An external perspective
ARM as an investment
the five-year view.
It makes sense for investors to take a long-term view of ARM. One of the reasons why the company has been outperforming the semiconductor industry for so many years, and has proven so resilient through the downtown of 2008 and 2009, is that it has been steadily gaining share in long-term structural growth markets. A quarterly view of the business simply won’t show this – nor will it provide the true picture regarding the slow-burn process of designing a processor, licensing it to leading semiconductor companies and, years later, receiving royalty revenues as chips move into volume production.
So what is the outlook for ARM between today and 2014? Let’s look at the fundamentals of the business from an investor’s perspective, and then examine the opportunities and challenges facing the company during the years ahead.
The ARM model
ARM enables companies across the semiconductor industry to outsource the complex and costly process of designing processors. The company provides a ‘manufacturer-agnostic’ design of a processor, spreading the cost of research and development across the companies who licence the design. This was a revolutionary idea 20 years ago. ARM’s success has been built on making this idea accepted and attractive across the semiconductor industry, initially for chips going into mobile phones and, increasingly, for chips going into other end-markets.
The ARM investment case
ARM has a number of key attractions from an investor’s perspective.
First, it enjoys exposure to a range of markets characterised by long-term and ongoing structural growth. Mobile phones in general, and multi-function, internet-enabled ‘smartphones’ in particular, are a key example of such growth.
ARM’s intellectual property already features in the majority of mobile phones in the world. The explosion of smartphones has provided a turbo-boost to ARM’s revenues, because these devices contain more ARM-based chips than traditional handsets. Indeed, ARM generates six or seven times more revenue from a typical smartphone than from a standard voice-only handset. This growth in smartphones looks set to continue for many years to come.
The second attraction for investors is the fact that ARM has been steadily gaining share in markets beyond mobile phones – a trend that is highly likely to persist, thanks to the ongoing proliferation of increasingly sophisticated devices such as digital TVs, cars, white goods and industrial applications.
Third, ARM is the incumbent of the industry and faces little, if any, direct competition. ARM’s main indirect competitors are its own customers, because some continue to use their own proprietary processor designs rather than license ARM technology. However, as end-markets require ever-more sophisticated chips, the costs of maintaining a proprietary design continue to increase, making ARM technology ever-more attractive.
Now the fourth attraction: ARM continues to increase its profitability. Operating margins currently stand at around 30% with most analysts expecting them to reach 40% over the medium term.
Fifth, ARM has a strong track record of returning cash to shareholders. This record is not expected to be interrupted as the company focuses on key areas of growth, as explained below.
Finally, the last but not least attraction: the company’s management team is deeply experienced and widely respected. As one analyst covering ARM simply puts it: “people trust the management team to continue to deliver into the future.”
There are three clear opportunities facing ARM over the next five years, which are set to improve the firm’s market share and increase its profitability.
Opportunity number one is the continued growth of the smartphone market. Every smartphone contains multiple ARM-based chips, and as smartphones become more advanced, the number of ARM-based chips per phone increases. In 2009 the average mobile phone handset contained an average of 2.1 ARM-based chips, up from 1.9 in 2008. This figure is set to rise further, as more handsets incorporate more complex functionality.
Making deeper inroads into other digital technology markets is the second key medium-term opportunity. As a wide range of digital devices, from TV set-top boxes to smart energy meters, become more sophisticated, ARM, having honed its expertise at producing smart, low-power processors, enjoys a wide range of other growth opportunities.
The mobile computing market – comprising devices such as netbooks, electronic books and ‘tablets’ – is an adjacent market with rich potential for ARM. Alongside the main applications processor, these devices also contain multiple chips controlling a range of functions including wireless internet access and data storage. ARM has an opportunity to capture increasing royalties for these peripheral chips in every mobile computer. The market for main applications processors in mobile computers is then the next nut for ARM to crack. This is an area featuring a formidable competitor in the form of Intel.
Expansion of ARM’s physical intellectual property division (PIPD) is the final major opportunity for the business. ARM has been licensing its processor technology since 1994, and the company believes that the licensing of physical IP – the design of logic libraries, memory compilers and other technologies – is the next big trend. It will take a few more years before it becomes clear how strong this trend will be – but the potential is widely seen as substantial.
Ask analysts to name the biggest medium-term risk facing ARM, and most will respond with one word: ‘Intel’. The world’s largest chip company has made it clear that it wants to make inroads into the ARM-based mobile device market, and the launch of its new Medfield chip, due in 2011, will give it a springboard for putting these aspirations into practice.
ARM responds to this threat by highlighting that while ARM technology is already moving into Intel’s mobile computing heartland, Intel technology is not yet ready to move into ARM’s low-power, high-performance smartphone heartland. Yet Intel will undoubtedly try to push into ARM’s territory during the years ahead – and the days of ARM’s 100% penetration of applications-processors in smartphones are clearly numbered.
Currency movement is a shorter term potential risk. Ninety five per cent of ARM’s revenues are generated in dollars, yet the firm reports in Sterling. The Dollar/Sterling exchange rate therefore has a material impact on earnings and profitability. This is certainly an irritation, from some investors’ point of view, as it can rob the business of some of its growth in the nearer term.
There are other potential hazards, too. What if smartphones do not proliferate as fast as expected, or if ARM does not grow market share in consumer electronics and embedded products? What if the physical IP market fails to take off? What if there is another global slump in consumer demand for electronic products?
Fundamentally bright outlook
Despite the potential hurdles, analysts are overwhelmingly upbeat about the five-year outlook for ARM. After all, the company is the world’s number-one provider of semiconductor IP. It has strong positions in a number of long-term structural growth markets, including smartphones, microcontrollers and consumer electronics. ARM’s business model remains unique and free from direct competition. Profits are growing, while cash is being returned to shareholders.
ARM has been outperforming its sector for a number of years, and the direction of that sector clearly plays to the business’s strengths.
Scott Payton is a freelance business and financial journalist. He is former editor of Real IR, the pan-European investor relations magazine, and Business Voice, the Confederation of British Industry’s magazine. He has written this article to provide an independent view on ARM as and investment opportunity.
- The world's number one supplier of semiconducter IP
- Strong track record of returning cash to shareholders
- Taking on the Intel challenge
Number of chips shipped (billions)