TIPS

Buy ARM at 90.5p
Says Robert Sutherland Smith of UK350.com - 26/04/08

In the search for fundamental value I was interested to read that an investment analyst at a leading investment bank had concluded that the next ten years estimated stream of royalty income of Arm Holdings (ARM) was, on his 'net present value' calculations and estimates, larger than the current market value of ARM equity. Naturally, these calculations are dependent on the assumptions made and the discount factor chosen; and I am not privy to those. So, noting that they were obviously prepared for a professional institutional client base by an investment bank with a reputation to keep they will have the 'provenance' of reasoned calculation.

Arm Holdings is a market leader in designing 'chips' (or microprocessors, to give them their proper name). Importantly, it is not a manufacturer and does not have the enormous fixed costs required for the fabrication of chips and therefore, none of that operational gearing that is advantageous to equity when demand conditions are strong or firm, but highly disadvantageous when economic conditions are weak - as generally expected to be in 2008.

So ARM is a company for which intellectual property returns are the clue to short term and long term success. Moreover, in the case of ARM Holdings, there is a simple and successful business model at work. Briefly, it licenses its design technology to original equipment makers etc. (referred to as its 'silicon partners') in exchange for a royalty on each gadget produced with Arm intellectual property inside it. It is a business model that has, for example, helped to make Arm a market leader in the provision of RISC microprocessors ('reduced instruction set computing' to give them their full name) for mobile handsets. Its partners appear to like the flexibility that licensing gives them. The proof is in the pudding of the reported fact that ARM technology is the 'main processor architecture' in most mobiles. In other words, ARM is the predominant market leader. And ARM's long term prospects are linked to the growth in future world demand for mobile devices. As more people use them worldwide and if ARM continues to successfully design chips for mobiles with increasing applications (accessing the web, satellite communication etc) then long term growth looks assured.

Late summer/autumn last year, the ARM share price reached 155p. It is now at 88.75p (more than 40% down) close to its lowest level since mid 2003. It was hit by a combination poor results last time, caused in part by a rising cost base and the generally poor outlook for economic demand. Although the company acknowledged its caution about the semi conductor industry generally, when it published its annual results in early February, it expressed qualified optimism about its own prospects. It stated that it looked for 'significant' earnings growth this year (before the impact of currency movements). It also reported its highest ever group order backlog book. Last year underlying 'normalised' earnings per share were reported as being 4.67p; more than twice the reported figure of 2.7p. Given the order book and confident but cautious tone of the last outlook statement, it would be reasonable to look for some uplift on last year's 'normalised' earnings per share figure. The company states that operational gearing this year should, deliver earnings growth 'significantly' higher than revenue growth. Last year, the growth in dollar revenue was 6%. Assuming that Sterling will if anything be weaker against the dollar this year in line with the recent weakness of Sterling against the dollar, I am estimating possible ARM earnings per share of a modest 5p for the current year, putting the shares on that assumption and estimate on a prospective PER of less than  18 times. But it is the value of the present value of future royalty income that indicatively underscores the embedded value of these shares. A BUY

Key Data

EPIC: ARM
Market: Full
Spread: 90.25p -90.5p (0.27%)

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