More on ARM
ARM Holdings
Embedded microprocessor designer ARM performed well in 2004 with revenues up 19% and EPS more than doubling. Its performance has been overshadowed by the expensive takeover of Artisan. What most concerns us about the takeover is not the premium that ARM has paid but the lack of apparent synergies which suggests a shift in focus from organic to acquisitive growth and may signal a lack of confidence in the company’s growth prospects. There are no technological synergies that required the merger (licensing in would have sufficed), sales synergies seem unlikely given the different customer bases, and there is certainly no room for cost savings. So far every indication is that this is a shareholder value destroying move, that has been reflected in the share price since it was announced.
Revenue growth has returned and margins are stronger. We are somewhat concerned about pricing. Per unit royalties are down this year, although they recovered last year the long term trend has been firmly downwards. So far volume growth has more than compensated for lower prices but once the market matures this may not be true, in other words, ARM may eventually (and this is admittedly still a long way off) move from high growth to decline rather than stability or low growth.
In 2004 royalty revenues (from sales of products using ARM technology) were greater than licensing revenues (from new customers, or singing up existing customers for more products). Licensing revenues are both an important source of revenues in its own right (approx 39% of revenues), and a leading indicator for roylaty revenues (approx 40% of revenues). The growth rate of licensing revenues was relatively subdued at 17% which we beleive is an early indication of ARM reaching maturity.
The company argues that the comparative stability of per unit roylaties over the last three years suggests that there is no indication of a long term downward trend in prices. We are not convinced: Firstly, looking at rates over the longer term the downward trend is clear. Secondly, ARM relies on moving customers to new generations of its technology to maintain royalty rates (rates on older technology will inevitably fall). The low growth in licensing suggests that this may be more difficult to do than in the past.
The other danger is that of new products in its key markets - ARM is strongest in battery powered devices that require high performance but low power consumption such as mobile phones and PDAs. There are players in the PC processor market (IBM and Transmeta for example) who compete with ARM in some market segments and whose technologies could be extended further into ARM’s low power consumption core market. Similarly microcontroller manufactures are beginning produce more powerful devices, and they have experience of similar requirements, albeit a lower down the power scale than ARM.
However these are long term threats and we think it very unlikely that ARM’s market share will be threatened in the medium term. ARM still has a strong position in the higher end of the embedded processor market, and a dominant position in some key segments such as mobile phones. Its business model is proven and licensing cores rather complete processors provides a level of flexibility needed by its market - but this model is now being copied.We are very confident about the long term growth of the embedded processor volumes and medium term growth in revenues.
The prospective PE of 26× (at 104p) is not unreasonable given that strong medium term growth is reasonably safe. We are concerned about the long term but even there ARM’s proven strong competitive position and technology are reassuring. Our biggest concern is the price paid for Artisan the implication that the company is prepared to buy acquisitive growth at high prices.
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