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I am a hedge fund analyst who has also worked on the sell side and within a derivatives house. I enjoy looking into the finer details of companies and put a little less weight on technicals. ...and no, the picture isn't me but a notable politician, and yes Mr. Samaras has been replaced! I am... More
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  • At ARM's Length? 0 comments
    Mar 18, 2013 1:12 PM | about stocks: ARMH

    Over the past few years, ARM's share price action has been nothing short of remarkable.

    (click to enlarge)

    Because of sleeping giants such as Intel. ARM spotted an opportunity in the processor market as old style processors (typically powering mains connected gadgets) were not particularly efficient enough to power a viable mobile gadget.

    Furthermore, instead of selling the finished product, ARM shook the processor market by focusing on simply designing the processor and then giving tech companies free access to their state of the art technology with a royalty fee per unit in return (they also have licensing deals for the initial development). This meant that smaller companies could stop worrying about the processor arms war because they had continual access to the cutting edge technology for a reasonable price dependent on their own success!

    ARM spent £134m on R&D in 2012 and this money effectively save the semiconductor industry £134m * the number of technology producers in the market per year. Furthermore, their licensing partnerships allow companies to take the finished product and tweak the design into whatever form they require it, as it is their job to take those designs to the foundry to be built.

    Since 2004, with a concentration on mobile efficient processors and a cheap and novel business model, ARM captured 95% of the entire mobile market!!! Intel, is nowhere to be seen. Even more amazing is the fact that 8.7bn ARM chips were produced and sold in 2012 meaning that 36% of the world's production of processors were ARM processors.

    Rightly so, the company exploded and even in the past five years, the price has risen from 100p to near 1000p and trades at 45x PE13.

    Now, as I stated in an earlier article about corn, it is very dangerous to call tops in stocks with such strong momentum but I thought I would see what the price target actually implied at the business level.

    Using one of the more bullish analysts, I recreated his DCF model coming out at 1081p. It involved his FCF assumptions for 2012 - 2015, a 20% growth of FCF for the next 7 years, followed by a terminal growth of 5%. My WACC stands at 8.33%. Here it is: ARMDCF.

    (click to enlarge)

    Just to make it clear, you can adjust all of my estimates to price your own model but the interesting part of this assumption lays on the non-dcf page, were I extrapolate what this price means in the real world.

    When the firm say that 8.7bn Arm chips were sold, this is attributable to the royalty division of the company. By dividing the royalty revenue, by the number of chips, we get a revenue of 4c per chip.

    With the licensing department, I have assumed that they will continue to add an additional 100 license partners per year each adding £210k in revenue.

    The 'other' section has been made to increase by £4m per year.

    By making the above assumptions, I can come up with a realistic assumption as to how many chips sold each year belong to the ARM family. As you can see under the bull case scenario, ARM would control 90% of the world processor market. This is simply not true.

    It is obvious that I have made the initial model too bullish and one of the methods of revenue that the company have actively gone after is an increasing share of their customers wallet. So let's assume a growth in rev per chip of 0.5p per year as well as a slowing license partner growth. In 2020, they now have 50% of the total processor market which is pretty high but it is reasonable considering their current position. Of course, we are now assuming that chips don't decrease in value (which they do) but anyhow, we want to see what assumptions the bulls have.

    The final point of contention is the processor growth market. At last count the mobile processor market grew at 17% and according to the most bearish broker, this was the source of 77% of the firm's royalty revenue.

    According to Gartner, of the 1.7bn phones sold last year, 1bn were smart-phones and they believe that this penetration will increase at a slower 3% per year.

    The DCF

    Looking at the model as opposed to the market sizing, any slow down will materially impact the performance. For example, if we drop the stage 2 growth rate to 15% the price target drops to 840p (10% drop) while the 2020 market penetration would still be 70%.

    There is no doubt that ARM is a great company. It is one of the great disruptive firms of the digital age and their strong business model is no way near to being copied, BUT despite the strength of the company, it does have a value. I can't resist a good meal of BBQ ribs but I'm not going to pay £200 for them!

    It is time to pay close attention to the quarterly figures as any miss to their highly bullish estimates will lead to a wave of profit taking and a very real profit opportunity.

    Good luck

    Disclosure: I have no positions in any stocks mentioned, but may initiate a short position in ARMH over the next 72 hours.

    Themes: semiconductors Stocks: ARMH
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