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You Can Still Make Money on ARM Holdings

By: SeekingAlpha
Posted: 7/6/2010 6:30:00 AM
Referenced Stocks: AAPL;AMZN;ARMH;BKS;GRMN;INTC;LF
Bruce Schrader submits:

Introduction

In recent months, a few contributors have written about ARM Holdings plc (LSE:ARM, in the United States as an ADR NASDAQ:[[ARMH]]); they have mostly focused on the use of ARM chips in 'hot' technology (see e.g. Greentech Media ).

Each of these articles is a good read and drives home the point that ARM chips are in a lot of devices. However, today, I would like to take a slightly broader view and look at ARM as a whole taking a little closer look at the company's financials. SPOILER ALERT: despite its 70x trailing 12 month earnings I still think you can make money on ARM.

About ARM

ARM designs what is called "system-on-a-chip"; which means, unlike in your computer, all the computing is done directly on the chip (this is not how a typical Intel Corporation ( INTC ) chip works, the technological specifics are beyond the scope of this article.)

There are two important facets of the above comment.

First, is the concept that everything is done on the chip. This means that devices can be made smaller and more energy efficient. Therefore many companies, such as Apple Inc. ( AAPL ) , Nintendo Co., Ltd (TYO:7974, as an ADR in the US PINK:[[NTDOY.PK]]), GPS manufacturers (Garmin Ltd. ( GRMN ), Tom Tom etc.), and ebook manufacturers (Kindle, Sony (TYO: 6758, NYSE: [[SNE]]) and Barnes & Noble ( BKS )) all use ARM technology. A less than complete list of devices that can be found on ARM's website (it is a long list).

Second, and what I consider most important, is that ARM designs the chips. They don't make the chips. This means the costs to ARM are low, the return on capital is solid and the cash flow is excellent. ARM passes the cost and complexity of manufacture to others.

Essentially all of the revenue ARM generates is either going to selling additional chips (either R&D or SG&A) or it is going right to the bottom line; this ability to generate cash flow is what makes ARM such an interesting company, especially compared to its peers. Add to this growth and you find a nearly perfect company, which if priced right could be a perfect investment opportunity.

In other words, when my Mac 'fanboy' friends bought the iPad a portion of that sale went right to ARM; likewise a portion of the sale of their new iPhone 4 will go right to ARM. If your friends are not Mac fanboys they may be gamers, and luckily Nintendo is coming out with a new Nintendo 3DS, which according to many will, as did the previous system, use an ARM chip. Just as the iPod created a mini music revolution, Amazon.com, Inc.'s ( AMZN ) Kindle is creating a reading revolution, so if your friends are not fanboys or gamers they'll likely own a Kindle, which of course uses the ARM chip. Even my 4-year-old niece owns an ARM chip in her Leapster by LeapFrog Enterprises, Inc. ( LF ). The point is pretty soon everyone will be walking around with at least one ARM chip and each of these chips makes ARM that much more of a compelling story.

The Numbers

Starting with what I have discussed already.

(1) ARM is a growth story. From FY05 to FY09 it has increased the number of licenses it has sold by an average annual rate of 13%. This means, on average, the number of t ypes of devices that use the ARM chip increased by 13% per year. Likewise the number of actual devices that use the ARM chip has increased on average by 23% per year. This average is more remarkable given that in the last year FY09 (e.g. coming off the recession) the sales of devices with ARM chips were flat. All this has led to an increase in dividends of, on average, 30% YoY from FY05 to FY09.

(2) ARM is a cash flow story. As noted above, ARM's sole function is to research and sell its technology. Therefore the company has been able to maintain remarkably high gross margins. Last year, FY09, the gross margin was 91.6%, and has shown consistent improvement over the last 5 years. This allowed the company, in FY09, to generate over 7 pence a share in cash flow from operations. This CFO provides a large cushion for their 2.5 pence dividend in FY09. Additionally, just over 8.6 pence/share is reinvested in ARM in the form of R&D. Given the high level of growth ARM has recently seen, management's choice to reinvest in the company is the logical one. The only black spot is that ARM has recently trended toward holding cash in short term investments. In FY08 ARM had nearly nothing invested in short term investments, however for FY09 this trend reversed and now the company has invested over £105M. Worst yet, the company is making a paltry 1.6% return on these investments. For the latest quarter this investment trend has continued as more than £40M has been added to the short term investment account.

(3) Despite a slow year ARM, in FY09 was able to generate a ROIC (as calculated by income before tax divided by equity less cash and cash equivalents) of over 9%. Likewise in FY08, when earnings were better, the ROIC was nearly 11%.

Investing in ARM is appealing for additional reasons:

Earnings

ARM generates its earnings in one of two ways. It grants licenses so that other companies can use the ARM chipset. These are onetime fees charged to companies that wish to use an ARM Chip. ARM also takes in, as a royalty, a payment each time an ARM chip is made. The size of the royalty and the license payment are negotiated with each customer. Although it has been decreasing recently, for each new license granted ARM has received on average £1.5M. ARM has stated that it uses these large upfront payments to help offset R&D and the SG&A. Therefore as more licenses are granted (up 13% from last year) ARM is able to reduce its licensing fee and still offset the R&D/SG&A expenses.

The royalty fees are what make ARM really shine. Unlike the license fees which are one time only, the royalty fees are received every time someone buys a product with an ARM chip. And because of the way technology works, the device manufacturer would need to introduce a new generation before switching away from the ARM chip. To be clear, unless Amazon makes a new generation Kindle, they are stuck using the ARM chip; the technology itself creates a barrier that protects market share.

The chart below shows that the average royalty ARM receives is around 4p/chip.

2005

2006

2007

2008

2009

Royalty Revenue (m)

87.8

107.8

104.1

147.7

155.4

chips (m)

1700

2400

2900

4000

3900

Revenue/chip

0.051

0.044

0.035

0.036

0.039

The royalty revenue per chip has been decreasing from 2005 to 2008, however has ticked up in the last year, in part due to a new chip which ARM can charge a higher royalty for.

ARM has been able to grow its earnings based on the number of ARM chips in use. The number of chips in use has increased because of the number of devices being purchased and because the newer devices being purchased contain more chips. Where a simple mobile phone requires one chip, the more advanced smart phones require 5 or 6 chips, meaning ARM's royalty revenue is 6x greater for those phones. With a secular shift to smart phones ARM should continue to see growth.

ARM expects that by 2014, 29B chips will be shipped in the segment. ARM currently has a 25% market share. Assuming the trends of the past continue and that ARM is correct about its 29B estimate, ARM should be trading at approximately 338.50 pence. Based on the current price of 270.50 pence, purchasing ARM now provides you with a 25% margin of safety.

(I have projected ARM's earnings based on the trend in chip sales, royalties and margins)

Base Case

2008

2009

2010E

2011E

2012E

2013E

2014E

Revenue

298,934

305,022

348,957

399,390

449,707

501,777

555,020

Cost of Revenue

-32,878

-25,471

-39,236

-42,270

-44,820

-46,850

-51,028

Gross profit

266,056

279,551

309,720

357,120

404,887

454,927

503,993

R&D

-87,588

-112,215

-115,156

-131,799

-148,403

-165,586

-183,157

SG&A

-118,525

-121,722

-139,583

-159,756

-179,883

-200,711

-222,008

Total operating expenses

-206,113

-233,937

-254,738

-291,555

-328,286

-366,297

-405,165

Profit from operations

59,943

45,614

54,982

65,566

76,601

88,630

98,828

Other

3,246

1,645

1,645

1,645

1,645

1,645

1,645

Profit before tax

63,189

47,259

56,627

67,211

78,246

90,275

100,473

Tax

-19,597

-6,820

-14,157

-16,803

-19,562

-22,569

-25,118

Profit for the year

43,592

40,439

42,470

50,408

58,685

67,706

75,355

Average Number of Shares

1,265,237

1,266,624

1,266,624

1,266,624

1,266,624

1,266,624

1,266,624

Terminal Value

EPS

3.40

3.20

3.35

3.98

4.63

5.35

5.95

318.27

Discounted value

338.43

Current Price

270.5

Margin of Safety

25%

*This assume a 4.5% discount rate and that after 2014 ARM grows with inflation at 3%.*

As a reality check, if ARM's market share remains constant but keeping everything else the same ARM still appears to be about 14% undervalued.

Conservative Case

2008

2009

2010E

2011E

2012E

2013E

2014E

Rrevenue

298,934

305,022

341,477

383,065

410,373

465,617

521,101

Cost of Revenue

-32,878

-25,471

-39,236

-42,270

-44,820

-46,850

-51,028

Gross profit

266,056

279,551

302,241

340,796

365,553

418,767

470,074

R&D

-87,588

-112,215

-112,687

-126,412

-135,423

-153,654

-171,963

SG&A

-118,525

-121,722

-136,591

-153,226

-164,149

-186,247

-208,440

Total operating expenses

-206,113

-233,937

-249,278

-279,638

-299,572

-339,900

-380,404

Profit from operations

59,943

45,614

52,963

61,158

65,981

78,867

89,670

Other

3,246

1,645

1,645

1,645

1,645

1,645

1,645

Profit before tax

63,189

47,259

54,608

62,803

67,626

80,512

91,315

Tax

-19,597

-6,820

-13,652

-15,701

-16,907

-20,128

-22,829

Profit for the year

43,592

40,439

40,956

47,102

50,720

60,384

68,486

Average Number of Shares

1,265,237

1,266,624

1,266,624

1,266,624

1,266,624

1,266,624

1,266,624

Terminal Value

EPS

3.40

3.20

3.23

3.72

4.00

4.77

5.41

289.25

Discounted value

307.60

Current Price

270.5

Margin of Safety

14%

Debt

One final note before concluding; ARM carries with it no long term debt. Except for some short term trade liabilities the company is debt free. This means that there are no interest payments to hinder the company's ability to generate its cash flow. This makes for a remarkably safe company.

Conclusion

By buying ARM at its current price, you are buying a strong company, with no debt, good growth and high earnings and cash flow on nearly no capital expenditures. You're buying a company that is able to consistently produce cash flow with very little solvency risk and buying a company, that in the near term is protected from competition. You are also buying into the smart phone hype, the iPad hype, the e-book hype and very likely will be buying into the portable 3D game system hype. If just a few of these 'hypes' meet their expectations, ARM should continue to see growth and excess returns.

Disclosure: I have a small position in ARM

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