number of years with 20-nanometer. And I think what we’re going to see is the number of people that adopt 20-nanometer is relatively low compared to most processed geometry transition points.

You would see more people stay on 28, innovate more around design, you’ll see the foundries create variance in 28-nanometer to make sure that improvements can be delivered. And we’ve already seen some of that. And we’re seeing for a number of years, the big investment that’s been going into next generation transistor technology to provide that big jump up in performance in areas scaling and voltage scaling, to really give you the benefit for the cost.

It’s all about fundamentally transistors are about what benefit can, I get for how much do I have to pay. And if that’s in the right direct then you can sell your product for more. So I think we’re in a transition period. I think the industry generally is looking to get to next generation technology is quickly as possible. And therefore you will see fewer people on 20.

Brett Simpson – Arete Research

But the influence for your business is obviously chip ASPs, the mobile price, the chip prices, particularly the high-end, because they’ve been fairly stable over the last couple of years. Do you think that’s going to change as part of this transition?

Simon Segars

Well, if the cost is absorbed in the chip price through, then on those very high-end devices, you should expect them to get more expensive, at the same time with 28-nanometer becoming more mature, more volume maybe run all that.

Then again in an ordinary mode, you might see downward cost pressure on that through the regular kind of economies, the scale that the semiconductor industry delivers So, the next of that – is that they have a net of that plays out, it’s kind of 2DD.

Brett Simpson – Arete Research

If I can just, I have follow-on for Tim. Tim, I go back six months ago, your Cortex A royalty units were growing triple-digits year-on-year. We’ve seen quite a big decline just in the growth the last couple of quarters.

And I’m just checking, is there any one-off events here, inventory events that you think might have caused such a sharp decline in the growth? Or in your view, when you look at the landscape and, was inventory a factor at all in such a market decline in the Cortex unit growth?

Tim Score

Well, I think inventory is a factor. I think also probably integration is a factor. But I mean, there is no, there is no kind of one-off strange thing that we’re not sharing with you. As Simon said, to some extent with the market share we have, we’re just very, very closely correlating to what’s happening in the market overall. I mean, clearly why we’re growing at 2%, not 20%, I’m not saying a lot of that is around the inventory. And what we’re seeing in that top end.

Sumant Wahi – Redburn Partners

Hi, thanks. It’s Sumant from Redburn. Just two quick questions, one is, on could you talk a little bit about your value of your solar enterprise royalties. How big are they as a mix of your overall royalty revenue at this point? And could – how much could that grow to in the next two years, do you expect it to reach to about 25% to 30% of royalty mix in this near term basis or not?

Simon Segars

One to two year period, no, in terms of volume that the volumes of those chips are dwarfed by microcontrollers there, dwarfed by small front chips. They’re large valuable chips, multi-core Version 8 architecture, so they’re valuable on an individual basis. But I think over the next couple of years, handsome volumes start to grow. It’s not going to create an enormous additional layer of royalty for us.

Now, out in time, our expectations as we grow 10% to 15% market share here, so, it should at that point, it should start to be more meaningful. But I think in the next couple of years, measure the success on the design wins and the overall ecosystem development as opposed to really trying to spot that in the numbers.

Sumant Wahi – Redburn Partners

Could you give us a bit of color on what the value that is for you at this point of time as percentage of your royalty?

Simon Segars

Last year we said that N-Spice networking was 5% in unit terms. I think on average the yield from that is higher than the blended. I think we have also said that if you look at the kind of Q4, the annualized is probably closer to 10% rather than 5%. And you saw again strong growth in Q1 in unit terms. And so, that gives you a feel for where we’re heading. But we’re not going to sort of give you values and units by sector.

Sumant Wahi – Redburn Partners

Okay. And one quick question on the cash capital structure. I mean, that’s a very useful slide looking at the net cash fair counts etcetera. I’m just wondering obviously, your cash will probably grow from current levels as your earnings grow. And if you maintain your share count, it’s the only way you return cash shareholders as why dividend going forward in a material way or is it – do we expect a lot more M&A happening in the medium term?

Simon Segars

Well, I think – two headline comments there. One is, we’ve stated repeatedly that over-time we see the dividend payout ratio increasing, okay. And that continues to be the plan of record. We’re non-committal on timing and quantum. But we do see the payout ratio we think it’s consistent with this business model and then with the operating leverage, the expansion.

Secondly, we confirmed in February that we intend to maintain a flat share count. That doesn’t mean that’s the limit of our buyback in the sense, ambition or option forever. If we think it’s the right thing to do to manage the cash buyback and in the future we will do like we did between 2005 and 2008 when we bought back 16% of the shares.

So, and we’re not saying that’s the maximum we’ll ever do. But we did confirm in February this year that we have a specific plan to maintain flat share count using the buyback, that doesn’t mean to say we’re not going to do more buyback in due course.

Sumant Wahi – Redburn Partners

So, in other words you’ll be returning the cash – despite this, I mean, even if you maintain a flat share count you will have an excess amount of cash which would keep developing over the next three to four years. Do you keep that on your balance sheet or do you return it or do you buy some stuff with that?

Simon Segars

I think you’re going to see a combination of an increasing payout ratio at least buyback to maintain a flat share count. You’re going to see a lot of investment in the business. You’re probably going to see some level of continued M&A, actually have done. But in terms of precisely what level of cash we’re going to run with over the next, two, three, four, five years, we’re not being very specific on that.

I mean, I’ve said to investors multiple times, we don’t plan to be able to cash file for the sake of the cash file. Now we can debate what a cash file in ARM terms but the conversation there says we don’t see a need to have materially more cash on our balance sheet than we currently have.

Sumant Wahi – Redburn Partners

Thank you.

Amit Harchandani – Citigroup

Good morning, gentlemen. Amit Harchandani from Citigroup. My first question pertains to your backlog evolution. I think at the end of Q1 we said backlog would be flat to the end of the year, now we have talked about rising backlog.

I would just maybe like to understand your thoughts on where do you see backlog ending up at the end of the year? And more importantly as you look longer term, obviously backlog has outgrown licensing significantly. And at some point of time you would expect that trend to stabilize maybe even reverse.

So, I’m just trying to look out as we look towards the coming years with licensing growth maybe tapering up. Would we expect more of stabilization in backlog or would you expect backlog to sort of continue, maybe gradually coming down over the next couple of years. What’s your thought on backlog evolution?

Simon Segars

Well, I think in time and backlog is a more, lumpy concept because of the revenue recognition rules, okay. It’s a more lumpy concept than revenue recognition itself. But if you kind of look through all of the accounting, in reality, backlog has to broadly grow the same rate as license revenue, out in time.

I mean, that’s because – because backlog represents typically somewhere between 40% and 60% of our license revenues. There is inevitably a close correlation. But you’ve seen in this period of high price revenue growth, the backlog is growing much faster because of the reasons that I went through.

So, it’s very hard to call backlog on this quarter, that quarter. And I think what we’re saying is, we expect given the amount of revenue recognition based on product deliverables that have come out the backlog in the first half.

And based on the pipeline that we see of licensees, the mix between revenue generator short term and backlog builders, when we look at that the pipeline in the second half, we expect the backlog to be higher at the end of this year than it is now.

Will it be precisely where it was in Q1, we’ll have to see, I mean, obviously when we spoke about that in April, we weren’t really, we wouldn’t particularly be predicting the backlog would be 10% down in June. I mean, what happened in practice was, if you look at the mix of deals that we’re in flight in June, the revenue bearing ones kind of signed.

And some of the backlog building ones has moved into the second half. They haven’t gone away. We expect them to happen this year that’s going to be good for backlog. Do I know what backlog is going to be at the end of the year, not precisely but it looks positive.

Amit Harchandani – Citigroup

And over the next few years, would you expect backlog to be stable?

Simon Segars

Well, I think it will move, it’s going to as you say, it’s going to normalize as license revenue normalizes well. But there will be a different timeline.

Amit Harchandani – Citigroup

And maybe as a quick follow-up if I could. FX has been painful clearly. Could you maybe remind us if there are any tools available at your disposal to mitigate the effect, I mean I know it’s very difficult, something outside. But how should we think about it?

Simon Segars

I’m not a magician.

Amit Harchandani – Citigroup

You’re not a magician, clearly you’re not. And that’s why I said, the factors outside your control. But is there anything in terms of?

Simon Segars

We had a non-executive on the board actually, just unfortunately he retired after nine years, he was a magician, Member of the Magic Circle. But I still don’t think that he could eradicate FX movements. I think hedging, isn’t that – you can smoothly impact. But the fact is ARM is left profitable business when there is $2 to the pound, then when it’s $1.50 to the pound. And that’s never going to change unless we moved all of our people out of the U.K. and went into, so dollar currencies.

There isn’t any magic. I think we kind of have to, in a way suck it up. We sort of – we as you know, we do sort of rolling hedging program. But we are going to be less profitable. So I’m sitting here at $1.71 thinking I’m not a currency forecaster but the future is bright for home currency. But then I probably sold at $1.65 as well, so we’ll see.

Tim Score

It’s been around that, we lose one way, we gain the other, seven years ago, it was 2:1. We then went down to that $1.45 and the FX adjustments were in our favor. We don’t win prizes for that, we don’t lose here.

Amit Harchandani – Citigroup

In terms of weather, you would be reconsidering your rolling FX strategies, is there something you’re thinking in terms of hedging a bit more longer term or you just continue with the way things are?

Simon Segars

There isn’t really an in structural. I mean, obviously you can make long-term bets on hedging. What that means is your – you’re going to make a big bet which you may be very right or you may be very wrong. And I don’t really think that’s the game now, it doesn’t really help us. I think we just have to accept the fact that we’re more profitable if the dollar is stronger. So, go dollar basically.

Amit Harchandani – Citigroup

Thank you. Should we keep people going?

Simon Segars

Yes.

Nick James – Numis

Good morning, it’s Nick James with Numis. Just a question on licensing and the engagement in new products. I guess, we used to think about new products from ARM being bigger, faster processes. And I guess, it maybe feels like that’s kind of different now and that the opportunity looking forward is to why the pieces of semiconductor IP, so if you can just kind of help us understand the market opportunity to licensing looking forward?

Simon Segars

Yes, as you say the bigger faster process is kind of get the limelight, when we launched Version 8 products, the Cortex A50 series that was a big kind of hero around our new big jump into the right products.

But in reality we’re developing products across our entire roadmap all the time. It’s processes, it’s graphics cause, it’s physical IP, it’s system interconnect components, I mean the acquisition that we’ve just done is about technology that helps people put these very complex chips together. And we have IP for that as well.

The sophistication of those products is going up all the time. It’s going to enable people to build very high performance SOCs, in every area in a power efficient way. So as over the last few years, the pervasiveness of the ARM architecture has broadened, yes, it isn’t just about the next generation processor for mobile.

We’re looking at the next generation processor for enterprise networking, for Cloud service, more mobile, for tablets, for IOT devices, for automotive. There is just a broad range of markets that we’re looking at. And we’ve been building the business to capitalize on that opportunity.

Over the last couple of years, we’ve stood here and talked about the increase in headcount. And it’s to enable us to create those roadmaps of products to service those markets and further broaden the royalty opportunity. And some of that is now starting to come out.

Nick James – Numis

And I guess, this is kind of new customers coming in and licensing ARM. Is there a widening opportunity within existing customers for kind of dollars of IP licenses with the new products coming for it?

Simon Segars

I mean, there is certainly a category of customers and this has always been the case for ARM, who either has multiple business divisions and they use ARM in one place and then they start using ARM in other places. That gives us greater opportunity.

All customers who having been successful in one place are looking to see where can they leverage the technology that built into other markets. So again that does broaden our opportunity.

On the other side of that eco-consolidation going on, and these things kind of balance out against each other, but broadly the use of ARM is getting wider. We’re targeting more markets and that’s why we believe there is great growth ahead.

Nick James – Numis

Thanks.

Simon Segars

Next, Andrew?

Andrew Gardiner – Barclays

Thank you, Andrew Gardiner from Barclays. You spent quite a bit of time on the enterprise side talking about service and the latest product launches. I was just wondering if you can help us with a bit more detail around the networking side as well.

If we go back to 2012, I think you had maybe one, maybe two partners start to ship. Last year it built even further up to I think, about 5% market share is what you had on your slides. But just as we’ve come through the first half of this year, can you give us any sort of update around perhaps number of partners in our shipping or number of sub-segments within the enterprise networking space that shipping just to get an idea of how that ramp is going relative to the licensing activity we saw a few years ago?

Simon Segars

I mean, nothing has fundamentally changed since. We were here talking in detail about that at the Analyst Day in May, just a couple of months ago. I don’t think you were here actually. But we talked a lot about – so turn up next time.

So, yes, we talked a lot about that and our prospects for growth and our anticipated market share. And over the last quarter, progress kind of we expected to plan. As you said, over the last little while, we’ve done some of the licensing I mentioned on the slide, four out of five of the – with the top chip companies providing this market have licensed Version 8 of the ARM architecture.

So, we expect to see those market shares that we laid out actually year ago, comes to fruition at a time.

Andrew Gardiner – Barclays

And perhaps, Tim, just a quick follow-up on the FX question. Given that you’re recognizing as you say sort of 60% in the most recent quarter of licensing out of backlog. Can you give us a sense as to where the average dollar rate is for the current backlog just to get an idea of how that phases in over the next few quarters?

Tim Score

I think the trend that you see in the last couple of quarters, in fact the license revenue effective FX rates on translation better than or stronger than the weighted average of the FX through the quarter, I think will continue for a good while.

Obviously, stuff is going into backlog now, now it’s going in at $1.70. But obviously most of this stuff is going to backlogs, going in into $1.50s and $1.60s. So you’re still going to see a translation rate that’s little bit stronger than market.

Simon Segars

There is Gareth at the back.

Gareth Jenkins – UBS

A lot of questions have been answered. But some, just wondered on OpEx, if you could talk about next year in terms of budgeting it’s probably a bit early. But you’ve historically talked about 50% of your revenue growth into OpEx. And I suspect given that you’re bouncing back quite aggressively on royalty revenues we should expect to lower growth rate than that 50% of growth?

So, could you help us around overhead and personal increases for next year? And then I’ve got a follow on for Simon sort of separate.

Tim Score

Well, the 2015 budget, as you say we are quite early in the 2015 budgeting cycle as in we haven’t really started in detail. But we are in the middle of actually looking at our five-year annual update of sort of five-year plan. And I mean, all things being equal, we would expect to continue to be investing both in the R&D capability of this business and as I describe, the business infrastructure.

I mean, I think as we sort of think about models for next year, I don’t see a particular step change. I mean, obviously we’re going through a year of quite strong net increase in headcount which will probably flow through into next year. But I don’t really see any fundamental change.

Now, I mean, precisely the trajectory of hiring an investment that we make will inevitably be influenced by how we see the market and the opportunity at the time. That’s probably what I can say at this point of the cycle.

Simon Segars

I mean, just to say that, here we, we do see huge opportunity here. And we are building the company for the future. So, some of the infrastructure development that Tim mentioned, I don’t if that Gareth is what you meant by overhead. But or maybe you meant, Tim and I.

That I hate to say really important part of the company, we have a lot of people working very hard and being able to enable them to get over their engineering work done as quickly as possible and deliver on-time to our customer with highest quality is really important. So we are looking at as we grow in five and 10-year period, what do we need to do now to make sure we’re successful there. And that obviously requires some investment on the assumption that we grow. And we believe those opportunities are big.

Now by that, I don’t want to scare you into thinking how OpEx is going to go massively. We would do that in a measured sensible way based on how the top line is going to grow.

Tim Score

But also on the sort of – we’re very focused on the sort of effectiveness and efficiency and productivity of the people. I mean, if you look at the way ARM’s OpEx develops, we tend to go through phases of investment and then phases of more sort of digestion and productivity. And we’ve obviously been through a long – quite a long period now of investment in ceasing this growth opportunity.

And I think we are very focused, as we look at this sort of five-year plan period of how we can actually make ourselves more effective and more efficient in everything we do. There is – when you have time to sort of sit back and think about how you do stuff, there is always, opportunities to be better and more effective. So, I think that’s going to be a key theme, which in financial terms will offset if you like some of the opportunity and the need to invest in ceasing the opportunity.

Gareth Jenkins – UBS

A completely different question just on IOT going forward. Can you talk about some of the steps that the industry is taking to make become a bit more harmonized so things like the threat community and so on? And what ARM’s place will be within that or whether we’ll see a more fragmented world where imagination gets some market share, Intel gets some market share and ARM get some market share, hopefully the lion’s share?

Simon Segars

Yes, I mean, fragmentation in IOT is clearly a risk. When you look at how devices they’re going to sense data, share that data to make their data available to services that might utilize that data. The easiest thing to do is to build a closed system. We think that’s a bad outcome.

And so, we want to see accelerated adoption of IOT that drives our volume. And to remove some of these barriers for data to be shared, because we think there is greatest return on what will they say if that happens.

So, we are looking at various activities for how standardization – appropriate standardization can occur around some of the technologies required for IOT. And Freddie is one of them. It’s about how do the products from different manufacturers actually work with each other instead of requiring their own completely closed system which is obviously very inefficient and likely to lead to more cost and lower deployment at the end of the day.

So, it’s one of those, we’re talking a lot of people up on the supply chain about these issues. We’re looking at security, we’re looking at encryption. We’re looking at the standards, as around this. And what the role of actually government is in setting off in the right direction as opposed to the wild west followed by massive control, which again I think will lead to a subtle to more solution.

So, there is lot out there, it’s very early days for IOT. But given our desire to see a rapid acceleration of the use of ARM processors here, we are investing to try and lower some of these barriers. Any other questions?

Unidentified Analyst

Just a follow-up. And mobile, your mobile customer’s licensees, can you perhaps talk about how many of those are double-digit percentage sales customers because we’re seeing a lot of consolidation and mobile semiconductor. I’m just wondering how concentrated your business now is with some of those folks getting bigger and bigger?

Simon Segars

I mean, in terms of units, you can see the data there, you know who is shipping what. And broadly speaking that all is kind of is in million miles away from that. So, there is some concentration going on, but there is a lot of competition there as well.

So, I wouldn’t take what the situation we’re in today as an indication of what’s going to happen for all time, rather go back 10 years the people were dominant then, have changed.

Unidentified Analyst

Just a quick follow-up in terms of the kind of licenses, for example, your perpetual licenses sometimes licenses of upper use maybe for a term period of time. You’ve seen 41 licenses signed right now but despite that the backlog went down simply because there was recognition from the backlog. So, I’m just trying to understand whether it’s essential not only to look at the number of licenses, but also in terms of the quality.

Because I guess perpetual is more expensive compared to safer use, compared to a term use. So, just trying to understand how are you seeing the adoption in terms of these different flavors or variants of licensing, is it more precise per user licenses, is it more perpetual, so what’s the – could you shed some color on that? Thank you.

Simon Segars

I don’t think there has been any big shift there. I mean, typically I don’t know typically happening to enhance ARM, our nearest products we don’t license on a per use basis. And so they have been matured in the market for a while. And part of that is because we want to engage with people who are going to commit to our latest generation products and really work with them to make it successful.

So, I mean, your measure of quality I don’t use – I don’t think the quality of our licensing. Every one of those license deals has an opportunity to turn into something big. But by your measure in terms of timeframe of license, the newer technology is going to be on a much longer term basis than perhaps some of the older technology. But it’s not to say that the older technology is always licensed on a per year’s basis either.

There is a real mix of that and that can change big time from one quarter to the other. But everyone one of those, typically I guess, new companies, maybe first company to ARM, a company that takes the first license to ARM technology might engage on a smaller term just because of uncertainty. But you never know who’s going to turn into a big company.

Unidentified Analyst

But nothing has changed yet, like normalized mix that we’ve seen so far. Thank you.

Simon Segars

All right. Well, if there are no more questions, thank you very much for coming. And we’ll see you on the road. Thanks.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!

Source: ARM Holdings' (ARMH) CEO Simon Segars on Q2 2014 Results - Earnings Call Transcript

Check out Seeking Alpha’s new Earnings Center »

This Transcript
All Transcripts