What’s Causing ARM Holdings Downgrades?

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ARM Holdings (NASDAQ: ARMH) seems to be losing favor with analysts. Over the last few days, the stock has been downgraded by prominent analysts including Morgan Stanley, Piper Jaffray and UBS AG. All three of them now rate the stock as ‘Neutral’ down from Buy. While the company is able to maintain its competitive edge in the chip market, the downgrades have more to do with the stock’s current valuation than with the operating fundamentals of ARM Holdings.

ARM Holdings recently hit its 12 years high price mark and is currently trading at a P/E ratio of 80, so it is natural that the stock’s lofty valuation is being questioned, and the future upside potential seems to be a bit limited. While ratios are a good stepping stone for evaluating a stock, these are not everything, and any good investor should certainly look beyond these very obvious indicators. ARM Holdings is all set to report its earnings on Feb. 5 and analysts are expecting the company to report earnings and revenue growth in low double digit percentages.

The interesting point about the ARM downgrades is that none of the analysts have actually cast any doubt on the future potential of the company. Their downgrades are valuation calls and have been triggered by the consistent rise of the stock price only. Looking at the business model of the company, ARM Holdings is in a rather unique position vis a vis its peers. The company does not manufacture chips by itself, thus saving itself the costs associated with machines and physical inventory. It derives its revenue by licensing out its processor technology, which more or less forms the backbone of mobile computing. In this way, the company fortunes are inextricably linked to the performance of tablet and smartphone segments. Looking at the trends in these segments, it is safe to assume that tablets and smartphones are only going to grow in influence, at least in the short term.

While ARM Holdings currently commands a lion’s share in the mobile computing chip segment, it has to watch out for growing competition from the likes of Intel (NASDAQ: INTC). Intel is an undisputed leader in the chip segment and has indirectly contributed to the rise of ARM Holdings by ignoring emerging mobile computing trends. However, sooner or later, it is going to amend the past mistakes and seems to be already on its way as it showed off its latest offerings during the recently concluded CES in Las Vegas. Intel demoed its low cost mobile processor Z2420, which is likely to be lapped up by the smartphone companies for their lower end units. These entry level smartphones are big sellers in emerging markets such as India, China and Africa. If Intel is able to get hold of this sub-segment, it may as well use the synergies to increase its influence to upper level phones.

Intel also has the brute force to quash ARM Holdings. The British company, while a market leader in its segment, reported its latest revenue at $785 million, which looks like pocket change in comparison to Intel’s 2011 revenue of $54 billion. Intel is also having a fresh look at its Atom processors to compete with ARM Holdings. Atom was initially designed for netbooks. Since the advent of tablets and smartphones annihilated the netbooks segment, Intel is looking to adapt the processors for tablets. With its strong R&D approach, it is highly likely that Intel can become a formidable competitor to ARM Holdings in a very short time period.

On the other hand, ARM Holdings is expected to benefit from Microsoft’s (NASDAQ: MSFT) stamp of approval. Microsoft’s new Surface tablet is designed to run on ARM chips as well. It is also being rumored that Apple is looking to move its laptops and desktops from Intel to ARM based processors. While the company is not very gung ho about Microsoft tablets, it is excited about the ARM version of Windows 8. ARM Holdings is also widening its horizons beyond smartphones and tablets. It is planning to increase its foothold in the smart appliances segment. While smart appliances like TVs etc. have yet to gain traction, ARM Holdings’ strategy can provide it early entrant advantage. This will also help the company in diversifying itself and gaining scale. Basically, the company is betting on its USP of lower power consumption and is looking to incorporate their design in all sorts of micro-chipped appliances.

Analysts have justified their rating downgrades by pinning them on stretched valuations. But at the very same time, ARM Holdings does have a clear and viable road plan. In the short term, the stock may see pullback, but existing investors can rely upon ARM Holdings.


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