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Executives

Warren East - Chief Executive Officer, Director and Member of Disclosure Committee

Tim Score - Chief Financial Officer, Director, Member of Compliance Committee, Member of Disclosure Committee and Member of Risk Review Committee

Analysts

Andrew Gardiner - Barclays Capital

Simon Schafer - Goldman Sachs Group Inc.

Brett Simpson - Arete Research Services LLP

Didier Scemama - RBS Research

Kai Korschelt - Deutsche Bank AG

Janardan Menon - Liberum Capital Limited

Sandeep Deshpande - JP Morgan Chase & Co

Unknown Analyst -

Sumant Wahi - Redburn Partners LLP

Nick Hyslop - RBC Capital Markets, LLC

Gareth Jenkins - UBS Investment Bank

Francois Meunier - Morgan Stanley

ARM Holdings plc (ARMH) Q2 2011 Earnings Call July 26, 2011 4:30 AM ET

Warren East

Okay. Well, it's 9:30, so we will get started. Thank you, all, very much for coming on to our half year results presentation. Here's an obligatory notice. And what we're going to do, as usual, is I will start with the business update. Tim will go into our results, financial results, to add some color, and then we'll deal with questions and answers.

The high-level structure of this business update, those of you who've heard me talk before will know that we're very enthusiastic about ARM's business model and the unique differentiators in our business model and our excellent technology and our ecosystem. So I'm going to go over those points to begin with then look at the business in a bit more detail for the relevant period and then step back and look at some drivers of growth for the future.

So if we look at the business and the business model, then this is a great set of results. It's a very strong quarter. It's our fifth consecutive record revenue quarter. It's our eighth consecutive quarter of growth, and we're very pleased with the overall picture.

I think an important message is that major semiconductor companies are still investing in ARM technology. If you look at the first half of the year, we've sold as many licenses in the first half of the year as we would have been happy selling in a complete year a couple of years ago. This is because existing semiconductor partners are continuing to license the ARM technology. And interestingly, in this current quarter, we're still seeing new companies coming to ARM for the first time. I mean, this is in the context of ARM's range of target applications really broadening out, and so we're getting into the space where companies who haven't seen the need to use ARM technology before are starting to license ARM technology. So that's great.

In terms of volume shipments from our semiconductor partners then we're continuing to outperform the industry. I'll come on and talk on that in a bit more detail. But we're particularly pleased with growth in microcontrollers, smartcards and connectivity. And if you look at this whole business model itself, we are continuing to gain a presence in the semiconductor industry with an outsourcing model. And this applies beyond the microprocessors, so the Physical IP part of our business, and in the graphics part of our business as well.

And all of that is generating increased profits and very good cash generation, and you'll see that in a bit more detail later as well.

So the business and the business model is in very good shape. The technology itself is also in good shape. We're continuing to license at the high end of our road map, so 2 additional Cortex-A15 licenses this quarter. The A15 is our state-of-the-art microprocessor core that's available at the moment. We've just released A15 this last quarter to the lead partners, who'd licensed it during the development. And so A15 is now starting to roll out to the semiconductor world at large and 2 additional licenses sold. And people are choosing to license A15 to take their smartphone products beyond, up another level of performance, and also to target tablets. And A15 is the first core that's really enabling people to think more seriously about ARM in servers.

At the same time, we continue to sell some licenses for next-generation products, where existing semiconductor partners are fleshing out their ARM portfolio with some of the newer products that we have in development. And our physical IP technology is also in great shape. We're very pleased with the process optimization packages, still selling very well. We sold an additional 4 processor optimization packages during the period for Cortex-A9 at 40 nanometers. And I'll come back to talk about Mali licensing, where we're seeing Mali being adopted for smartphones and digital TVs as well. So technology is also in good shape.

The ecosystem is an essential part of the ARM business model, and we contend that we have an excellent ecosystem. And this was a quarter in which various ARM partners achieved for themselves key milestones. We had Google announcing their Chrome operating system for ARM. Microsoft created some stir by demonstrating Windows 8 on ARM, running Office applications and running Internet Explorer. So these big companies in the ARM ecosystem scoring good results during the quarter.

We also saw the ecosystem developing around Mali, Mali being used in smartphones and digital TVs, starting to ship in volumes. This is encouraging a developing ecosystem around Mali. You get -- start to get the sort of inertia effect of volumes creating a demand for ecosystem development, that ecosystem development then fueling more design wins, so fueling more volume. And so we're pleased to see several providers in the graphic space making progress with developing their products around Mali, notably games engine developer Unity, who started to develop their engine around ARM. So that is great news.

And as I said, I'll come back to talk a little bit more about that in the future.

So now let's go to the business in a bit more detail, and this is a slide you've seen several times before. But hopefully, we can see the progression now. First off, licensing revenue, very strong. Q2 licensing revenue, its highest ever, and this has enabled us to sell -- we've sold 68 licenses during the first half of the year, so we're now over 800 licenses in total.

When you peel back the detail on that licensing, very healthy licensing of the Cortex products, Cortex-A9, 6 licenses; Cortex-A15, a couple; and some of the new products as well. But at the other end of the processing scale, in the microcontroller space, we're also seeing very strong licensing for Cortex-M, 12 licenses in the quarter. We are now over 100 Cortex-M licenses in total, and that bodes very well for microcontroller shipments in future years.

Licensing of Mali graphics technology continues its solid execution in that part of the business, another 5 licenses. We could have a step chart for Mali a bit like the one for processor licenses in total. We're now up to over 50 Mali licenses with those that are added during Q2.

We normally talk about the split of licenses in the first intended use that our semiconductor partners have, and the picture that has been emerging for the last couple of years or so continues in the quarter that we're reporting today. 28 of the 29 licenses sold in the quarter were nonmobile, and that's a very consistent picture of what's been happening over the last several years. And that's very encouraging for our nonmobile shipments as we look forward.

Talking about shipments as we look forward then, future royalties. The chart on the bottom right is the sort of extension of the picture that we've been building for some time and a reminder on this slide of some of the timescales involved here. Typically, licenses that we sign today, it will be at least 4 years, more like 5, really, for appreciable volumes of consumers going into shops and buying products, incorporating that technology, which means our royalties come to fruition.

And you can see that in the chart on the bottom right, where if we look at the dark blue color at the top, and you can see licenses sold in the period 2006 to 2011, some 400 licenses now, actually starting to make a difference after about 5 years, and we can see that starting to make a difference. So I joked with Ian that maybe this is the last time you see this chart in its current form because I think maybe come February, when we produce it again, we'll have to come up with a fourth color because we'll be doing licenses from 2010 onwards. And you'll see the 2006 -- the 2010 slipping back into the middle as it starts to drive -- as those licenses start to drive an appreciable proportion of our total volume. You can see that the volume being driven by the cumulative licensing there.

And in terms of the chart in the bottom left, and I believe there's a sort of full-size version of that in the appendix. This is a chart we introduced in February. And it's basically highlighting the licensing that we are doing to equip the semiconductor companies who service the target markets in which we want to win a significant market share, like 80% or beyond.

And a reminder of the way the charts decoded, we highlight with the little dots the number of semiconductor companies who supply semiconductors to those OEMs to effectively take us to about 80% market share. And when there's a blue dot, that means they're equipped and shipping. If there's a red dot, it's the other end of the spectrum. And the green and the amber dots are different stages in the process, where partners have the technology, but they're not designing with it, have the technology, have designs but not yet shipping and so on. And so there's continued progress there to grow our market share, continued progress in the necessary licensing.

In terms of what's actually happening with royalties and the royalty numbers coming through, the first half of the year was very encouraging for us. We saw ARM royalties grow at about 3x the rate of the underlying industry, and that's a continuation of the trend shown in the chart on the left-hand side of the screen, where the growth line of ARM's royalties, there's always a gap between that, and the underlying industry indicating our growth in market shares.

And on the right of the slide is a little of the detail in second quarter about where all those devices went. We're pleased with the record volumes, so up 30% year-on-year, nearly 2 billion units in the quarter. And it seems so very long ago that we were high-fiving 2 billion units in the year as a whole, so that's very encouraging for us to see.

Mobile continues to be very strong, obviously, but I think the highlight of different application areas is certainly MCUs, on the back of the Cortex-M licensing that has been happening over the last several years, let's say, over 100 Cortex-M licenses now. Then we saw yet another quarter of very strong growth in ARM microcontroller shipments. And so that's really very encouraging for us.

And for those aficionados that follow the detail of the pie chart, this is the first time that nonmobile has actually been over 40%. So we've reached a bit of a milestone there in the mobile-nonmobile split.

Switching to the Physical IP side of our business. This has been a story of continued execution this quarter. The business is in a very healthy state at the moment, licensing and royalty up consistently year-on-year, 19% and 11%, respectively. But we're particularly encouraged to see continued execution of our selling platforms of Physical IP products, absolutely leading-edge technology, the 20-nanometer technologies, but also some of our older technologies for those customers who are building products that typically run on much older geometries. We're still selling new Physical IP into that sector of the market. So cumulatively, the number of Physical IP platforms out there continues to grow, encouraging at all ends of the spectrum.

And the processor optimization packages, that's also very encouraging for us. The chart on the bottom right shows the sort of steady execution, progress quarter-by-quarter in processor optimization packages. And in the quarter that we're talking about, we sold 6 Cortex-A9s. We sold 4 Cortex-A9 processor optimization packages. So that is a metric which continues to perform well, the effective penetration of processor optimization packages into our Cortex-A9 marketplace. And so we're pleased with the progress on the POPs.

So that was a quick runaround at the business, and I'll just briefly touch on drivers for the future. And on a high level, then our business is subject to several long-term trends. These long-term trends about the semiconductor industry driving outsourcing, this long-term trends about energy, and this is driving demand for our low-power technology. But one other long-term trend that ARM's particularly exposed to is the increasing presence of the Internet, and this was highlighted in a recent report that we're quoting here. And this report that Cisco published highlights some really interesting facts. You only have to go back a few years to 2003 to find about one Internet connection per 20 people. Around about now, then there's almost 2 Internet connections for every person on the planet. And as we look forward, then that number explodes. In fact, if you look at the numbers, then as we look back over the last 7 years, the number of Internet connections has grown at a compound annual rate of nearly 60%. And as we look forward, we're anticipating the number of Internet connections to grow at a compound rate of about 30%.

So I think we're nearly in the middle of this huge trend for Internet-connected devices as we move from a stage where you have to make a deliberate effort to go use an Internet connection to "I've got an Internet connection on me somewhere" to "It's just all happening around me" and "It's happening without me noticing." And that's the world of smart meters, of connected medical devices, machine-to-machine communication and so on. So fantastic opportunity for us because we implement all that connectivity. You need something like an ARM microprocessor to do it, to run the protocols that do it. And that's why we're very excited about this long-term trend. And it isn't just about smartphones and tablets. It's about a huge range of different products.

And just looking back at the last quarter, here are some of the products that bring that sort of vision to reality. Yes, we've got the high-visibility ones, so things like the Samsung GALAXY S II phone, stunning smartphone of the quarter, powered with a dual-core A9 and quad Mali processor. The benchmarks, the graphics benchmarks for this phone, absolutely outstanding, and that phone is turning heads across the industry. So we're very pleased with that.

But then there's a range of the typical smartphone, tablets and digital TV-type devices. And a reminder that in sort of market analysis slides, which you'll find in the appendix, those types of products sum to a total opportunity of about $4 billion in 2015. If you look behind those products, at what's driving some of the connectivity, what's driving some of the storage, then you see the middle line, 11 billion units in 2015. And the embedded machine-to-machine type world that I was talking about a moment or 2 ago, that's an even more significant volume by 2015. And here are some of the pictures of where ARM is being designed in as we speak or products that were released over the last quarter. So in terms of long-term trends driving our growth over the next 5 to 10 years or so, I think we're in very, very good shape.

So summarizing where we are for Q2. We've got very strong license revenues, and what's really encouraging about that is it's a reflection of the design activity that's out there around leading companies continuing to make and making for the first time long-term commitments to the ARM technology. It's, in the first half of the year, a record number of licenses by some considerable margin, and that's very encouraging. And, of course, it is driving very strong license revenue at the moment. We're sitting on top of a backlog at near-record levels with a very healthy pipeline of opportunities.

At the other end of the sort of production story, shipments of ARM-based products are going very well. They're continuing to outperform the industry, as I say, about 3x industry growth as we look over the last 12 months. And so that's very encouraging as we drive ARM into not only the market segments which are growing structurally and outgrowing the market, but as we grow ARM into new applications. And as we do that, of course, we are continuing to invest in new technology. We're growing the number of design engineers we have, which is increasing our capability to design more and more of this technology. At the same time, the business model is enabling us to make that investment along with increasing our margins, increasing our cash generation.

Now the bottom half of this slide is a bit of an advert. We've gone all commercial. And this is an advert for our technology conference, which happens in October in Santa Clara. And last year, we introduced an investor event at that technology conference. This year, we're doing the investor event again. There's an e-mail there because Goldman Sachs are helping us with organizing that investor event. There are a few places still available, and do see Ian if you're interested in coming to that event.

And with that, I'll hand it over to Tim. Thank you.

Tim Score

Morning, everybody. There are quite a few numbers in the earnings release and lots of detailed numbers in the slide deck that's on the web and actually, quite a few numbers in Warren's presentation. So the good news is I've got 2 slides, 3 including this one. And I'm going to focus mostly on outlook and guidance and give some color on that and help you with that if there's any need for that.

So this first slide with the highlights. Warren's largely touched on this clearly. This quarter is exceptional for the license performance. $58 million is a record by some margin. And although 29 processor licenses is not a record, it is running at, as Warren said, about twice what we might have considered to be a reasonable quarterly average 2 or 3 years ago. So the installed base of licensees, which are, let's face it, in place to generate future royalties going forward, is growing at a faster pace than ever, which is very encouraging.

Also encouraging at the end of Q2 is, notwithstanding the high billings in the quarter, the backlog sort of flat sequentially and obviously still at historically high levels and the opportunity pipeline healthy for the second half, and I'll also touch on that a little bit more on the next slide when we talk about what that means for looking into the second half.

Royalty momentum remains. Warren's touched on it, and I draw it out there. Remember, we had a $9 million catch-up in Q2 2010 last year, so the headline growth is suppressed by that. But the absolute underlying growth is 33%, so still moving in a very strong direction.

Headcount, we are investing, as Warren said, mostly in new technology, mostly in our R&D capacity, developing new technology, up just under 100 people in the first half. We're still in investment mode. We'll continue to hire new people through the second half. And mainly, that underlying move is what drives our normalized operating expenses, which were $59.4 million in Q2, a smidgen ahead of where the consensus was but in the range we guided, guiding to $60 million to $62 million for the third quarter. But notwithstanding that investment, we're reporting today record margins over 44%, somewhere we've not been before, so the operating leverage is coming through as the revenues grow. And we've announced today an interim dividend of 20%, consistent with our ongoing policy of progressive dividend.

So those are the sort of highlights of the numbers. So you're looking into the second half, very strong licensing looks set to continue. I mean, the ARM addressable market is, as you know, broadening out both ends, at the micro controller end and at the mobile computing end and beyond. So that is bringing quite a number of new licensees to the ARM story, as well as encouraging our existing licensees to reequip with our latest technology.

And all of this, as I said, is underpinning share gains out in the future in our targeted markets, and Warren showed the picture of what that means in terms of attracting the key semiconductor players.

So for the second half, we go in there with a healthy backlog and a healthy pipeline. Now I'm conscious that -- I think it's about 6 months ago, I stood up here and said that we could move the range of likely license revenue outcomes from $35 million to $40 million to $40 million to $45 million. And I'm conscious that since we said that, we've done 2 quarters in the 50s. Now you guys and gals don't actually quite believe me because the consensus for Q3 and Q4 is $47 million and $48 million, so beyond the range already. But I think it's fair to say that based on the backlog and based on that pipeline, we would expect to see upside against that current consensus in licensing in the second half. So that's encouraging.

And we also say in the release that if you look at this pipeline of opportunities, the outlook for the backlog itself in the second half is promising as well, so not just the revenues in Q3 and Q4, but also for the exit backlog. Obviously, that's much harder to forecast in detail because they're very dependent on timing of deals, specifically the bigger deals around the end of the year. But the prognosis does look good for licensing and backlog development.

I think, as we've said in our release, the prognosis for royalty against the current consensus, which is about $89 million in Q3 and about $102 million in Q4, I think, is less clear based on the industry data that we have today. I mean, our Q3 royalties are based on Q2 shipments. The data that we read about Q2 shipments appears to suggest sort of low single digit, maybe edging to mid-single digit in some forecasts for Q2. So that is obviously the context in which we should think about our Q3 royalties. And when we look at Q4, we're typically -- certainly, in the last 3 years, we've seen a $10 million sequential uptick, part of the normal seasonality. It's less clear to us and less obvious at this stage, given the macro uncertainty and the potential impact on consumer confidence, that we're going to see that type of uplift. Current consensus is for a $13 million uplift in Q4, which will be higher than we've ever seen, which, at the moment, seems to us to be fairly aggressive in the context of the macro environment.

So I think the net-net of looking at licensing and looking at royalties is that -- what we're actually saying today is notwithstanding the fact that we've outperformed in Q2 by about $15 million. You can essentially bank that and then look at your second half, and we're suggesting that the right thing to do at this stage is to hold it because there looks like there's an upside on licensing. It looks like there's some risk on royalty given the industry data we have. And the net-net of all that is that we are currently -- and we are happy with the second half. What that means in number terms is the consensus coming into these results is $745 million for the full year, and if you bank the second 2 over-performance and hold the second half, you're obviously in $760 million territory. And in many ways, that is more positive guidance or more specifically positive guidance we've given in the past, where we've tended to say at least in line with expectations, but we've rolled in the current quarter out-performance, whereas this time, we bank the current quarter out-performance and then confirmed expectations, which, in many ways, is more positive than saying at least in line to something that includes the current quarter overage.

So that's kind of how we're looking at the second half, positive for licensing, positive momentum for royalty but some uncertain macro indicators out there, and it's just too early to say. And if there's any further need of clarity, I'm sure we'll touch it on the Q&A.

So with that, I think we'll move on to questions.

Question-and-Answer Session

Warren East

I think Didier got his hand up first.

Didier Scemama - RBS Research

Didier Scemama from RBS. Two quick questions. You've answered the third one that was on the licensing outlook for the second half, Tim. I'm just looking at your microcontroller business, up 100%, in the context of the market, up 10%. Presumably, some of that is a bit of a build based on the commentaries that we've seen from some of your licensees, but still a phenomenal performance. Do you think that, looking at the profit warnings that we've seen from companies that have either not used ARM or not used ARM too much, they are also suffering to some degree beyond the macro environment and all those weaknesses and so on. Do you think they are suffering also from the fact that ARM is taking market share? That will be my first question. And the second part of the question is related to OpEx in Q4. So Tim, you've alluded that you're going to continue to invest in R&D. Should we expect OpEx in Q4 to be up versus Q3, I mean, taking into account maybe grads recruitment and this kind of stuff?

Warren East

Okay. So on the microcontroller one, short answer is yes, we are taking market share. This is an architecture issue, and we are seeing demand from the end customer base who want their traditional microcontroller vendors to offer them ARM-based solutions. If you go back 12 months or so ago, you saw Freescale, very strong microcontroller company, launching a handful of ColdFire, their own architecture microcontrollers alongside 200 ARM microcontroller parts. So I think absolutely, companies are responding to demand from the engineers in the design community who want the ARM architecture.

Didier Scemama - RBS Research

So the follow-up would be I completely understand the caution you're putting on royalties in the second half, but given the backdrop of the substantial out-performance that you have relative to the market in the cycle, perhaps you are a bit too cautious even on your royalties outlook in the second half?

Warren East

Well, as Tim just said, if you look at the second quarter shipments from the semiconductor companies, our data pointed to a few percent of sequential increase. And typically, we have a $10 million, for the last few years, uplift. What we're saying is that wherever we look right now, there's macroeconomic uncertainty. We're not just exposed to microcontrollers, we are exposed to consumer products that are purchased by consumers. There is uncertainty about consumer expenditure, and therefore, maybe that $10 million uplift is going to be somewhat muted, or there's a risk that it's going to be muted. And that's why we're sort of being a little bit cautious about it.

Tim Score

Yes. And in terms of OpEx, I will expect there's more sequential increase because the headcount will be increasing gradually through the second half.

Brett Simpson - Arete Research Services LLP

It's Brett Simpson, Arete. I just had a quick question on the licensing. Tim, you suggested there may be some questions about extra clarity, but last quarter, you talked about a normalized quarterly licensing figure of about $45 million going forward, and you just printed $58 million, which is great. But looking ahead, you said 2/3 of the intake is nonmobile for licensing, and you're suggesting the pipeline is pretty good for orders. So why wouldn't we see licensing revenues in the sort of 60s for quarterly run rate going forward?

Tim Score

Yes, I think what I've said is $40 million to $45 million is what I said 6 months ago. What I see in the market is $47 million to $48 million. We've just done a $51 million and a $58 million, and we've painted a picture of a high backlog and a robust pipeline. But I mean, I don't think that necessarily translates into 60s at this stage. Licensing is inherently lumpy, and the good news for us is it's being lumpy on top of a range. But again, we need to be cautious. I mean, we're signing some very substantial deals with some very substantial players, and if they occur on a Monday, not a Friday, our quarterly results can look very different. So I just don't think it's right to be too bullish. But I mean, you've probably never heard us be as positive about the licensing outlook at a quarterly presentation that we've just been. Precisely how that pans out in the numbers, we will see.

Brett Simpson - Arete Research Services LLP

Did backlog actually rise in the quarter?

Tim Score

No, flat. No, flat sequentially.

Brett Simpson - Arete Research Services LLP

And how much of the revenues you booked in the quarter was new licensing -- was licensing you actually booked in the quarter rather than from backlog?

Tim Score

About 50%.

Francois Meunier - Morgan Stanley

It's Francois from Morgan Stanley. The first question is on AMD. I think if I remember the call last quarter, you were feeling quite bullish about the AMD potentially transitioning to ARM. I don't think we've seen anything so far. Obviously, you can't pronounce anything, but what's your feeling on this, this quarter? The next question would be on the A15 license you've signed with, I guess, a new customer for servers. Obviously, we are all very eager to hear from ARM at some point 64-bits multi-threading flavor of the A15 or whatever it's going to be called, A17 or whatever. Shall we expect the design cycles to have shrunk? Because I think from the A9 to A15 or from the -- yes, it was something like 2.5 years. You've announced A15 last year. Shall we expect something at the end of this year or next year, or will it take longer?

Warren East

Right then. Well, AMD first. AMD was hitting headlines when we did the quarterly presentation last time, and so we were asked questions about AMD. And we said that we've been in ongoing discussions with AMD about microprocessors for the last 10 years or more, and no, we haven't persuaded them, but discussions continue. And over the last quarter, they're in the business of selling microprocessors. We're in the business of selling microprocessor designs. It's our job to try and sell microprocessor designs to companies building microprocessors, so we talked to AMD. We've got nothing specific to announce on AMD this morning. On servers and A15 and what comes beyond A15 and so on, I'm sorry, we will announce new technologies when we choose to announce them and not at earnings presentations. So yes, we know that in order to fully target the server market, then there's some technologies that isn't in the current ARM portfolio, things like 64 bit. And we absolutely anticipate being able to target the full spectrum of server applications in due course, and so we'll announce the appropriate technologies at the right time.

Francois Meunier - Morgan Stanley

So is it more a question of time or more a question of budget allocation for the 64 bits as it takes a long time anyway?

Warren East

It does take a long time to develop these new microprocessors. We started developing A15 quite a long time ago now. Typically, it's sort of somewhere between 2 and 4 years to develop a new microprocessor, totally new microprocessor rather than a derivative. And that's been ongoing as far as we have future technologies that we haven't talked about publicly in the works. We've been growing, as Tim said, we've been growing our headcount mainly in R&D or development of our microprocessors. We grew by nearly 200 people last year. We grew by 100 in the first half of this year, and we'll grow some more in the second half. And I don't think it's a question of budget.

Sumant Wahi - Redburn Partners LLP

It's Sumant from Redburn. Just a quick question on your slide on royalties from licensing. If I remember from Q2, you were showing about 770 licenses sold up to now and showing royalties from it. And this time, you're showing 800, whereas you've signed about 68 licenses. I'm just wondering if there are some license orders or licenses which you have kind of removed as not generating royalty. That's my first question.

Warren East

Well, we do. When we refer to a number of licenses out there, we are actually talking about licenses that we believe will generate royalties in the future. And always, there is a little bit of correction over the total, as companies disappear, as some licenses effectively whither on the vine. And that's updated continuously. So if you follow the arithmetic in absolute detail from quarter-to-quarter, you will see some dropping out, but we're now at over 800 licenses.

Sumant Wahi - Redburn Partners LLP

And just a second question is in the Physical IP, the POP solution. I was just wondering, what is the current attach rate you have with sort of Cortex-A9 or A15 sort of licenses? Is that a good way to look at it? And then if you could just give us a bit of an idea on the licensing value and sort of additional royalties you could achieve from that, please.

Warren East

Okay. So in terms of attach rates, I think at the last set of results, we talked about having -- well, certainly, if we look back over the POPs, about 50% of the number of Cortex-A9 licenses, there's a POP as well. In the quarter just reported, we sold 6 Cortex-A9 licenses, we sold 4 POPs. So it's a bit better than 50%. But I would caution law of small numbers. So 50% is probably a good number. We happened to do a bit better in the current quarter. In terms of royalty-generating potential, then Physical IP royalty on a chip will be roughly half the typical royalty that we would earn on a microprocessor. And I say roughly because it's calculated on a different basis. It's calculated as a proportion of wafer cost rather than individual die cost, so it depends on the die area, yield and all those sorts of things. But roughly half in microprocessor royalty. So if there's a POP and a Cortex-A9, you can roughly take your expected royalty and multiply it by 1.5.

Sumant Wahi - Redburn Partners LLP

But your Physical IP is much more broader than just your POP solutions, so if a particular chip was on POPs and Physical IP, are we talking about a larger number than that, or is still...

Warren East

No, POP is essentially a packaging exercise, a product marketing exercise. POP is a predetermined collection of ARM Physical IP that needs a deterministic result for implementing one of our microprocessors. And so from a royalty point of view, it's simply saying if a microprocessor is implemented with a POP, it means ARM Physical IP is present on the chip, and therefore, a Physical IP royalty is earned on the chip.

Gareth Jenkins - UBS Investment Bank

Gareth Jenkins, UBS. Just 2 quick ones, if I could, or maybe not quick. On your earlier slide, you showed a picture of the Motorola Atrix, which I think is a smartphone/laptop, also the ASUS Padfone is a smartphone/tablet. Do you think there's a danger that you end up with some cannibalization, where you end up with one processor unit driving multiple devices going forward? And then just secondly, in terms of Mali and the ecosystem, can you tell us how many Mali licensees are now shipping and whether you think your previous comment around tens of millions of Mali shipments towards the end of this year as run rate, there's upside to that given where we see ourselves today?

Warren East

Okay. I think we showed pictures on the slides of interesting products. And there are some interesting hybrid-type products out there at the moment as the world grapples with the notion of computers and smartphones and what's a good form factor for consumers. And frankly, we always say, well, we're not experts in end product design. We enable these companies with the microprocessing technology, the form factors that are going to prove to be successful will be the ones that prove to be successful. And as long as we enable as many of them as possible, we'll be in good shape to benefit. And so I am sure we're going to see some of these products come and go, and that's not a particular comment on the 2 that you mentioned. It simply means that from a royalty point of view, we're delighted to be in those products, but we're not really sort of pinning massive hopes on particular form factors being successful. Your other comment was about -- or question was about Mali and number of people shipping and my confidence in the tens of millions of units shipping this year. I'll remain confident in tens of millions of units shipping this year. I think we've seen great success with things like the Galaxy S II. But on its own, I don't think that's sufficient to cause me to want to sort of up the estimates. I think we'll stick with tens of millions of units this year. And as a reminder, what's good about those tens of millions of units is that it drives ecosystem development. And we see ecosystem, the maturity of the Mali ecosystem as being the most significant retardant on growth of our Mali presence. And so seeing tens of millions of units shipped this year is good for our ecosystem, which is good for future volumes of Mali.

Nick Hyslop - RBC Capital Markets, LLC

Nick Hyslop from RBC. Warren, you've been quite helpful in the past talking about the percentage of royalty per chip based on the chip price going forward, and you've indicated that that could run up to around 3% as you look forward a couple of years. Could you just update us on your thought process around there with the latest licenses you're signing in terms of how you think that could develop?

Warren East

There's a -- the question referred to a discussion we had back in February about royalty rates per chip theoretically reaching about 3% of the chip price rate. As a reminder, I mean, inflated royalty rate for higher-end microprocessor cores, such as Cortex-A9 and Cortex-A15 being in the 1.5% to 2% range rather than the typically around 1%, with an addition of 1% for our Mali graphics processor, with an addition of about 0.5% for Physical IP, we take all that together, and you get about 3%. There is no change to that picture. Now we've continued to sell Cortex A9s, and we've got a couple of Cortex-A15s as well. The royalty rates that we're achieving are consistent with what we said before, i.e. they're a higher royalty rate than the more traditional levels that we've seen from ARM7s and ARM9s. And so there isn't really any change. I would just point out one number in the release, where we talk about the volumes of Cortex-A products now being 4% of our total volumes. So although we get very excited about these higher royalty rates on the Cortex-A products, remember, only 4% of the 1.9 billion units were actually Cortex-A products in the last quarter. So when you're looking for evidence of this effect in our royalty numbers, it's still a very, very small effect.

Nick Hyslop - RBC Capital Markets, LLC

And to be granular, if you were to take a current product which has the highest ARM royalty on it, what would that number be?

Warren East

I wouldn't sort of hazard a guess because we supply across such a range. There are chips out that are ARM-powered that are selling for hundreds of dollars a day. And under some license agreements, there are sort of royalty caps on multi-hundred-dollar chips and that sort of thing. So it's just not a question I can answer.

Janardan Menon - Liberum Capital Limited

It's Janardan from Liberum Capital. Just trying to dig in a bit deeper into the microcontroller growth rates, the 100% that you reported. Now presumably, there are 2 factors operating there, one is replacement of the 8-bit and 16-bit microcontrollers by 32-bit microcontrollers, which leads you to grow faster. And second is your customers, like the STs, the Atmels, who have moved from propriety cores to ARM cores. That latter factor, I'm just trying to get a fix on that. What percentage of those customers' cores do you think are today shipping with ARM? I mean, I'm saying if it's 20%, it's still a long way to go. If it's 80%, then there's less migration within that customer base. I'm just trying to get an idea for the latter part, rather than the former part. Second question is your confidence on licensing into the second half of the year. Is that coming from the traditional large customers, where you have presumably more visibility and therefore lends to more confidence including on the backlog, which you said will be sort of at least flat at the end of the year? Or is it coming from the sort of spread of ARM across large number of small companies in new product areas? And which is the bigger weighting in the licensing confidence for the second half of the year?

Tim Score

I mean, the answer to your second question, Jan, is really both. I mean, the confidence about second half licensing is partly based on the entry backlog into the second half. And obviously, we have a view of how that backlog is likely to mature into revenue, given engineering deliverables, et cetera. So that's one factor which is used per -- today typically can account for about 50% of target license revenues, so that's important. But then when you look into the detail of the opportunity pipeline, it really is a combination of reequipping existing licensees, but also a size of opportunity pipeline with other licensees who may be looking at ARM for the first time or -- so it's a volume thing as well as a value and existing licensees thing.

Warren East

On the microcontrollers, you highlighted 2 factors, the replacement of 8-bit architectures and the replacement of in-house 32-bit architectures. Primarily, it's a replacement of 8-bit architectures that's driving the growth at the moment. We do have agreements in place with companies like Atmel and companies like Freescale, where they have in-house 32-bit. I honestly wouldn't know off the top of my head exactly the sort of -- if I look at Atmel shipments, for instance, what proportion is on base, what proportion is their in-house AVR base. I think it is quite low, the ARM penetration at the moment amongst these companies, and I don't see it shifting very rapidly. It's much more of a sort of steady progress as end customers demand variants from these people based on the ARM architecture. There are certain applications where some of these players are very, very established, and it's a much easier win for ARM to displace an 8-bit solution than is for ARM to go and displace those established 32-bit processors. So I think we've got a long way to go on the second factor.

Simon Schafer - Goldman Sachs Group Inc.

Simon Schafer, Goldman Sachs. I just had a question about operating profitability. There used to be this 40% number out there as a target, and given licensing is so much better and royalties are growing, we can actually see that. Going forward, royalties is actually growing faster. So I guess, my question is, what are you managing the business towards now? Are you just hoping to grow OpEx significantly enough to keep that 45 run rate, or is that exceeding your expectations? How should we think about the underlying level of normalized margin?

Tim Score

Well, I mean, we don't specifically manage the business for margin. I mean, if you look at this model, the way of developing and creating value is actually by designing technology that is ever more broadly applicable to end markets, and that is going to drive margins, profitability and cash. I think it was about 2007, when we're about 30%, that I said that we -- this business can sustain 40% and more in the medium term. And everyone said what's the medium term. I said 2 or 3 years ex cycle, that sort of thing. So we're there now. And my comments really are if you look out 5 years plus, I expect the margin to continue to increase. Now the pace at which it increases will depend obviously on things like cycles and exchange rates, but it would also depend crucially on our investment opportunities at any given time to create the next wave of licensing and, therefore, royalty. And it may be in 5 years time, but this is a more valuable business with a 50% margin than it would be with a 55% or 60% margin in terms of its longer-term prospects. So that is kind of how we look at it. We're looking at how can we complement this business model, how can we make sure that we achieve market share penetration, in a sense, as rapidly as possible. Because we know if we achieve that, the margin will grow.

Sandeep Deshpande - JP Morgan Chase & Co

Sandeep Deshpande here, JPMorgan Cazenove. A couple of questions. Firstly, on the -- back again to the licensing revenues, I mean, exiting the year, I mean, you could do, I mean, almost $200 million worth of licensing. The base will be very high for the next year. Can we understand, in terms of the licensing revenue that you are doing for the year, how much of it is truly -- I mean, breaking it out between what were your old existing customers and versus new business which you have generated so that of the base itself has risen as opposed to, essentially, that you're selling to the same customer maybe higher-value product, et cetera? That's one question. The second question I have is on the way you have shown your key operating numbers in the current quarter. You have taken off some costs associated with Linaro, I think, and I don't understand why we should be taking off costs associated with Linaro when it is an ongoing expense? And then finally, with regard to royalty growth, I mean, clearly, into the next year, you're going to see some of this associated with Windows on ARM, et cetera. Can you help us -- I mean, it's actually a more question associated with how you sign your licenses. Do you have -- you mentioned it a minute ago, but do you have actually fixed royalties on any devices, or it is always a percentage?

Warren East

Okay. Shall I do the new customers and the royalties? So the first question was about breaking down the -- looking at the license base and breaking it down between new customers, new applications and sort of reequipping semiconductor companies in the traditional space. It is actually very difficult for us to break this out because you get a customer who is an established ARM semiconductor partner with a track record in phones and smartphones and then tablets, and they'll use the same license to build a product to perhaps target servers. And how do we deal with that? It's a very difficult sort of breakdown to do. What I can point you at is if you look back quarter-by-quarter, we always report the number of licenses sold, the number sold to new people buying an ARM license for the first time. And of the 29 sold in the last quarter, I think we had 12 new people. Was it 9? 9 new people. So 20 licenses were sold to existing customers, 9 to new customers. That's probably quite a high proportion. In a normal quarter, it might be more like 20 and 5, that sort of proportion. As we target new applications, do we always have percentage royalty, or do we have some sort of fixed royalties? When you're only signing 29 licenses in a quarter, each one is essentially a little bit unique and negotiated in a unique way, and we always take account of the target end markets that that semiconductor company is going after. Most of those license deals, however, end up being a percentage, the royalty as a percentage. We do have a few fixed rates out there. It's probably becoming an increasingly small proportion of the total which have fixed royalty rates, most of them really are percentage.

Tim Score

And on Linaro, just a reminder, this is an organization that ARM and a number of its licensees set up about a year ago to develop sort of optimized software and tools for Linux-based products. And the reason we've presented it in a way we have is that $6.8 million that you see there is our contribution to Linaro for the next 2 years. And therefore, there will be no other profit and loss entry for Linaro for another 2 years. So in the sense, for transparency, it seemed easier to treat it consistently with how we treated it in Q2 2010 and Q3 2010, when we showed it as a separate column. So that's way the way it is because -- I mean, yes, you can argue about the normalized, but the fact is it isn't going to be there for the next 2 years.

Sandeep Deshpande - JP Morgan Chase & Co

But wouldn't it be more fairer to have it just every quarter because it is an ongoing expense?

Tim Score

Well, I mean, the situation is the accounting requirement when you're committed to the contribution is that you have to expense it there and then. So it's $6.9 million. It's transparent. There will be nothing else for 2 years. In a sense, how you evaluate the headline number, the date is there is for you to analyze. But as I said, because we had to account for it in one go, we're showing it separately.

Unknown Analyst -

Just a quick one on Mali, actually. You've sold, I think, 20 Mali licenses in the last 3 quarters, but I don't think you've sold any to new customers. Is that something that concerns you or investors should be concerned about still?

Warren East

Yes. When we say new customers, we mean people who don't have an ARM license at all. If I look at the 5 Mali licenses sold in the last quarter, for instance, then I think 2 of those 5 were people who didn't have Mali before and 3 were existing Mali licensees upgrading their Mali license. They all happened to be ARM customers.

Kai Korschelt - Deutsche Bank AG

It's Kai Korschelt, Deutsche. Just a quick question on the mobile royalties, which are, I think, about roughly 60% of PD. It looks like the trend in the handset market, there's exploding growth in sort of low-end 2G, the China Shanxi market-type devices, which probably would have a lower royalty opportunity for ARM. And obviously, the smartphone/tablet-type devices are growing fast. But the feature phone segment, where ARM does have exposure to, is sort of falling away. So I'm just wondering if you've ever done or looked at the split of that 60%, whether we could get a stab at what roughly the exposure by segment is, so we could maybe understand the future trajectory of that part of the royalties, please.

Warren East

Yes, if you look in the appendix, you'll find the analysis of opportunities for 2015. And there, you can see what we expect the number of smartphones, the number of feature phones, the number of low-end voice phones to be. I'm not quite sure what page this is because I have a printed version. Maybe Ian can help us with the Page number. Slide 20. Yes, Slide 20, in the appendix. And that's where we break down what we think, how we think the market is going to break down in 2015. When we update these numbers every year, we show you what we think the snapshot has been over the last 12 months, and we'll give you our updated version of the 5 years-out view. It does change. Our sources are the same, sort of industry analysts that you look at. And the world changes. And we also use some of our bottoms-up intelligence communication with the handset manufacturers as well to generate these numbers. And I'm just conscious of the fact that we have about 5 minutes left before we have to disappear. So we've only got a few questions.

Andrew Gardiner - Barclays Capital

Andrew Gardiner with Barclays. Just first on the royalties side, you've cautioned us about being too aggressive on the Cortex-A royalty rates and factoring that through to revenue by saying that's only 4% of units currently. But to put into context, can you help us understand what percent of revenue it maybe at the moment? And then also, on the PIPD POPs, the roughly 50% attach rate that you're seeing, what are the kind of customers that are going for those? Are those perhaps smaller licensees that may not have the full design capabilities enhanced? Are you also seeing interest from some of the larger semiconductor players?

Warren East

Yes, the first one is estimates of Cortex-A in terms of royalty revenue as well as volume, and we tend to not talk about that in public. The reason we don't talk about it in public is when you put the 2 pieces of information together, or when our customers put the 2 pieces of information together, then they can reverse-engineer exactly what royalty rates their competitors are getting, and it all becomes a bit commercially sensitive. So I'm afraid I'm going to leave that as an exercise for the analyst community. What we do say is that these Cortex-A9s, they're going into high-end smartphone chips. You can get a read of what high-end smartphone chips sell for. We're talking $15 plus for an apps processor with something like that, maybe $15 to $35. And we do say that typically, the royalty rate is greater than the 1%, typically here in the north of 1.5%. So we give you some basic information, but we don't talk about the answer, I'm sorry, on that one. And I'm afraid I forgot the second question. POPs, yes. People buy POPs for 2 reasons. One, if they don't have the design capability in-house, and you're right, that tends to be smaller companies. And so POPs do enable smaller companies to build competitive implementations of things like Cortex-A9. But we're also selling POPs to, I'm looking at last quarter, to some more established players. Unfortunately, this is -- they don't want us to be public about it. More established players who do have the capability would want to use a POP because it gives them a deterministic result, and it's a time-to-market to a deterministic result, that's why they buy it.

Unknown Analyst -

Just a quick follow-up on Cortex, on Cortex-A. One, can you give us a sense for the portion of your licensees so far of Cortex-A that might be licensed in nontraditional semiconductor players, just players that haven't really shipped silicon traditionally? And I guess, when you look at the business, you've typically up until now licensed cores and physical IP. But is there any scope to increase that to license a full application process or a white label platform for nontraditional semi guys to license?

Warren East

Yes. We have sold Cortex-A9s to some people whom you would regard as nontraditional. I would say it's a very small proportion right now, probably around about 10%, something like that. And the other question was more interesting. It was about if we'd consider extending licensing to license sort of white label platform. The answer is that if we look back over the years, then we started off licensing a very bare microprocessor core. And over the 20 years that we've been doing this, we're now licensing much more of the microprocessor subsystem than we were. And as the subsystem around the microprocessor becomes more inextricably linked to the performance that you get out of it, then the semiconductor companies are comfortable with ARM doing that. They want ARM to provide that, and they don't see lots of that as such a differentiator. They seek to differentiate in other parts of the system on chip device. So if you project that forward, there may be a time when that level arises all the way to the apps processor, but we're nowhere near that time at the moment. And our business is dependent on being able to sell next generations of products, on reequipping lots of our semiconductor partners, and the last thing we want to do is do their job for them because we don't have the expertise that they have. And the real competition is other architectures. And we want to sustain our business, so we're not going to cannibalize their business. So long term, there is a trend in that direction. I have no idea how far that trend will go, but we continue to evolve our business model as the world outside changes. But we need to do it carefully so that we maintain the advantages of real expertise differentiating in the right places to ensure that ARM-based system on-chip devices are competitive.

Unknown Analyst -

I think Tudor threw an interesting 40% market share in portable computing in 2015, if I remember correctly. If I did the calculation at the end of Q2, the ARM architecture in portable computing, as defined by ARM netbooks plus notebooks plus tablets, is at about 23%. It was obviously 0 or close to 0 in netbooks and notebooks. Can you maybe share with us what was the assumption on the market share on netbooks and notebooks to get to that 40% market share? That'd be great.

Warren East

Actually, I can't. Tudor was quoting an analyst, and that was based on an external analyst, and it was indeed based on proportion of tablets versus proportion of netbooks. I have no idea what the assumption was behind that. So a disappointing answer to the penultimate question, I'm afraid.

Unknown Analyst -

This question hopefully is a bit more specific and you can give the answer. It's on the patent box tax. This is something which obviously -- the labor government, I think, introduces an idea of reducing the tax rate from about 24%, 28% down to 10% in U.K. Now if I understand it correctly, it's affecting the ARM revenues earned from patents, considering yours is an IP business. Assuming that you will benefit from this tax rate reduction, what is your view when this could come in and how much could your overall tax rate of effectively 20% go down to from this perspective?

Tim Score

Well, just a reminder, our overall tax rate forecast for the year in this release is 26%. It's actually a combination of rates around the world. And we already have a U.K. rate signposted to go down to 23% in 2 or 3 years time. We would expect the patent box regime should it be implemented, and all the expectations are that it is actually coming to law, to benefit companies like ARM. And we are involved in that process to try and make sure that happens. And then there's lots of detailed implementation about precisely which of your revenues and patents, et cetera. But I think if it comes in, the overall message is ARM's medium to long-term tax rate is going to be considerably lower than it is right now.

Warren East

A much better answers than the last question. So thank you very much, everybody, for coming along. We'll be back in October with Q3.

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