ARM Holdings (NASDAQ:ARMH) dropped a stink-bomb on the chip industry yesterday as CEO Warren East noted that the firm was readying for a slowdown in the mobile chip industry. To fuel the fire, Deutsche Bank downgraded ARM Holdings to "Sell" from "Overvalued" on fears that Intel (NASDAQ:INTC) is threatening its turf.
While ARM's sky-high valuation of 50x earnings (it was 54x before the report) makes it a very easy short target in light of the looming threat from x86-based chips in the tablet and smartphone arenas, it is important to note, as I did in my July article, "ARM Holdings Isn't The Best Way To Play The ARM", that ARM Holdings isn't the best way to play the growth in the mobile revolution.
To reiterate, ARM only sells intellectual property and collects a license fee, while the ARM SoC vendors make the big bucks selling full system-on-chip solutions to the device vendors. These vendors also trade at much more attractive valuations. I strongly urge that investors who believe in the actual SoC vendors for the mobile space consider the following companies whose share prices have dropped considerably in sympathy to ARM's announcement:
1. Nvidia (NASDAQ:NVDA)
Nvidia recently reported a blow-out quarter in which it beat analyst estimates and issued guidance well above what analysts were modeling.
Fears surrounding the discrete graphics chip business for desktops and notebooks were quelled as the firm reported 15% sequential growth in the graphics segment. Further, the firm has a very strong lineup in the professional/HPC segment and expects that "Tesla" products based on a faster version of the current "Kepler" chip to be released later in the year.
More pertinently, Nvidia's "Tegra" business -- the mobile SoC for smartphones and tablets -- finally saw a nice boost in the most recent quarter, laying to rest fears of viability in the segment. Design wins in Microsoft's (NASDAQ:MSFT) "Surface," Google's (NASDAQ:GOOG) "Nexus 7" tablet, and the potential announcement of a win in Amazon's (NASDAQ:AMZN) upcoming successor to the "Kindle Fire" could prove to be significant positive catalysts here.
While the P/E ratio is about 17, the firm has a substantial cash position, which makes the valuation even more attractive at 10.3x earnings ex-cash.
2. Qualcomm (NASDAQ:QCOM)
Qualcomm has been a solid performer with excellent growth. There's not much to be said here: the firm's Snapdragon S4 is an incredible performer, the firm has seen double digit revenue and earnings growth over the last several years, and it has a rock solid balance sheet.
Qualcomm will benefit from Windows RT based tablets, as its products are particularly well positioned from a performance and performance per watt standpoint. Further, Qualcomm is one of the few system-on-chip vendors that provides a quad core solution (and each of Qualcomm's cores blows away the current ARM Cortex A9 designs that power Nvidia and Samsung's quad core solutions). Qualcomm further benefits from its dominant position in the cellular baseband chip arena, with 45% market share.
For a more detailed view of the long case, see my recently published, "Qualcomm: A Fundamentally Strong And Undervalued Company".
While not an ARM player, Intel is actually one of the main reasons that Deutsche Bank downgraded ARM. Intel is finally posing a serious threat to the ARM ecosystem.
While I expect Nvidia, Qualcomm, and Texas Instruments (NYSE:TXN) to continue to collectively hold the lion's share of the smartphone chip business, the Intel threat can no longer be ignored. Intel's vertical integration, from design to manufacturing, allows the chip giant to enjoy higher gross margins than its fabless, ARM-licensee peers. Further, Intel's vertical integration gives it a quicker time-to-market over ARM-licensees, which could significantly bolster the firm's competitive advantage going forward.
On the tablet side, I expect Windows 8 tablets to be quite popular due to compatibility with legacy software and the simultaneous blend of a touch-friendly UI and a traditional notebook/desktop UI. While compatibility with legacy Windows software designed for x86 chips will become less important for users going forward, this could be the factor that tips the scales in favor of Atom based tablets over ARM based ones in the low end, assuming the price delta is minimal.
In short, ARM's valuation is so sky high that, of course, any bad news on the growth front can and should cause a significant drop in share price. But the solid, more modestly valued companies listed here still stand to gain as tablets and smartphones see secular growth, since these firms make significant money selling the chips.
ARM's problem is that everybody already has an ARM license, so the growth opportunities are muted, hence significantly threatening the high valuation.
Disclosure: I am long INTC, AMD, NVDA. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.