British Chipmaker ARM Beats On Earnings, But Royalties Are A Question

| About: ARM Holdings, (ARMH)

British chip maker Arm Holdings (ARMHY), whose circuitry is designed into cell phone chips made by other companies, like Texas Instruments (NYSE:TXN), has folks split after last night announcing sales of $133 million that were above analysts’ estimates of $130 million and profit of 9 cents a share, above estimates for 7 cents a share, and saying it will meet analysts expectations for sales of $566 million in the year ending this December.

ARM’s business is complicated enough to yield divergent views about an upside quarter. The company had a strong backlog, up some 15%, but it still has to close lots of deals to collect royalties on its intellectual property in order to meet that $566 million, and some say it can, some worry it can’t:

  • A.G. Edwards’s Gary Mobley says ARM is “a great company,” but he’s lowering his estimate for 2007 profit per share to 34 cents form 30 cents and thinks with weak trends in semiconductors, it’s going to be a struggle to find royalty revenue: “[W]e believe ARM is experiencing solid licensing trends, offset by weak royalty trends. ARM records royalty revenue 3-months in arrears. This means that the current soft semiconductor industry sales trends will negatively impact ARM’s first half 2007 royalty revenue.”

    While ARM has been cutting more deals to get paid for its intellectual property, the rate its getting paid is going down: On one hand, royalty units exceeded our expectations by 11%. However, this was offset by another sharp reduction in the royalty rate per unit (down 8% quarter-over-quarter).”

    Mobley says the 4th quarter’s profit was also boosted by a favorable tax rate, and had it not been, profit per share would have been below consensus at 6 cents. Mobley has a Hold rating on the stock and thinks its fairly valued at a current price of $7.62, which implies a price-to-earnings multiple of 21x his estimate for next year of 36 cents a share.

  • On the other hand, William Blair & Co.’s Corey Tobin argues that “While ARM still needs to generate healthy royalty growth in 2007 to achieve this forecast (as royalties are not impacted immediately by licensing activity), we believe the company is starting the year on very solid footing from a licensing perspective.” As for the decline in royalty rates that worries Mobley, Tobin thinks that the huge number of cell phones to be sold this year will bring enough volume to offset the decline: While it is difficult to conjecture when this rate will stabilize, our view on this trend is very simple: more revenue at virtually 100% gross margin is better than less. It is important to note that what is driving this decline [in royalty rates] is robust unit volume growth, reflecting greater proliferation of ARM’s technology, in our opinion (a positive).”

    Tobin has an outperform rating on the stock, and at 24x an estimated 32 cents this year, he thinks the stock has room to run, even without expansion of its valuation multiple, as long as the company can maintain what he thinks will be earnings growth in the mid-teens, year-over-year. He hasn’t set a price target, however.

ARM shares took the dim view today, falling 1.17%.