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ARM Holdings plc (ARMHY)

Q2 2007 Earnings Call

July 26, 2007, 8:300 AM ET

Executives

Bruce Beckloff - VP, IR

Warren East - CEO

Tim Score - CFO

Analysts

Gary Mobley - AG Edwards

Corey Tobin - William Blair & Company

Presentation

Operator

Thank you for the standing by, and welcome to the ARM Holdings Q2 Result Conference Call. At this time, all participants are in a listen-only mode. There will be a presentation followed by your question-and-answer session. [Operator Instructions]. I must advice you that this conference is being recorded today, Thursday, the 26th of July, 2007.

I would like to turn the conference over to your speaker today, Bruce Beckloff. Please go ahead, sir.

Bruce Beckloff - Vice President, Investor Relations

Thank you very much. Good afternoon everyone and good morning to you over in the States. This is Bruce Beckloff, the VP of IR at ARM.

On today's Q2 and half year results conference call, we have Warren East, the Chief Executive Officer; and Tim Score, the Chief Financial Officer. On today's call, Warren and Tim will take us through the highlights and comments from the quarter results and then we'll open it up to Q&A session.

As a reminder, the presentation and release as well as the webcast of this morning's presentation can be found on ARM IR website, at www.arm.com/ir. Before I hand over to them, I just have a few words to read out with respect to this conference call and what we are about to discuss. The content for this conference call 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 investment should not act or rely on the content of this call.

The following conference call will contain forward-looking 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.

On this note, I'll hand over to Warren.

Warren East - Chief Executive Officer

Thank you, Bruce. Good afternoon and good morning and thank you for joining us. So I will start with an overview and then hand over to Tim. Today, 2007 has been a challenging year for the semiconductor industry as a whole and nobody seems to be immune to this and as a result, in April we indicated that revenues for Q2 would be broadly similar to those that we saw in Q1. And set against this challenging backdrop, we are very pleased today to announce a very solid set of numbers with profit and operating margin well ahead of expectations and a very strong, even record performance in licensing revenues which we are showcasing on newer technology and overall revenue in line with expectations.

So going into the second half now, our pipeline remains strong and our record backlog of future orders that existed in January only marginally reduced. So I am just going to go into a bit more detail on each of the parts of the business.

In the Processor division, we had a record quarter for license revenue and that completed the first half which was up some 25% year-on-year, in fact Q2 was up 26% in Processor division licensing compared with Q2 last year. And to do that we signed 15 licenses bringing the total number of licenses to 491, and that means we now have 6 new partners, bringing the total of semiconductor partners up to 197, which incidentally is up from 184 twelve months ago, so new partners are still going well.

Within that licensing activity, there were 4 newer ARM11 licenses, three new Cortex licenses and a further sale of our Mali Graphics product. And actually on the Graphics product, there was meaningful revenue being recognized on some of the earlier graphics licensing within 12 months of the acquisition. So our graphics business is now tracking ahead of our own internal plan.

It was good to see in Q2 a high proportion of the Processor licensing being driven by non-mobile applications. And in the quarter, we introduced ARM11 to the foundry program which should help drive this non-mobile activity even more over the next several quarters. In the mobile space, you may have noted this morning that we announced that Infineon have chosen to adopt ARM processors across their entire range of wireless chipset including ultra low cost phones. In the main though, mobile licensing was really related to smarter phones, which is of course giving rise to potential ARM IP per phone and therefore, enhance royalties.

Royalties themselves is reported in the quarter were affected by the semiconductor industry correction cycle with infantry of the hang and that was very marked in Q1 which is the quarter to which these royalties relate. And this together with the normal seasonality that we see in Q1 across consumer segments, PC and mobile sector all offset a very strong growth in microcontrollers to together produce an overall decline in volumes versus the previous record quarter, of some 10% sequentially. But if you compare that to the quarter 12 months ago, though we saw our 17% increase in volumes over 2006 and that continues to demonstrate strong growth in market share cross all affected and support our longer term volume predictions, which remain absolutely unchanged.

So switching to Physical IP Division, we signed 17 licenses there, including a large 45-nanometer package with a non-foundry customer who specializes in high performance products. And in a matter of a few days we do anticipate signature of an important license which we originally expected to sign before the quarter-end. This lumpiness in booking is combined with a) deliberate challenging channeling of engineering resource into advanced product development with satisfied customer demand and b) lower levels of foundry utilization in the first quarter, combined to produce disappointing quarter for overall PIPD revenue. However, we don't really expect this combination of circumstances to occur again and we are confident of stronger second half revenue for PIPD.

And looking at the longer term 4 to 7 year time line that we originally outlined for Physical IP, after two and a half years our strategy is absolutely on plan. Interaction with major IDM discussions has stepped up considerably, we now have approximately three times more ongoing discussions and evaluations than we had some 12 months ago, so things are looking pretty good there.

Further, flat underlying royalty year-on-year against a backdrop of a 15% decline in foundry utilization is I think an encouraging sign of substantial market share growth in the underlying Physical IP business.

Our Development Systems business now; that delivered inline with expectations and is basically an encouraging sign even during this challenging year in the semiconductor industry, it's an encouraging indicator of the level ongoing design activity.

Looking into ARM, at the organization, we have reorganized internally and we have moved from having four separate divisions and three separate business units to four product oriented divisions and a core services division. So that simplification is inline with our operational focus this year on simplification and driving productivity improvement and its one of the drivers of enhanced margin this quarter.

As the year is unfolded, expectations for the overall semiconductor revenue growth in '07 have had several regular damn good revisions. ARM is not...this clearly the first half revenues been affected, but we retained near record backlog and the strong pipeline with licensing, based on healthy portfolio, products that our customers actually want to use and we got new products coming along later in the year and that combined with the rebalancing of our resources globally, general better cost control of operating... better control of operating expenses, better cost control is already delivering margin improvements. So the pace and the timing of why doing this re-upturn is uncertain and we can't really predict that but what we can do is expect that full year earnings will be inline with expectations.

Now I hand over to Tim.

Tim Score - Chief Financial Officer

Thank you, Warren. Good afternoon and good morning to folks in the U.S. As usual the full financial slide that is available on our website, so I want just sort of try and pick out some of the salient points that we think are inherent in these Q2 results.

As Warren revenues, our overall revenues were in line with that guidance, being at similar level to Q1 and that gave us 11% revenue growth in the first half compared with an overall industry growth that was something under 5% and at a time where obviously our relatives have been impacted in the short term by the inventory correction. And one of the key drivers of that growth of course is the Processor Licensing business which Warren said, has grown by 25% in the first half, a very strong forward indicator of ARM's continued ability to penetrate both mobile and non-mobile sectors.

PIPD licensing was weaker for the reasons Warren outlined, but in... for each of those reasons, we do see improvements in the second half. And after strong licensing quarter in PD looking at the overall Group backlog at the end of the quarter, as Warren said, slightly off the record levels at the beginning of the year, but still historically high. And I think importantly, in looking for... looking at the licensing prospect in the second half, the maturity profile of the backlog has if you like, shortened in terms of recognition into revenue, with 46% of the total backlog we expect to be converted into revenue in the second half. The equivalent number at the end of Q1 was 41%, so quite a significant shortening there for backlog maturity profile.

The full analysis backlog in terms of maturity and composition, it included in the slide set as usual. Warren touched on royalties, on the Processor side, the same level as 2006 in dollar terms, reflecting the impact of the inventory correction. And in PIPD, similarly Q1 being the relevant shipping quarter being arguably the low points of the foundry utilization and ARM's royalties were at the same level as the year ago, which actually the... we review as credit to performance, given that overall foundry revenues in the same period were down approximately 15%.

Moving onto costs, we had as you know quite a significant year of investment in new heads into the business in 2006. We increased the headcount by 25%. We indicated at the start of this year that 2007 would be the year of digestion of those new people into the business and increase productivity and of lower net recruitment. Headcount at the end of Q2 is actually about 22 higher than it was at the start of the year. Importantly, headcount is up about 50 in sort of the lower cost regions, India and China and down about 26% in the rest of the world and that's kind of illustrating the ongoing regional rebalancing of ARM's resources.

So this and general sort of rigorous cost control have given rise OpEx in Q2 of just under £38 million for a total of £77 million in the first half. We expect that full year operating expenses in 2007 will be no more than £160 million.

In terms of what we are doing on profitability and cash generation, we confirmed in April that we would intend to manage the business to run with the net cash position of about £50 million by the end of 2007. The cash balance at the end of the half is just under £110 million, we have bought back about £46 million worth of shares in the first half and we expect our buyback program to accelerate reasonably significantly in the second half as we move towards our target balance of £50 million of cash. We also of course announced today something that we have flagged in April, which is a doubling of the interim dividend in 2007 over 2006. Both... that announcement of the dividend and the ongoing buyback in the move to lowering that cash balance reflect our confidence in the long term growth in revenues, earnings and cash generation of this business.

Moving to the outlook, we enter the second half of 2007 with a strong order backlog, as we've said, a backlog that has a short in the maturity profile into revenue and we have a healthy opportunity for sales, licensing both in PD and PIPD. Further, we are confident that our royalty revenues will benefit from the generally anticipated up tick in industry conditions in the second half, the impact of inventory correction reduces, foundry utilization rates increase and the momentum behind smart phone sales gathers pace. And as a result, although the pace of improvement in industry is somewhat uncertain, assuming the dollar, sterling exchange rate remains similar to the effective rate that we've seen in Q2 at about 197, we are confident of achieving full year earnings in line with expectations.

With that I hand over to questions.

Warren East - Chief Executive Officer

Operator, we will move over to the Q&A session now.

Question And Answer

Operator

Thank you. [Operator Instructions]. Your first question comes from Gary Mobley from AG Edwards, please ask your question.

Gary Mobley - AG Edwards

Hi guys. I had a question relating to your announcement with Infineon this morning. It's good to see that you guys are penetrating the low end of those phones and I am sure that will fortify your position there at Nokia for Infineon's recent win. But I am curious what sort of additional opportunity you might have in the low end of the baseband market with all the participants perhaps in particular Freescale?

Warren East - Chief Executive Officer

Gary --you know I think the question... well, the reason for the announcement this morning, one of the overlying questions that's been around about ARM is about competitive threat especially at the ultra low cost side. For the most part, the other players out there had chosen ARM for even their low end baseband processor cores. So I don't think there is particularly new opportunity in Freescale for their ultra low cost and in fact, as far as I know at least a good portion of that is already ARM-based.

Gary Mobley - AG Edwards

Okay. And the backlog, overall was down 5% sequentially, what was the split between PD and PIPD?

Tim Score - Chief Financial Officer

The details Gary, so I am bored by reading them all out, but they are... its on page 20 of the slides. The composition at the end of Q2 is just under 50% in Processors and just under 30% in PIPD.

Gary Mobley - AG Edwards

Okay. And as far as royalty pairs go, you add a 4 in the quarter on a sequential basis; units were down roughly 10.5% sequentially. It seems though you guys were hit a bit more than overall industry trends, I know last year you had what a low single-digit sequential decline in Q2 in royalty units, so does make sense that the inventory correction might exasperated that, but 10.5% unit decline seems a bit high. Was there anything exceptional in that number?

Warren East - Chief Executive Officer

You know its in the release we tried to give some color on exactly what areas were hit more, I mean particularly, in Q1 what there is about 30 or 40 million left handsets, so even if you took that at a normal course for handset number, those are big chunk there right there. And actually because of the smart phone penetration, it didn't all come from the handset side. We did see some weakness in things that are typically attached to PC, so things like hard disk drives, and printers and there is just the general kind of post-Christmas season, consumer electronics things like portable audio players, portable media players and digital television. So it was actually, if you look at the individual applications that we did see reductions in from Q1 to Q2, it was quite well spread. But those were the key ones that we saw with that were hit the worse.

Gary Mobley - AG Edwards

Okay. Last question for Tim; any currency hedging in the quarter?

Tim Score - Chief Financial Officer

We have our sort of normal process ongoing Gary, as sort of hedging for quarter and a quarter half out. We haven't changed that policy.

Gary Mobley - AG Edwards

Okay, thank you guys.

Operator

From Corey Tobin from William Blair, please ask your question.

Corey Tobin - William Blair & Company

Hi, good morning guys. A couple of areas I want to touch upon. The first is just really into PIPD, I mean you mentioned in the press release that some of the engineering resources were shifted more toward R&D and therefore, that might have... is interpreted that as... we interpret that as therefore that might have impacted revenue this year. Yes, we also saw backlog down in that segment. So the question is how shall we interpret those two data points? I mean if more resources were dedicated away from activities that would have recognized revenues this quarter and you have backlog which is still down, can you just comment on the overall outlook for licensing in PIPD and also what you are seeing in the pipeline there?

Warren East - Chief Executive Officer

Yes. I mean the simple arithematical answer is that had those engineering resources not been dedicated to move R&D, had they been dedicated to converting backlog to revenue, then we would have delivered more revenue and the backlog would have been eroded somewhat further. There are 3 factors behind the depressed overall revenue; utilization of foundries, and some lumpiness in a deal that wasn't signed before the end of quarter, as we expected it to be signed before the end of the quarter and this reallocation of engineering resource. The backlog itself, you will note that for the most of the quarters they develop 2.5 years, has steadily increased and certainly as of the beginning of this year, it was at a record level of getting on for twice the level of a couple of years ago. So the backlog itself is very, very healthy in PIPD and the fact that some quarters, we erode the backlog and some quarters we build it and that's just... this is the natural event flow of which deal comes, get booked and which ones we can convert to revenue.

Corey Tobin - William Blair & Company

So Warren, I at your commentary that you thought, I believe you said earlier that your demand the same sort of circumstances coming together with respect to PIPD revenue this quarter, in the future I guess implying that we seem to have a low point. Is it safe to assume that you are implying, we are seeing the low point for PIPD revenue for the rest of this year and what is your confidence, if that's the case?

Warren East - Chief Executive Officer

Well, I think we've seen the low point this year because I have confidence in the particular situation that led to the engineering resource being allocated at it was allocated. That was partially customer-driven and we'd actually make no completed that activity and that engineering resource weren't going to that particular job again. So that's given me fundamental confidence. Now, if some of the other reasons get worked, then it's possible of course, but that's not the low point. But we absolutely expect that to be the low point, we expect the royalties to be increased over the next couple of quarters because we can see foundry utilizations being stronger in calendar Q2 this year, which implies stronger royalty that we will be reporting in Q3. And in any quarter, we can have some lumpiness on the booking, but as Tim indicated we got fairly healthy pipeline of opportunities and every now and again some of those opportunities that we expect to close by end of the quarter don't close and that just happened to happen in the quarter that we are reporting. But I am not saying, it can never happen again, I am saying actually this combination of three things hitting at once is actually quite unlikely.

Corey Tobin - William Blair & Company

Understood. And just to round off on this topic, you mentioned I think you said in you prepared comments, Warren three times more ongoing discussions with respect to PIPD. Can you just clarify that? And was that specifically with IDM that you were referring to there?

Warren East - Chief Executive Officer

Yes, that is specifically with IDMs. What we are trying to do with rather than say just increasing traction with IDMs which is essentially what's happening, before we can actually report sales, what are the precursors of sales that we can attach them some quantity tool and so it is like an ongoing discussion with some technical evaluation and there are three times as many as when we added them up and looked what's actually going on now and what was actually going on 12 months ago, its about three times as much as that activity as there was 12 months ago and so that some quantified measure of our increased confidence in the activity.

Corey Tobin - William Blair & Company

I understood, great. Now shifting for a second if I could to the expense side of things, 32% this quarter in terms of operating margin, what's the outlook here as you may be beyond 2007 we are looking at 2008 and you get this full benefit of the rationalization and the increased efficiency programs that you have in place this year where do you expect that to turn to, is high 30 still an appropriate target?

Tim Score - Chief Financial Officer

Yes I mean certainly we have used these results and this common tree and this outlook as being completely consistent with what we said at the analyst day, where we pointed to sort of medium term operating margins sustainable over 40%. I think as I said, we expect this year to have OpEx no more than £160 million. I think as a general rule, we are seeking to grow our cost at a rate no more than half of the growth rate in revenue. Part of that occurs because of the unfolding of this business model as royalties grow and part of it occurs through what we would call, self help, its things like resource balancing where our engineering efforts actually takes place. So there is a number of levers we can pull, both inherent in the business model and in actual proactive management by cost base that can accelerate that leverage.

Corey Tobin - William Blair & Company

Great. Then finally, one more thing, you commented in the earnings outlook in the press release, curious any comment with respect to top line?

Tim Score - Chief Financial Officer

Can you say that again Corey?

Corey Tobin - William Blair & Company

You commented in your press release on your earnings outlook being consistent with what you conveyed before. Any comment with respect to where do you think the top line might come in for the rest of 2007?

Tim Score - Chief Financial Officer

Well, I think the consensus out in the market at the moment is $550 million. We have said, we have grown 11% in the first half, we think the things are going to improve in the second half. We see improvements in royalties, we see improvements in PIPD. I think what we are saying today is that we can't be very certain exactly at the pace at which our royalties pick up in the second half, but what we can be very confident about is irrespective of that trajectory, we feel we can get earnings. And I think if the trajectory is higher than our average assumption, then I think you can expect to see upside based on the lower cost base. I think if the revenue trajectory is a little bit low than our average assumption, then I think we are going to hit earnings because our costs are on a lower trajectory.

Corey Tobin - William Blair & Company

Very good, thank you.

Operator

[Operator Instructions]. There are no further questions at this time. Please continue.

Warren East - Chief Executive Officer

Great. Well, thank you very much everybody and we will be back in October with our Q3 results. Thank you.

Tim Score - Chief Financial Officer

Thanks.

Warren East - Chief Executive Officer

Bye.

Operator

That does conclude our conference for today. Thank you for participating.

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