Is ARM Holdings Stretching Its Limits?

by Ted Leinbach

Is ARM Holdings Stretching Its Limits?

by Tony Daltorio, Investment U Research

Friday, May 28, 2010

Britain's ARM Holdings ADR (Nasdaq: ARMH) seems to have its fingers everywhere.

The world's leading semiconductor intellectual property supplier, it operates a unique business model. The company designs and licenses intellectual property. And that sets it apart from the more typical focus on manufacturing and semiconductor chip sales.

ARM Holdings designs microprocessors for low-powered gadgets. More than 95% of the world's cell phones include its products, as does over 25% of all electronic devices.

That includes digital cameras, power switches, industrial machinery and the Apple (Nasdaq: AAPL) iPad. ARM has even been with the newly crowned "largest tech company" since its founding back in 1990.

The British business has no apparent intention on slowing down anytime soon either. It continues to reach outward into devices such as smartcards, set-top boxes and smart grid devices.

But surprisingly, that probably won't help it much in the long run.

ARM Expands Its Dominion

ARM-designed chips already dominate the mobile phone market and look set to take over the fast-growing, smart meters market next. These new readers indicate how much water, electricity or gas residents of any given home use. And they do it all electronically.

Europe's Accent recently found a way to make them even better through a new line of modular system-on-a-chip processors. Based on the ARM Cortex M-3 processor core, it cuts the number of parts smart meters require by half, and the cost by 30%.

The 32-bit processor can handle far more complex tasks than the 8-bit version found in meters and other grid equipment today. Accent has the enviable position of making processors for Centron meters from industry giant Itron (Nasdaq: ITRI). So ARM has a steady supply of business from that alliance.

It also has good standing with Grid Net, which designs and licenses WiMax smart meters. Grid Net employs ARM processors in its products, which it sells to the global giant, General Electric (NYSE: GE).

ARM's Semiconductor Market Competition

With its dominance in the mobile market and its growing popularity in the smart grid market, ARM Holdings seems to have it made. But appearances can be deceiving.

Concerns have grown around the stock, which trades at a rich 37 times forward earnings for this year. Many in the industry worry about the company's future in the ultra competitive semiconductor market. Despite its reach, generating sizable licensing revenues from its designs has proven tough.

Last year, about 1.2 billion mobile phones sold globally. Of those, 172.4 million were smartphones, which rely on ARM-designed chips at higher rates than usual.

  • Yet ARM's annual revenue was only $489.5 million, largely because it has very little pricing power. It receives only about 1% royalty on each chip that uses its intellectual property.
  • An applications processor chip in a smartphone costs between $15 and $20. So ARM gets a mere 15 to 20 cents. And many of the less complex chips sell for less than $1, generating even less revenue.
  • ARM's average royalty per chip was 5 cents in the first quarter, down from nearly 9 cents in 2004. Despite its best attempts to inch that up to 2%, it has encountered little but trouble.

ARM itself admits that the going is slow. But if it raises its royalty rate too much, chipmakers could start making their own semiconductors again. Qualcomm (Nasdaq: QCOM), for one, easily has the resources to do just that. And many of its competitors and fellow ARM clients can do the same.

The ARMs Race With Intel

Just to make things even more difficult for ARM, one company already designs its own chips. Intel (NASDAQ: INTC) makes the x86 - among others - which most of the world's computers use.

And Intel keeps notching up the competition further.

It has recently developed low-powered, Atom-branded chips that could replace ARM-based semiconductors in mobile phones. So far, it has only sold such technology for net-books and small, low-powered, portable computers. Mobile phones require much greater power efficiency than the Atom chips have given in the past.

But that could all be changing. Intel's latest attempt reduces energy consumption by 50 times... very close to what ARM's product uses.

To combat all of that, ARM has moved into Intel's traditional computing territory. For one, Marvell Technology (Nasdaq: MRVL) recently announced its plans to start shipping an ARM-based chip for computer servers later this year.

And the two chipmakers will go head-to-head for inclusion in tablet computers around the same time. While ARM has secured its spot in Apple's iPad, much of the competition may opt for Intel.

In part, that simply comes down to the fact that the Microsoft (Nasdaq: MSFT) Windows operating system doesn't work on ARM devices. Fortunately though, Linux and the Chrome system from Google (Nasdaq: GOOG) do.

Unfortunately, ARM Holdings shouldn't hold out much hope for better pricing power anytime soon. The company will still generate meager revenues from licensing. And its stock - already richly priced - isn't likely to see gains from here.

Good investing,

Tony Daltorio

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