ARM Holdings Plc (ARMH) Simon Segars on Q2 2016 Results - Earnings Call Transcript

| About: ARM Holdings, (ARMH)

ARM Holdings Plc (NASDAQ:ARMH)

Q2 2016 Earnings Call

July 27, 2016 4:30 am ET

Executives

Ian Thornton - Head-Investor Relations

Simon Segars - Chief Executive Officer & Director

Chris Kennedy - Chief Financial Officer & Director

Analysts

Francois A. Meunier - Morgan Stanley & Co. International Plc

Matthew D. Ramsay - Canaccord Genuity, Inc.

Sandeep Deshpande - JPMorgan Securities Plc

Andrew M. Gardiner - Barclays Capital Securities Ltd.

Kai Korschelt - Bank of America Merrill Lynch

Lee Simpson - Stifel Nicolaus Europe Ltd.

Jaguar Bajwa - Arete Research Services LLP

Johannes Schaller - Deutsche Bank AG (Broker)

Operator

Ladies and gentlemen, good morning. Thank you for standing by. And welcome to the ARM Q2 results analyst conference call. At this time, all participants are in a listen-only mode. There will be a presentation, followed by a question and answer session. I must also advise you that this conference is being recorded today, Wednesday, the 27th of July 2016.

I'm now handing the call over to your first speaker today, Mr. Ian Thornton. Please go ahead, sir.

Ian Thornton - Head-Investor Relations

Thanks you, Andre. Good morning, everybody. This is Ian Thornton, VP of Investor Relations at ARM. On today's Q2 results conference call, we have Simon Segars, Chief Executive Officer, and Chris Kennedy, Chief Financial Officer. On today's call, Simon and Chris will take us through the highlights and comments from the quarter's result, and then we'll open up the call to a Q&A session. As a reminder, the press release and some financial data can be found at ARM's Investor Relations website at www.arm.com/ir.

And now a few words with respect to this conference call and what we're about to discuss. The contents of this conference call are being directed only to those of you who have professional experience in matters relating to investment, and the information communicated on this call is being made available only to investment professionals. Any person present on this call who does not have professional experience in matters relating to investments should not act on or rely on the content of this call.

The following conference call may include forward-looking statements, which will be statements which are other than statements of historical fact. The company's actual results for future periods may differ materially from these statements, as they are based on current expectations and are subject to a number of risks and uncertainties. Clearly, this quarter is a little different from our normal quarterly results. As a reminder, on the 18th of July, 2016, SoftBank and ARM announced that we have reached agreement on the terms of a recommended all-cash acquisition of 1,700 pence per share.

The Rule 2.7 Announcement containing details of the offer and all documentations related to the offer can be found on the website www.acceleratingtech.com. Therefore, this conference call will not go over details of the offer. And, given the restrictions placed on forward-looking statements as a result of the offer, we will not be giving revenue or cost guidance, nor make any forward-looking statement about our business or the broader market opportunity. At the end of the call, there will be a shorter-than-normal Q&A session, since we will not be giving any further information about the offer that is already in the public domain, nor making any forward-looking statement.

I will now hand over to Simon to give an overview of Q2 2016

Simon Segars - Chief Executive Officer & Director

Thanks, Ian, and good morning, everybody. Thank you for joining our Q2 2016 results conference call. As normal, I will run through the business highlights and then hand over to Chris to provide some more detail on the numbers.

ARM has reported another good quarter, with total technology licensing revenues up 7% year on year and total royalty revenues up 12% year on year. This quarter, more thought-leading companies made long-term commitments to ARM technology, and our semiconductor partners announced many new and exciting ARM-based products for a wide variety of applications, including sensors, supercomputers, and satellites. These design wins characterize the drivers of our long-term growth: More advanced ARM technology being chosen by more partners to be deployed in more markets.

Putting some detail on this. Fujitsu and RIKEN announced that their next-generation supercomputer will be based on ARMv8-A-based chips. When that machine goes into operation in 2020, RIKEN expected to have 100 times the performance of their current supercomputer, which is ranked number five in the world.

At the smaller end of the spectrum, we're seeing ARM technology being deployed in an increasingly wide range of devices. As an example, NASA recently completed a three-year study into high-performance space computing requirements and selected the ARM Cortex-A53 processor for its onboard computers. We saw dozens of ARM partners, including Applied Micro, Broadcom, Cavium, Mellanox, and NXP, all announce new chips for networking infrastructure and servers. And Qualcomm, ST, (4:32) Xilinx, and many others announced new embedded intelligence chips for smart sensors, medical equipment, automotive applications, and so on. ARM has been investing and developing technologies for many years in these areas. It is great to see our partners being so successful.

ARM is continuing to invest in new technologies. During the quarter, we announced the Cortex-A73 CPU and Mali-G71 graphics processor. Together, these processors will enable virtual reality and augmented reality in smart mobile devices. We also announced the supporting technologies needed to integrate these processors into an SoC, including on-chip interconnect, physical IP libraries, software tools, and support from our ecosystem partners. Ten of our customers now have access to the Cortex-A73 and/or Mali-G71, and are building them into their next-generation mobile application chips.

In May, ARM announced the acquisition of Apical for £251 million. Apical is at the forefront of embedded computer vision technology, building on its leadership in imaging products. Together with our existing technology, this will help the ARM partnership to address some of the challenges of next-generation products such as driverless cars, robotics, and sophisticated security systems. At acquisition, the Apical team was about 100 people strong, the majority being R&D engineers. We're very pleased with the integration process so far. The companies have similar cultures, which is helping with integration of teams, processes, and roadmaps.

In June, we entered into a strategic partnership with Hopu Investment Management, a Chinese private equity firm, through which we are launching a fund that will be focused on the Internet of Things, smart devices, Big Data, and cloud computing. Also in June, we signed an architecture license with Guizhou Huaxintong, a joint venture between Qualcomm and China's Guizhou Province. Guizhou Huaxintong's stated aim is to develop advanced server chipset technologies in the rapidly expanding Chinese server market, the second-largest data center market in the world.

Now I'll discuss the revenue drivers in the different parts of the business in more detail, starting with technology licensing. We signed 25 licenses with 23 customers in the quarter. Just as in Q1, over half of our customers this quarter were new to ARM. Five of the licenses signed were for ARM's Cortex-A processors, mainly for use in smartphones and networking infrastructure. Thirteen of the licenses were for Cortex-M processors, for use in embedded devices and in the Internet of Things. Two of the licenses were for Cortex-R class processors, for use in advanced memory controllers and wireless communications. We also signed two licenses for our Mali multimedia processors for smartphone and digital TVs.

Physical IP licensing was down 37%, compared to the strong number reported in Q2 2015. This was a result of the timing of engineering milestones and a higher proportion of semiconductor companies opting to take single-use licenses rather than multi-use licenses for our POP IP technology. We also signed a major deal in the quarter to develop a 10-nanometer library of physical IP for a (8:10) foundry's most advanced manufacturing process, which was backlog building.

And now I'll switch to the royalty side of the business. ARM's royalty revenues are reported one quarter in arrears, so our royalty for Q2 was generated from chips sold by our licensees in Q1. Processor royalty revenue was up 11% year on year. By comparison, the semiconductor market declined 3% in the relevant period. And so we outperformed the industry by 14 percentage points.

In Q1, the smartphone market was down around 10% sequentially, and there was also a widely reported inventory correction in the smartphone supply chain. We saw an impact from both of these factors in Q2. The sale of application processors in smartphones also declined by about 10% sequentially, and the sales of peripheral chips for use in a smartphone declined to a much greater extent.

During the quarter, approximately 250 million chips contained ARMv8-A processors, and 110 million of these chips were octa-core. Around 65% of all smartphones sold in Q1 contained an ARMv8-A processor, and around 30% contained an octa-core chip, up from around 25% in the prior quarter. Physical IP royalty revenue grew 17% year on year, due to the increase in shipments of wafers using ARM's physical IP at advanced nodes.

I'll now hand over to Chris, who will provide some further details on the numbers.

Chris Kennedy - Chief Financial Officer & Director

Thank you, Simon. Good morning, everybody. Hopefully, many of you will have had a chance to have a quick look at ARM's Q2 2016 earnings release. The quarterly results and financial data are on our website as usual.

Q2 dollar revenues of $388 million were up 9% year on year, with 7% growth in technology licensing and 12% growth in technology royalties. In Q2 2015, the sterling-to-dollar effective exchange rate was 1.56. In Q2 this year, it was 1.45. That's an 8% weakening of sterling versus the dollar, so Q2 sterling revenues were up 17%.

We also had the release of a tax provision following the receipt of correspondence from a tax authority. Combining these together resulted in EPS growth of 18% year on year. Without the tax provision release, EPS would have increased around 7%. For those wondering about the impact of Brexit and the subsequent weakening of sterling, as it happened right at the end of the quarter, there was very little impact on our Q2 results.

As we have often discussed on these calls, quarterly license revenues can be lumpy. In Q2, processor licensing was particularly strong, up 14% year on year. This was driven by 25 processor licenses, including a high-value architecture license. In contrast, physical IP license revenue was down 37% year on year to $14 million for the reasons that Simon has already covered. About 50% of our processor licensing revenue came from backlog in the quarter, which is within the typical range of between 40% and 60%. Group backlog was down around 10% sequentially.

Normalized OpEx in Q1 (sic) [Q2] (11:35) was £130.7 million, up 32% year on year and down 2% sequentially. As you will recall, we announced a step-up in R&D investments in Q3 last year. Most of that step-up was achieved in H2 last year, and we're now in a period of more stable head count and cost growth. Excluding the acquisition of Apical, head count was up about 1.5% sequentially.

The group's effective normalized tax rate was 6% in Q2 2016, which is much lower than prior quarters due to the release of a tax provision of $11.5 million. Excluding the tax provision release, our tax rate would have been around 15%.

Normally at this point I would talk about outlook. However, given the restriction placed on forward-looking statements as the result of the SoftBank offer to ARM, it's not appropriate for us to provide the usual guidance for full-year 2016 revenues or next quarter's cost range or the full year's tax rates. I'll now come back to Simon.

Simon Segars - Chief Executive Officer & Director

Thanks, Chris. And now, we'll go to Q&A. As usual, if I could ask you just to ask one question at a time, we'll be able to get everyone's question in. And if there's time at the end, we can come back for a second round. And also as a reminder, we will not be discussing the details of the offer from SoftBank to ARM, nor will we be giving any forward-looking statements.

So if I can hand back to the operator to manage the Q&A, please.

Question-and-Answer Session

Operator

Certainly, thank you. And your first question comes from the line of Francois Meunier from Morgan Stanley. Please go ahead.

Francois A. Meunier - Morgan Stanley & Co. International Plc

Morning, gentlemen.

Simon Segars - Chief Executive Officer & Director

Hey, Francois.

Francois A. Meunier - Morgan Stanley & Co. International Plc

Hey, yeah. So just a quick question on Q2. I think on Q1, you disclosed the growth which you had in network, which was plus 10%. I don't know if you could disclose or give some flavor around network infrastructure revenue growth in Q2, if you can?

Francois A. Meunier - Morgan Stanley & Co. International Plc

Not off the top of my head; I don't have that in front of me, but in terms of proportion of a unit, we did see a bit of a sequential growth in that split, but up about a percentage point sequentially and year on year into that enterprise segment.

Francois A. Meunier - Morgan Stanley & Co. International Plc

Okay. Thanks for the clarification. Thank you.

Chris Kennedy - Chief Financial Officer & Director

(14:21). It was also up 10% in Q2 as well as Q1.

Francois A. Meunier - Morgan Stanley & Co. International Plc

Okay. Thanks again.

Operator

Thank you. Your following question comes from the line of Matt Ramsay from Canaccord Genuity. Please go ahead.

Matthew D. Ramsay - Canaccord Genuity, Inc.

Thank you very much for taking my questions. Good morning, guys, and obviously congratulations on the deal. It's been a pleasure to work with you guys over the years. I guess, Simon, I don't know how much you can comment on this, but I'd be interested in just any feedback you've gotten from licensees around the SoftBank announcement. There's been lots of debate of that, potentially for you guys up to invest more heavily, but I mean one of the things I've always admired about the team is the ability to balance the needs of all the different licensees as you guys have moved forward with the business. So, any comments there? And, Chris, if you could break out at all for us any contribution to either costs or revenue from Apical in the quarter, that would really help. Thanks, guys.

Simon Segars - Chief Executive Officer & Director

Okay. Thanks, Matt. Well, as I said, I can't comment on structure of the deal. We've spent a lot of time communicating with all constituencies. A key message that we said previously is that there would be no change to our business model, no change to the way that we go about working with our partners. But beyond that, I don't want to go into any specifics.

Chris Kennedy - Chief Financial Officer & Director

Yeah. And on Apical – I appreciate that you haven't had too much time to look at the statement. Bottom of page 18, we break out the Apical results. So in Q2, it added about £1 million in revenue and pre-tax profit of £100,000. And we also give the sort of pro forma, had it been consolidated for six months, with the £6.9 million of revenue and £0.4 million pre-tax profit.

Matthew D. Ramsay - Canaccord Genuity, Inc.

All right. Thanks, guys. Appreciate it.

Operator

Thank you. Your next question comes from the line of Sandeep Deshpande from JPMorgan. Please go ahead.

Sandeep Deshpande - JPMorgan Securities Plc

Yeah. Hi. Thanks for letting me on. Simon, you've announced a few wins in the server market in the quarter. Do you see yourself – I mean, with what you've already – in terms of the wins you've announced and what you've not announced publicly, that you're on track to do the 25% share in units by 2020 at this point in the server market? And secondly, do you see that you're already seeing the impact of the smartphone slowdown in your numbers and that this is now actually already in the number, and so from here onwards, you will not see a further impact? Thank you.

Simon Segars - Chief Executive Officer & Director

Well, I'll just answer those questions in the context of Q2.

Sandeep Deshpande - JPMorgan Securities Plc

Yeah.

Simon Segars - Chief Executive Officer & Director

I mean, if you look sequentially, units are down. If you look at the split of where those units have gone, you'll see that mobile and connectivity for Q2 sits at 40% versus 45% in Q1, which obviously relates to chips that were sold in Q4. Now that's a seasonality that we would typically see, Q1 being slower for smartphone shipments than off of Q4. And obviously, during Q1, there was a lot of pessimism and discussion about supply chain inventory. So I think it's reasonable to say that that effect is seen in Q2. Can't say anything about the future, because that would be a forward-looking statement and, as we said, we won't be making any of those today. And similarly with servers, very pleased with the progress that we've demonstrated to date. Very pleased with the deals that we've closed and announced in Q2, but beyond that, I can't go into any more detail.

Sandeep Deshpande - JPMorgan Securities Plc

Thanks. And all the best.

Operator

Thank you. Your following question comes from the line of Andrew Gardiner from Barclays. Please go ahead.

Andrew M. Gardiner - Barclays Capital Securities Ltd.

Good morning, guys. Yes, sort of congrats from my side as well. Certainly ARM will be missed within the coverage. Just within the – what you can comment in terms of the quarter and how you're seeing the smartphone space, I'm just interested in hearing your thoughts on the level of sort of content gain or feature gain in terms of v8 and multicore and Mali. Certainly if you look at v8, it seems to have flattened out, at least quarter on quarter. I presume it's sort of seasonal, but I'm just interested in your thoughts on how the licensees are progressing there, and whether you're seeing any slowing in terms of appetite for upgrading to more advanced processors through sort of mid and low end of the smartphone market. Thanks.

Simon Segars - Chief Executive Officer & Director

Well, again, focusing all of that around Q2. If we look back at the growth of v8-A into smartphones, that was 30% a year ago. It grew to 50% in Q4. Q1 was at 65%. Q2, as we just reported, 65%. Seeing a growth in octa-core in that time period. So Q2 2015, octa-core was at 5% penetration, up to 30% in Q2. Now, as I just said, Q1 was a slower quarter for smartphones. So I don't think you can read too much into the sequential changes in those numbers from Q4 – well, our Q1 to our Q2, obviously market Q4 to market Q1. Time will tell, but again that's – just to make any further comment on that, I'd be talking about the future.

And in terms of general appetites to upgrade, I think the Q2 licensing reflects continued demand for our technologies across the different categories of our product lineup. So we're very pleased with the breadth of licensing of Q2, and that would seem to continue our historic trend.

Andrew M. Gardiner - Barclays Capital Securities Ltd.

Okay. Thank you. Best wishes for the future.

Simon Segars - Chief Executive Officer & Director

Thanks, Andrew.

Operator

Thank you. The following question comes from the line of Kai Korschelt from Merrill Lynch. Please go ahead.

Kai Korschelt - Bank of America Merrill Lynch

Yes. Good morning, gents, and again, yeah, congratulations on getting a good deal for the company. So my first question was really a bit broader, and it was particularly around IoT. So what do you think has been – we've been talking about it for some years – what do you think so far has been holding back the sort of breakthrough adoption, and what do you think can or could be a catalyst for that product category to take off? And then just a quick follow-up on the tax rate; it was very low. Were there any sort of unusual effects in the second quarter? Thank you.

Simon Segars - Chief Executive Officer & Director

As you say, we've been talking about IoT for a long time. We've been, we believe, building or creating the building blocks that will be required for IoT systems. Cortex-M is a big part of that, and you've seen in the quarter very strong licensing of Cortex-M again. And our mbed platform that we've discussed for some time has continued to make good progress in terms of delivering against the objectives that we set out. And we believe that these are key technologies that will help IoT become a reality. What we've seen up till now is people developing IoT platforms in a very vertically oriented way. And I think that's an understandable step for the industry to be making at this stage as people really work out what the benefits of IOT are going to be. So up till now I think we have made good progress. How this proceeds from here is again a projection of the future. So I'm not going to make one of those. But I think the work that ARM has done has been the right things for us to have done over the last couple of years to prepare for this market.

On the tax rate – (22:49)

Chris Kennedy - Chief Financial Officer & Director

Yeah, on the tax rate. Yeah, I mean, it is unusually low at 6%. As I said, we'd – underlying, would expect that to be around 15%. And that's because in the quarter, we released a tax provision which actually goes back over 10 years, and we've concluded we no longer need it following some recent correspondence with the tax authorities.

Kai Korschelt - Bank of America Merrill Lynch

Okay. Thank you. Best of luck.

Simon Segars - Chief Executive Officer & Director

Thank you.

Kai Korschelt - Bank of America Merrill Lynch

Yep.

Operator

Your next question comes from the line of Lee Simpson from Stifel. Please go ahead.

Lee Simpson - Stifel Nicolaus Europe Ltd.

Great. Thanks for letting me on, and congratulations to all on such a strong deal.

Simon Segars - Chief Executive Officer & Director

Thanks, Lee.

Lee Simpson - Stifel Nicolaus Europe Ltd.

Couple questions if I could. Just trying to understand – and maybe you kind of can't answer this one. Could you maybe outline again for us, what is the nature of the relationship with Thundersoft? I mean, is this an arm's-length investment, or do you see something more strategic developing from that? And maybe alongside that, a couple of quick ones – 1,695, the number of UK employees, does that now include Apical? And could you just remind me when the Scheme Document actually released to investors?

Simon Segars - Chief Executive Officer & Director

So multiple questions in there; (24:09) for not following the rules. So, very quickly, 1,695 UK employees includes Apical.

The question about Thundersoft. We made a completely arm's-length investment in them a long time ago. They went public – I think it was last year. We still hold shares in Thundersoft. So, from an investment point of view, it's just completely arm's length. There's no overlap in a way that they're managing their business or we're managing ours. They are a partner of ours in our accelerator program in China. So we have a joint venture with Thundersoft. That has set up a number of accelerators or incubators around China, which is bringing in entrepreneurial start-up companies into the ARM ecosystem. So we're very pleased about that (25:05).

Schedule documents, I can't put a concrete date on that. Sometime over the next couple of weeks, that will be published.

Lee Simpson - Stifel Nicolaus Europe Ltd.

Great. Thanks, guys, and all the best.

Simon Segars - Chief Executive Officer & Director

Thank you.

Operator

Thank you. Next question comes from the line of Jaguar Bajwa from Arete Research. Please go ahead.

Jaguar Bajwa - Arete Research Services LLP

Hi, guys. Thanks for taking my question. Just the first one, maybe – can I get a classification on that turns number that you gave during the prepared remarks? Is that okay?

Chris Kennedy - Chief Financial Officer & Director

Yeah, so 50% of the license revenue came from backlog and 50% from turns.

Jaguar Bajwa - Arete Research Services LLP

Okay, great. And then, just for the question. Despite the big architectural deal you did in the quarter, backlog (25:46) the maturity of your licensing now. Did you recognize more from the architectural deal in the P&L this quarter than you kind of usually have done historically? And maybe, could you give us a rough estimate of how much of that architectural deal went into the P&L this quarter? Thanks.

Chris Kennedy - Chief Financial Officer & Director

So we can't disclose details about individual licenses, but it's a rules-driven process. So the amount we recognized in the quarter is to do with the IP that that license involves. If it's mature IP that the customer's capable of using, then we take that to revenue. If it's for future delivery, then that goes into backlog and is released when that IP is delivered.

Simon Segars - Chief Executive Officer & Director

But there is no difference in the handling of that license than any other similar license.

Jaguar Bajwa - Arete Research Services LLP

Okay. Thank you very much.

Simon Segars - Chief Executive Officer & Director

Thank you.

Operator

Your next question comes from the line of Douglas Smith from Agency Partners. (26:49) Please go ahead.

Unknown Speaker

Yeah. Good morning. I was wondering if you could talk a little bit about what you're seeing in the automobile market. I know it's one you've always said you had a lot of hopes for. Many other people seem to think it's very strong right now. Could you comment particularly – are you seeing strength, and is it navigation, infotainment, self-driving capabilities?

Simon Segars - Chief Executive Officer & Director

Well, I mean, ARM has historically played a role in automotive electronics. We've had our – our processors have been designed into many different parts of the car over the years. We've been in airbags and ABS systems and infotainment systems within cars. Over the last few years, as interest around autonomous driving has grown, and as the sophistication of driver assistance systems have grown, we have seen a increased demand for embedded processing, and many of our partners have been working on products based on our technology, to go and address that space.

So clearly, the trends are towards a greater silicon content in cars. We've talked about that before. How it plays out, how much market share ARM gains, not in a position to talk about today, as that's a discussion about the future. But, as I said, we've just seen, over the last few years, an increasing amount of semiconductor content and increasing amount of processor-based semiconductor content going into cars.

Unknown Speaker

Okay. Thanks a lot for all that, and it's been a pleasure working with the management and the investor relations team as well.

Ian Thornton - Head-Investor Relations

Thank you very much.

Operator

Thank you. And your next question comes from the line of Johannes Schaller from Deutsche Bank. Please go ahead.

Johannes Schaller - Deutsche Bank AG (Broker)

Yeah. Thanks, and congratulations on such an amazing deal from my side as well. Just two questions around IoT, given that we heard about that so much. I know you can't talk about things going forward. But could you give us a sense just where, in your view, IoT-related royalty revenues stood in the second quarter and how that grew? I know it's probably not a lot and there's some definition to that, but maybe you can give us a bit of a feeling.

And then also, if you just look at the deals you have so far. Are most of your – would you imagine most of your IoT-related deals to just get you a percentage royalty rate on the silicon, like most of your other deals, or is there maybe also something where you can derive more of the value of the services, et cetera, that are related to IoT? If you can give us a bit of a feeling on that, that would be great. Thank you.

Simon Segars - Chief Executive Officer & Director

So we don't break out royalty dollars between the different segments. But again, if you look at the table that's on page 7, you can see that 42% of the volume in Q2 went into embedded. And that's a very broad category. That can be all manner of devices. Some of those are connected IoT-like systems, and some of them are more unconnected control applications, controlling the motor in a dishwasher, for example, a standalone black box type application. So embedded, very broad space. 42% of 3.6 billion chips, I can't do that math in my head, but that's a large number of chips. How many of those are connected, how many of those aren't, we don't have a breakdown here.

And in terms of today's business and today's business model, the IoT opportunity – well, obviously, not IoT opportunity – revenues from the IoT space are about the percentage royalty on the chips that contain Cortex-M's that are going into these connected devices. Again, whether or not that changes over time would be talking about the future, so I better not speculate on that.

Johannes Schaller - Deutsche Bank AG (Broker)

That's helpful. Thank you very much, Simon. All the best.

Simon Segars - Chief Executive Officer & Director

Thank you.

Operator

Thank you very much. There are no further questions. Please continue. Thank you.

Simon Segars - Chief Executive Officer & Director

Well, if there are no further questions, then thank you very much for joining us today, and we'll call that a day. Thank you very much. Goodbye.

Operator

Thank you. That does conclude the conference for today. Thank you all for participating; you may all disconnect. Have a good rest of the day.

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